There are three parties to the transaction (i) the lessor (equity investor), (ii) the lender and (iii) the lessee. In such a lease, the leasing company (equity investor) buys the asset through substantial borrowing, with full recourse to the lessee and any recourse to it. The lender (loan participant) obtains an assignment of the lease and the rentals to be paid by the lessee as well as first mortgage assets on the leased asset. The transaction is routed through a trustee who looks after the interests of the lender and lessor. On receipt of the rentals from the lessee, the trustee remits the debt service component of the rental to the loan participant and the balance to the lessor.
To illustrate, assume the Hypothetical Ltd (HLL) has structured a leveraged lease with an investment cost of Rs 50 crore. The investment is to he financed by equity from the company and loan from the Hypothetical Bank Ltd (HBL) in the ratio of 1:5. The interest on loan may be assumed to be 20 per cent per annum, to be repaid in five equated annual installments the required rate of return (gross yield) of the HLL is 24 per cent, calculate (i) the equated annual installment and (ii) the annual lease rental.
(j) Equated Annual Installment to HBL:
Given HLL's required rate of return of 24 per cent, (X - Rs 13.4 crore) x PVIFA (24,5) - Rs 10
Like other lease transactions, cruises lilt to claim tax shields on depreciation and other capital allowances on the entire investment cost, including the non-recourse debt. The return on equity (profit after tax divided by net-worth) is, therefore high.
From the lessee point of view, the effective rate of interest implicit in the lease arrangement is less than on a straight loan as the portion of the tax benefits, in the form of lower rental payments, to the lessor. Leveraged lease packages are generally structured for leasing investment intensive assets like aircrafts, ships and so on.