2. “Why own a cow when the milk is so cheap? All
you really need is milk and not the cow.”
-By Donald B. Grant
3. Firms generally own fixed assets and report them
on their balance sheet for accounting purpose.
The important point is the use of the assets, not
their ownership. But, how to get the rights to use
the assets?
◦ Option 1: Buy
◦ Option 2: Lease
Ownership of the asset never passes to the
lessee, or with a lease there is often no
agreement for legal ownership of the asset to
pass to the lessee.
4. Prior to the 1950s, leasing was generally
associated with real estate – land and buildings.
Today, however, it is possible to lease virtually any
kind of fixed assets, which is the paradigm shift in
leasing.
In India, the concept was pioneered in 1973 when
the First Leasing Company was set up (in Madras)
and the eighties have seen a rapid growth of this
business.
Lease, as a concept which involves a contract
whereby the ownership, financing and risk taking
of any equipment or asset are separated and
shared by two or more parties.
5. The lessor, who owns the property. The
lessor is pronounced ‘less-or’
The lessee, who obtains use of the property
in exchange for one or more lease, or rental
payments. The term lessee is pronounced
‘less-ee’, not ‘lease-ee’
The third parties – financial intermediaries, in
case of leverage financing.
6. A lease is a commercial arrangement whereby an
equipment owner or Manufacturer conveys the
right to use the equipment in return for a rental.
In other words, lease is a contract between the
owner of an asset (the lessor) and its user (the
lessee) for the right to use the asset during a
specified period in return for a mutually agreed
periodic payment (the lease rentals).
For example, apartments, houses, offices,
automobiles, etc.
7. “A lease is an agreement whereby the lessor
conveys to the lessee, in return for rent, the
right to use an asset for an agreed period of
time. Lessor is a person who conveys to the
another person (lessee) the right to use an
asset in consideration of a payment of
periodic rental, under a lease agreement.
Lessee is a person who obtains from the
lessor, the right to use the asset for a
periodical rental payment for an agreed
period of time.”
8. i) Contract specifies who maintains the asset
Full-service lease -- lessor pays maintenance
Net lease -- lessee pays maintenance costs
ii) Cancelable or noncancelable lease?
Operating lease (short-term, cancelable) vs.
financial lease (longer-term, noncancelable)
iii) Options at expiration to lessee
Transfer of ownership
iv) The parties (two or more), the asset, the term
or period, the rentals, leasing process, etc.
9.
10. Long-term, non-cancellable lease. The essential
point of financial lease agreement is that it
contains a condition whereby the lessor agrees to
transfer the title for the asset at the end of the
lease period at a nominal cost. At lease it must give
an option to the lessee to purchase the asset at the
expiry of the lease.
Under this lease the lessor recovers about 90% of
the fair value of the asset as lease rentals and the
lease period is 75% of the economic life of the
asset. The lease agreement is irrevocable.
11. Practically, all the risks and all the benefits arising in
lease are transferred to the lessee who bears the cost
of maintenance, insurance and repairs. Only title
deeds remain with the lessor.
Financial lease is also known as ‘capital lease’. In
India, financial leases are very popular with high-cost
and high technology equipment.
Key elements in Financial Lease:
i. The lessor will purchase that asset;
ii. The lessee will have use of that asset during the
lease;
iii. The lessee will pay a series of rentals or
installments for the use of that asset;
12. iv. The lessor will recover a large part or all of the
cost of the asset plus earn interest from the
rentals paid by the lessee;
v. The lessee has the option to acquire ownership of
the asset at the end;
vi. The lossor is the legal owner of the asset during
duration of the lease.
iv. The lessee usually has a right to renew the lease at
expiry.
vii. However, the lessee has control over the asset
providing them the benefits and risks.
13. An operating lease stands in contrast to the
financial lease in almost all aspects. This lease
agreement gives to the lessee only a limited right
to use the asset.
The lessor is responsible for the upkeep and
maintenance of the asset. Ordinarily, operating
leases require the lessor to maintain and service
the leased equipment.
The lessee is not given any uplift to purchase the
asset at the end of the lease period.
