Lease Evaluation: The Lessor’s Angle

Lease Evaluation: The Lessor's Angle

This topic concerns how a lessor (the entity owning the asset and renting it out) determines the profitability and feasibility of offering a lease. It's about pricing the lease correctly and managing risks to ensure a worthwhile return on their investment. Essentially, it's the mirror image of how a lessee evaluates a lease, focusing on the lessor's gains.

Key Concepts Covered:

• Break-Even Rental: The minimum rental amount the lessor needs to charge to cover their costs (asset cost, direct expenses, etc.) and achieve their minimum required rate of return. This acts as a floor price.

• Gross Yield: A pre-tax measure of the profitability of the lease, calculated as the discount rate that equates the present value of lease rentals and residual value (estimated value of the asset at the end of the lease) to the initial investment cost.

• Risk Assessment: Identifying and managing risks associated with the lease, such as:

  • Default Risk: The risk that the lessee will fail to make payments.
  • Residual Value Risk: The risk that the asset's value at the end of the lease term will be lower than anticipated.
  • Interest Rate Risk: The risk that changes in interest rates will affect the lessor's cost of funds.
  • Political and Currency Risk: Relevant for cross-border leases, these concern instability in the lessee's country and fluctuations in exchange rates.

• Setting the Price considering riskThe return that a lessor desire depends up on several factors ,including the type of asset ,risk and also depends on the prevailing interest rates.

Example:

Scenario: ABC Leasing Company is considering purchasing equipment for ₹500,000 and leasing it to XYZ Manufacturing. They require a gross yield of 15% pre-tax. The lease term is 5 years, and they estimate a residual value of ₹50,000 at the end of the lease. They incur initial direct costs of ₹5,000.

Calculation (Simplified):

To find the approximate annual lease payment, we need to solve for it (L) in this equation: 500000 + 5000 = (L / (1.15)^1) + (L / (1.15)^2) + (L / (1.15)^3) + (L / (1.15)^4) + (L / (1.15)^5) + (50000 / (1.15)^5)

Solving this (using a financial calculator or spreadsheet software) we get :

L = ₹144,404.85 (Approximate annual lease payment)

This ₹144,404.85 represents the approximate annual lease payment that ABC Leasing Company must charge to achieve their 15% gross yield. The important note is that this is before taking into account the applicable taxes.

Question with Solution:

Question: Alpha Leasing is evaluating leasing machinery to a company which requires a 12% pre-tax yield and following information.

• Machinery Cost: ₹1,000,000
• Lease Term: 5 years
• Estimated Residual Value: ₹100,000
• Initial Direct Cost: ₹10,000
• Company follows Effective Rate of Interest method What will be the annual lease rental for a 12% yield?

Solution: Let the Annual Lease Rental be Y.

Therefore the gross yield on the lease is

1000000+10000=Y(PVF(12%,1)+PVF(12%,2)+PVF(12%,3)+PVF(12%,4)+PVF(12%,5)) + 100000(PVIF(12%,5))

1010000=Y(3.604) +100000(.5674) 953260=Y(3.604) Y= ₹264499

Therefore annual lease rental should be ₹ 264499 for a 12% yield.