 To get maximum benefit from the lease contract, LESSI and LESSIR tries to determine the related cash flows and then they discount these cash flows at their respective cost of capital in order to determine the quality of the resulting NPVs. And then these NPVs are assessed to go for the decision of a lease or not to lease. A first valuation is the valuation of operating lease. For that purpose, we have a little exercise where we have cost of a limo, limo's economic life, limo's lease term, the annual maintenance cost, depreciation policy which is under the makers that is modified accelerated cost recovery system. We have solvage value which is assumed here at zero, we have cost of capital and tax rate. If we determine present value of these related cash flows, we come to the present value of 98,150 dollars that is the present value of the lease contract under this exercise. Now there is a question that how much rentals in advance be there to break even this lease and NPV. Dear students, you can see we have a cash flow chart over the lease term. We have initial cost, we have maintenance cost, then tax shields on this maintenance cost and then tax shield on the depreciation. If we add up these cash flows, we have the total cash flows that are highlighted in red block. When we convert these cash flows into their present value, we have a present value of 98.15 or 98,150. Now we need to determine equal amount of cash flows under an annuity scheme so that we can break even this 98.15. We determine a break even level at an annuity of 26.19 or 26,190. We know that the lessee is allowed to have tax shield in its lease payments. So at 5% tax bracket, we have this tax shield. When we deduct this tax shield from the annual cash flows, we have a break even rental of 17.02 or 17,200 which is the present value at 7% and this present value at break even point is equal to the overall present value of the lease contract. If an asset is needed for a very shorter period of time, say one day, one week or so, then it is better to rent it. But if the asset is required for a period beyond one year, then it is much better to buy it. Between the option of rent or buying, there is a grey period which is to be decided by the lessee only. If we determine a decision rule for the operating lease, we can say that buy if the equivalent annual cost of ownership and operations is less than the best rate that an other lesser can offer to the lessee. Now the question arises when to go for an operating lease. It depends upon the lesser's ability to buy and manage the asset at a cost less than the lessee. This means that if a lessee can maintain the asset at a cost lesser than the maintenance cost borne by the lesser, then the lessee may go for the operating lease. Also the operating lease may be contained certain useful terms that can be used for the final decision making. Let's take an example. There is a one year lease for $25,000 and there is a six year lease for $28,000 with the cancellation options if the lessee feels this lease expensive and the option can be exercised after one year and onward. Now in these two examples, the second example seems better as the lessee have an option of cancelling the lease if it feels that the lease is onerous for his business. What are finance leases? Finance leases covers major parts of the asset's economic life. These are non-cancellable. These carry business risk of owing and operating the capital asset. These lease payments create a fixed obligation for the lessee to make these payments in a series on periodic basis. These lease carry a mode means these are another way of borrowing money to pay for the asset. The decision regarding financial lease rests on lease versus borrow. You have to analyze the financial worth of lease and financial worth of a borrowing option. But under operating lease the decision rule is buying versus rent. Now how to value a finance lease? For that purpose we have a little exercise. We have cost of bus. We have lease terms. We have first payment at time zero means the rentals are in advance. We have annual payments. We have maintenance cost, depreciation policy which is under makers, solvage value which is zero at the end of the project's life. Then we have marginal tax rates and lessee's incremental borrowing rate. It is notable that lessee under finance lease is not allowed to use tax shield on depreciation expense. So in this case the lessee foregoes the tax shield. Tax shield instead is allowed on the lease payments. On the left half you can see a schedule over the lease terms. In this schedule we have payment for the new bus as its cost. We have tax depreciation which is a lost tax shield because lessee is not allowed. So we have lease payments after the lessee go for the lease. Then we have a tax shield on these lease payments. And finally we have cash flows of this lease term. We have different cash flows from the zero time period to the time period of seventh year who really owns the assets. Is it a lessee or a lessee? You see that if we acquire an asset under secured loan how our balance sheet would look like. We have let's say in the example we have a bus of $100 placed in the asset site. We have other assets of $1000 on the liabilities side. We place our secured loan. Then we have other debt and equity. The balance sheet has a total of $1100 on both of the sides. When we acquire assets under secured loan we feel certain features like the lessee must make series of periodic payments to the lender. Then if the lessee defaults the lender acquired back the assets from the possession of the lessee. But upon payment of the loan when the loan repayments are fully satisfied the asset goes back to the lessee. But what is the status of the asset under a finance lease? You know that under finance lease lessee is the legal honor of the asset whereas we have seen that under borrowing it is the lender who is the honor of the asset but the lesser or the user is the user of the asset. Under finance lease lessee is allowed to deduct depreciation expense from taxable income. The as under finance lease it is the lesser who owns the asset therefore by law the lesser is allowed to use tax shield on the depreciation of the asset he owns. The lesser has nothing to do with the benefit gain or loss incurred on the assets because now the asset is in the position of the lessee and he is the honor of all the benefits gains and risk attached to this particular asset. As the finance lease expires the lesser gets the possession of the asset. Now in this case how the balance sheet may look like if we compare this balance sheet with the earlier balance sheet under the borrowing option we can see that there is only one change that under finance lease the lessee shows this obligation as finance lease in its liabilities sites of the balance sheet. There is no other difference that we see for rest of the contents of the balance sheet. Is there any implication of taxation for a lease contract? However lessee who is the user of the asset lessee is not allowed to reap the benefits of tax shield on depreciation because he is not the legal honor of the asset instead the lessee is allowed to reap the benefits of tax shields on the lease payments he makes periodically to the lesser. So far as the lesser is concerned as he is the legal honor of the asset by tax laws the lesser is allowed to reap benefits of tax shields on the depreciation of the assets he owns and in this regard the lessee must report the lease rentals in his accounts as his income which is subject to the tax law.