14. Key elements in Operating Lease:
i. Normally the lease is for a short period;
ii. Revocable at a short notice.
iii. Operating lease which is short-term and where
the asset may be hired to several lessees.
iv. Usually not fully amortized.
v. Usually require the lessor to maintain and insure
the asset.
vi. Lessee enjoys a cancellation option.
For example, computers and office copying machine,
automobiles, trucks and aircrafts, are the primary types
of equipment involve in operating leases, mines,
computers hardware, trucks and automobiles are found
suitable for operating lease because the rate of
obsolescence is very high in this kind of assets.
15. It is a sub-part of finance lease. Under this, the owner
of an asset sells the asset to a party (the buyer), who
in turn leases back the same asset to the owner in
consideration of lease rentals.
However, under this arrangement, the assets are not
physically exchanged but it all happens in records
only. This is nothing but a paper transaction.
Sale and lease back transaction is suitable for those
assets, which are not subjected depreciation but
appreciation, say land. The advantage of this method
is that the lessee can satisfy himself completely
regarding the quality of the asset and after possession
of the asset convert the sale into a lease arrangement.
16. • Under this transaction, the seller assumes the role
of a lessee and the buyer assumes the role of a
lessor. The seller gets the agreed selling price and
the buyer gets the lease rentals.
• It is possible to structure the sale at agreed value
(below or above the fair market price) and to adjust
difference in the lease rentals. Thus the effect of
profit /loss on sale of assets can be deferred.
• The lessor realizes any residual value.
• Lessors: insurance companies, institutional
investors, finance companies, and independent
companies, etc.
17. • Two sets of cash flows occur:
– The lessee receives cash today from the sale.
– The lessee agrees to make periodic lease payments,
thereby retaining the use of the asset.
• The assets and the flow of funds can be explained as
below.
18. Under leveraged leasing arrangement, a third
party is involved beside lessor and lessee. The
lessor borrows a part of the purchase cost (say
80%) of the asset from the third party i.e. lender,
and the asset that purchased put as security
against the loans.
The lender is paid off from the lease rentals
directly by the lessee and the surplus after
meeting the claims of the lender goes to the
lessor.
The lessor, the owner of the asset is entitled to
depreciation allowance associated with the asset.
19. Leveraged Lease framework
For example, popular for big-ticket assets such as
aircraft, oil rigs, and railway equipments, vehicles,
etc.
20. Under direct leasing, a firm acquires the right to
use an asset from the manufacturer directly.
The ownership of the asset leased out remains with
the manufacturer itself.
The major types of direct lessor include:
manufacturers, finance companies, independent
lease companies, special purpose leasing
companies etc like - IBM leases computers and
Xerox leases copiers, etc.
21. There are several extolled advantages of acquiring capital assets
on lease:
(1) SAVING OF CAPITAL: Leasing covers the full cost of the
equipment used in the business by providing 100% finance. The
lessee is not to provide or pay any margin money as there is no
down payment. In this way the saving in capital or financial
resources can be used for other productive purposes e.g.
purchase of inventories.
(2) FLEXIBILITY AND CONVENIENCE: The lease agreement can be
tailor- made in respect of lease period and lease rentals
according to the convenience and requirements of all lessees.
(3) PLANNING CASH FLOWS: Leasing enables the lessee to plan its
cash flows properly. The rentals can be paid out of the cash
coming into the business from the use of the same assets.
(4) IMPROVEMENT IN LIQUADITY: Leasing enables the lessee to
improve their liquidity position by adopting the sale and lease
back technique.
22. Because leasing is beneficial to both lessee and lessor:
For Lessor:
• Ownership of asset
• Lower transaction costs
• Lighter regulations, because they are not deposit
taking institutions.
• Tax incentives (lesser than sales tax)
• Ownership and easy finance
• Better control on utilization of funds, etc.
23. For Lessee:
• Avoidance of initial cash outlay
• Efficient use of funds
• Fewer requirements about balance sheets
• Cheaper source of financing
• Enhanced borrowing capacity (debt/equity ratio)
• No outside security/collateral needed
• Low documentation cost
• Protect against obsolescence
• Leasing can finance a higher % of equipment than
bank loans
• Tax benefits
• Better liquidity (sale and lease back), etc.
