 In continuation of the lease valuation, there are certain other issues that can be faced by the Lesser and the Lessie while valuing their lease contracts. The first issue is the usage of discount rate that is used for determining the NPV of the lease contract. When we talk about Lessie, Lessie may use discount rate other than the discount rate used by the Lesser and Lessie also may use a discount that is after tax discount rate as the discount rate for determining the net present value of its lease contract. Now the question arises why to use after tax interest rate as the discount rate? There are two reasons because as we see that a lender pay tax on the interest income he earns under a contract of borrowing, therefore it receives its net return as after tax return. So far as the borrower is concerned, a borrower can detect interest payments as expense in its income statement. So what is then the net cost of borrowing to the borrower to determine net cost of borrowing to the determine it is then necessary to deduct the taxable portion of the interest expense that is why we call it then as after tax borrowing cost. Then after tax interest rate it is the effective rate to transfer debt equivalent flows from one time period to another time period. This means that to equalize debt amount under the borrowing contract we need to use after tax discount rate so that we can determine present value of each period covered under the borrowing contract. For that purpose on the screen you can see that we have used 6.5% as the discount rate which is the after tax discount rate and it gives our net present value of minus 700 to the lessy. This means that the borrowing to the lessy in this case is an expensive item under a borrowing contract then a lease contract. We also see that a stand alone positive or negative NPV is not sufficient we have to use a certain other criteria along with the resulting NPV for that purpose we have a comparative NPV amounts which we create on the basis for final decision of our choice. We can say that we have to determine NPV under lease contract and NPV under a loan contract then we need to compare NPV of the lease contract with the NPV of the loan contract and if NPV under lease contract is better then NPV under loan contract then the loan option seems better. For that purpose if we see on the screen we can see that we have a lease cash flows chart that display of cash flows from 0 to 7 years and in the lower half we have an equivalent loan to the lease that is offered to the lessy we can see that in this chart we have amount borrowed which is 89.72 as an initial cost of the asset we have interest at 10% we have interest tax shield which is 35% these interest tax shield is offered to the borrower then we have interest payment after tax and we then have our repayment of principal. In other words we can call this schedule as a loan amortization schedule and finally we have the annual cash flows under this borrowing contract for the full 7 years. How value of lease can be determined in fact we need to determine incremental values that are relative to the borrowing via an equivalent loans this means we need to determine additional amount of cash flows then a positive lease value means that if you acquire an asset then lease financing is advantageous and the vice versa we can see but that does not mean that asset should be acquired in fact a financial lease is superior to buying or borrowing if the lease financing exceeds the equivalent loan financing this means we can summarize this in the way that the net present value of a financial lease contract should be in excess to the net present value of a borrowing contract. In this regard we have another little exercise we have a bus manufacturer that is offering routine maintenance at a cost of 2000 dollars and the bus is estimated to fetch $10,000 after eight years with this data we can determine the net present value of our lease term that we are discussing in our examples now see that we have negative 700 NPV of the lease then we have to determine the present value of the annual maintenance cost which is offered to the lessy and we have to determine present value of the salvage value this is a negative amount here because previously we assume zero value at the end of the project life so the lessy is here at loss of this salvage value now when we determine the net present value of this lease contract it comes to six thousand and four hundred dollars now see that the lease which was earlier fetching a negative seven hundred dollars for the lessy is now offering him a positive net value of sixty four thousand dollars so in this way we can see that this lease now seems much better in fact a lease contract may be unattractive going to some less financing than the equivalent loan to make an attractive option for the lessy there may be certain evolution and other additions that can be considered like any routine maintenance or insurance expense offered by the lesser to the lessy or any salvage value at the end of the life of the asset that the assessor can have we can also determine benefits under financial lease both for the lessy and the lesser so far as benefits to the lesser are concerned we need to remember that if tax it is similar for the lessy and the lesser then no one will have any benefit under the financial lease contract in this case the cash outflows from the lessy will be similar to the cash inflows to the lesser just there would be the change of signs like in this example on the screen we see that for lesser the net present value of the lease is plus 700 but for the lessy the same equation when worked with reverse sign it resulted in a net present value of negative 700 therefore the net benefit of plus 700 for the lesser and negative 700 for the lessy yields nothing for any of the two but the lesser can win under financial lease contract in a case if the tax rate differs for both of the lesser and the lessy value of the lease to the lessy the how it can be determined to get benefit under financial lease by a lessy it is necessary that the tax rules should differ for the lessy and the lesser only then both of lessy and the lesser can win in this type of financial lease contract for example let us assume there is no tax for the lessy then how it will work on the screen we can see that the cash flow pattern would be look like this for a hundred dollars cost of a new asset there is an annual lease payment of 16.9 when we discount back these cash flows to their present value at the cost of 10 percent which is opportunity cost to the lessy and this is when after tax is also the 10 percent because in this case we assume no tax rate for the lessy so discounting these cash flows at 10 percent cost of capital the resulting NPV is 820 dollars so we see that under financial lease where the lessy is under no tax burden there is a net gain of 700 to the lesser because of tax shield on interest expense and depreciation and there is a net gain of 820 to the lessy under the same lease contract because lessy is not required to pay any tax this mutual gain in this lease contract earned by the lessy and the lesser is at the expense of the government because the government gains from lease contract through tax on lease payments this lease contract allows tax shield on depreciation and interest expense to the lesser and these tax shields are of no use for the lessy also the accelerated depreciation and positive interest rate gives net loss to the government in the present value of tax shield as a result of the lease contract a collective are combined gains for the lesser and the lessy will be higher if the lesser's tax rate is much higher than the lessy's tax rate and depreciation is a depreciation tax shield is received early in the lease period a lease period is longer enough and the lease payments are widely concentrated towards the end of the lease contract and the interest rate under the lease contract is much higher finally we have another type of lease contract and that is leveraged lease under leveraged lease contract the leasing company set up and another company that is known as a special purpose entity this special purpose entity is required to borrow funds from the market and to these borrow funds the leasing company contributes some amount as its own equity now the special purpose entity uses this collective amount for the purchase of the asset in the market and the lease contract is placed with the borrower as a collateral to the loan now what happens afterwards we can see that the leasing company gets no cash inflows because now the role of lesser is played is played by the special purpose entity and the lessy makes periodic payments to this special purpose entity and with these periodic lease payments the special purpose entity serves its debt it pays interest and principal to the borrower when the debt is paid off the the asset reverts back to the to the lessy this relationship between the lessy between special purpose entity and the company can a leasing company can be seen in this diagram where there is a lessy who is taking an asset on the lease it makes lease payments the special purpose entity that uses this series of payment as a debt service to the buyer so far as the tax shields on depreciation and interest expense is there it goes to the leasing company who is also contributing towards the fund for the acquisition of the asset