Leasing

The basic characteristics of leases and how to differentiate between operating and financial (or capital) leases The benefits and disadvantages of leases How the lease decision can be evaluated using the discounted cash flow valuation methods

Asset-based lending Financial lease Lessee Lessor Leveraged lease Off-balance-sheet financing

Operating lease Sale and leaseback (SLB) agreement Secured financing Small and mediumsized enterprises (SMEs)

The decision to invest in an asset that has a long life is a capital budgeting decision. The decision to acquire is a separate decision from the decision on the method of financing the acquisition When these two decisions are combined, this is called asset-based lending because the financing is tied directly to a particular asset. Examples of asset-based lending include: Secured loans Leases

Lease is a contract under which a lessor, the owner of the assets, gives right to use the asset to a lessee, the user of the assets, for an agreed period of time for a consideration called the lease rentals. Hence A lease contract is an agreement where the owner conveys to the user the right to use an asset in return for a number of specified payments over an agreed period of time Lessor is the owner of the asset Lessee is the user of the asset

Operating Lease
A lease where some of the benefits of ownership do not transfer to the lessee and remain with the lessor.

Financial (Capital) Lease

A lease where essentially all the benefits of ownership transfer to the lessee; also known as a capital or full payout lease.

Shot-term, cancelable lease agreements are called operating lease. Tourist renting a car, lease contracts for computers, office equipments and hotel rooms. The Lessor is generally responsible for maintenance and insurance. Risk of obsolescence remains with the lessor.

Long-term, non-cancelable lease contracts are known as financial lease. Examples are plant, machinery, land, building, ships and aircrafts. Amortize the cost of the asset over the terms of the leaseCapital or Full pay-out leases.

Table 16-1 Operating versus Financial Leases

OPERATING Lessee
Asset Not on balance sheet (B/S); disclose in footnotes Expense the full amount as rental expense

FINANCIAL Lessee
Report on B/S

Lessor
Report on B/S

Lessor
Not on B/S

Lease payments

Claim as rental income

Depreciation expense (associated with leased asset)

Cannot claim

Claim

Decompose into interest and principal repayment, and expense the interest portion Claim

Claim the interest portion of payments received as interest income Cannot claim

Sometimes, a user may sell an (existing) asset owned by him to the lessor (leasing company) and lease it back from him. Such sale and lease back arrangements may provide substantial tax benefits. In April 1989, Shipping Credit and Investment Corporation of India purchased Great Eastern Shipping Company bulk carrier, Jag Lata, for Rs 12.5 Cr and then leased it back to GESC on a 5 years lease, the rentals being Rs 28.13 Lakh per month. The ships WDV was Rs 2.5 Cr.

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The lessee is deemed to own the asset and will claim depreciation on the firms income statement and record the value as an asset and liability on the balance sheet. Such leases usually: Require the lessee to carry out maintenance and insure the asset
Provides the lessee with a fixed purchase option The lease agreement covers 75% of the economic life of the asset Is structured so that the present value of lease payments exceeds 90 % of the cost Involves fixed rental payments.

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 If a lease is NOT a capital lease, then it is an operating lease Operating leases do not transfer to the lessee the benefits of ownership

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 A three-way agreement among the lessee, the lessor, and a third party lender in which the lessor buys the asset with only a small down payment and the lender supplies the financing

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Financial leases are included on the balance sheet of the lessee

Operating leases are off-balance-sheet financing for the lessee (included only in the notes to the financial statements)

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Leasing is an alternative means of obtaining the use of an asset. There are four main differences in the cash flows for a company that leases an asset instead of buying it: 1. It does not have to pay for the asset up front 2. It does not get to sell the asset when it is finished with it, if it is an operating lease, or if title is not transferred through a financial lease 3. It makes regular lease payments. If the lease is an operating lease, then the full amount of the lease payments is tax deductible; only the interest portion is deductible for capital leases 4. Operating leases are not depreciated.
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IRR of Leasing Analysis

Estimate incremental cash flows that result from leasing Solve for the discount rate (IRR) that equates the incremental cash flows with the initial value of the asset. (This is the after-tax IRR or cost of leasing)
If IRR of leasing > after-tax cost of borrowing (borrow and buy the asset) If IRR of leasing < after-tax cost of borrowing (lease the asset)

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NPV of Leasing Analysis

Estimate incremental cash flows that result from leasing Calculate NPV using after-tax cost of borrowing as the discount rate.
If NPV of leasing is If NPV of leasing the asset)

(borrow and buy the asset)

+ after-tax cost of borrowing (lease

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The direct cash flow consequences are:

1. The purchase price of the asset is avoided. 2. The depreciation tax shield Is lost. 3. The after tax lease rentals are paid.

The net present value of these cash flows at after tax cost of debt should be calculated. If it is positive lease is beneficial.

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1. 2. 3. 4. 5. 6. 7. 8.

Cheaper financing Reduce the risks of asset ownership Implicit interest rates Maintenance Convenience Flexibility Capital budgeting restrictions Financial statement effects

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In this chapter you have learned:

That firms can gain the use of assets through leasing rather than outright ownership The general differences between operating and financial leases How to evaluate a potential lease decision using discounted cash flow analysis The various reasons firms might have for entering into lease arrangements
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