24. • Good Reasons
– Taxes may be reduced by leasing.
– The lease contract may reduce certain types of
uncertainty.
– Transactions costs can be higher for buying an
asset and financing it with debt or equity than
for leasing the asset.
• Bad Reasons
– Accounting
25.
26. Leases are evaluated by both the lessor and
the lessee.
The lessee determine whether leasing an
asset is less costly than buying it.
The lessor decide whether the lease payments
provide a satisfactory return on the capital
invested in leased asset.
Lease evaluation consist the following steps:
27. Decide to acquire the asset: In a lease analysis, the
concern is whether to obtain the use of the
machine by lease or by purchase.
How to finance the acquisition: Capital to finance
new assets must be obtained from some source
i.e. cash flows, equity, debt, etc. Alternatively, the
assets could be leased.
Comparison between lease vs debt financing: A
lease is comparable to a loan in the sense that the
firm is required to make a specified series of
payments, and a failure to meet these payments
could result in bankruptcy. If a company has a
target capital structure, then $1 lease financing
displaces $1 of lease financing. Thus, the most
appropriate comparison is lease financing versus
debt financing.
28. Cost of leasing
Lt = Lt(1-T) x PVIFA kdt,n
(When lease payment is made at the end of the year)
Lt = Lt + Lt(1-T) x PVIFA kdt, n – Lt x T x PVIF kdt, n
(When lease payment is made in advance)
Cost of buying
Cost = Io – (ITC+D x T x PVIFA kd, n + Salvage value x PVIF kdt, n)
Net advantage of leasing (NAL)
NAL = PV cost of owing – PV cost of leasing
Decision: If NAL is positive, lease the asset
If NAL is negative, buy the asset
29. Given,
Borrowing and buying
life = 10 years
Cost = $ 10 million
Plan to use only for 5 years
Borrowing cost = 10% before tax
Estimated scrap after 10 years = $ 50,000
Estimated salvage value (CSV) 5 years = $ 1,000,000 before tax
Maintenance cost = $ 500,000 per year payable at the beginning of each year
Depreciation = MACRS 5 year class life
Tax = 40%
Leasing
lease period = 5 years
Rental/ lease payment = $ 2,750,000 at the beginning of each year
Required: Make the lease evaluation.
30. Lease analysis, lessee’s point of view
(Amt in thousand) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
A. Cost of borrowing and buying
1. After tax loan payment ($10m x 6%) (600) (600) (600) (600) (10600)
2. Maintenance cost (500) (500) (500) (500) (500)
3. Maintenance tax saving (500 x 40%) 200 200 200 200 200
4. Depreciation tax saving 800 1280 760 480 440
5. Residual value (CSV) 1000
8. Tax on residual claim (1000-600) x 40%) (160)
Net cash flow (300) (100) 380 (140) (420) (9320)
PVIF 6%, 5 years 1 0.943 0.890 0.840 0.792 0.747
PV of owing = $ 7468.38 (300) (94) 338 (118) (333) (6962)
B. Cost of leasing
1. Lease payment (2750) (2750) (2750) (2750) (2750)
2. Lease rent tax saving (2750 x 40%) 1100 1100 1100 1100 1100
3. Net cash flow (1650) (1650) (1650) (1650) (1650)
PVIF 6%, 5 years 1 0.943 0.890 0.840 0.792
PV of leasing = $7367.25 (1650) (1556) (1469) (1386) (1307)
Note: Assuming that lease payment at the beginning of the year do not change the tax
effect
31. Net advantage of leasing (NAL) = PV of owing - PV of leasing
= (7468.38 -7367.25)
= 101.13
Decision: Since, the NAL is positive, it is wise to lease the equipment.
Working note:
Year 1 Year 2 Year 3 Year 4 Year 5
Dep. Rate 0.2 0.32 0.19 0.12 0.11
Dep. 2000 3200 1900 1200 1100
Dep. Tax saving 800 1280 760 480 440
Cost 10000
Less: Depn 9400
Book value 600
