1. Lease Financing
Firms generally own fixed assets and report them on their balance sheets, owning assets are not
important but the important is the usage of assets. It is common to use facilities and equipment is
to buy them but there is also an important aspect that is to lease them.
Leasing refer to the use of assets in exchange for rental payments.
Parties Involves
There are two parties involving in leasing:
1. Lessor: Lessor is who owns the property.
2. Lessee: lessee who obtains use of property in exchange for one and more lease, or rental,
payments.
Types of Leases
1. Operating leases
2. Financial, or capital, leases
3. Sale-and-leaseback arrangements
4. Combination leases
5. Synthetic leases
Operating leases(OL) – Operating leases generally provide for both financing and maintenance
– leases can be used for computers and office copying machine, automobiles, trucks and aircraft,
basically these are the primary type of equipment involved in operating leases.
• It require the lessor to maintain and service the leased equipment and the cost of the
maintenance is built into the lease payments.
• It is not fully amortized- lease contract is written for a period considerably shorter than
the expected economic life of the assets. The reason is, rental payments are not
sufficient for the lessor to recover the full cost of the asset.
• Cancellation Clause – the lessee has right to cancel the lease agreement and return the
asset to the lessor prior to the expiration date of lease agreement.
2. Financial or capital Leases – Financial lease is also termed as capital lease, it is different from
OL. In this the lessee (user firm) chooses and negotiates the price from the manufacture. Then it
arranges the lessor to buy equipment from manufacture and execute the lease contract
simultaneously.
• It do not provide maintenance service
• FLs are not cancellable
• FLs are fully amortized – the lessor receives full rental payment- leased equipment plus a
return on invested capital.
Sale-and-Leaseback Arrangements – it is stated that the firms purchases the assets and sell the
property to another firm and simultaneously executes an agreement to lease the property back
for the stated period under specific term. The lessor gets the full purchase price plus a return
on their investment.
Under this the leased equipment is used not new and the lessor buys it from user-lessee instead
of a manufacturer or a distributor.
Combination Leases – it is combination of operating lease and financial lease – like
cancellation clause are part of OL but nowadays FLs also contain the cancellation clauses.
These clauses include prepayment condition; the lessee must take penalty payments sufficient
to enable the recover the unamortized cost of the leased property.
Synthetic Leases –under the synthetic leases, a corporation that wanted to acquire assets, first
established the special purpose entity and then entity obtain debt fund from financial institution
and own the assets from the manufacture, and the corporation lease the assets from SPE.
Tax Effects
The full amount of the lease payments is a tax-deductible expense for the lessee but it should
be written in a form of acceptable to the IRS. A lease that complies with all IRS requirements
is called a guideline, or tax oriented lease, and the tax benefits of ownership (depreciation and
investment tax credits) belong to the lessor.
Evaluation by the Lessee
3. The lessee must determine whether leasing an asset is less costly than buying it. In the lease
decision, the major concern is to use of the equipment by taken the ownership or by lease them.
It is basically decision of financing. If the cost of the capital obtained by leasing is lower than
the cost of debt, then the cost of capital used in the capital budgeting decision should be
recalculate.
The analysis for the leave-versus-borrow decision consist of – 1. Estimating the cash flows
associated with borrowing and buying the asset, 2. Estimating the cash flows associated with
leasing the assets. 3. Compare the two financing methods to determine the preferable.
To compare the cost streams of buying versus leasing, consider it on the basis of present value.
Net advantage to leasing (NAL) = PV of leasing – PV of owning.
Evaluation of Lessor
The potential lessor need to the rate of return on the capital invested in lease. The lessor
analysis involves – 1. Determining the net cash outlay, which is usually invoice price of the
leased equipment less any lease payment made in advance, 2- determining the periodic cash
inflows, which consist of the lease payments minus both income taxes and any maintenance
expense (the lessor must bear) 3. Estimate the after-tax residual value of the property when the
lease expires. 4. Determining whether the rate of return on the lease exceeds the Lessor’s
opportunity cost of capital or, whether the NPV of the lease exceeds zero.
Other issues related to lease analysis
1. Estimated residual Value
2. Increase credit Availability
3. Real Estate leases
4. Vehicle Leases
5. Leasing and Tax laws