Lease finance-presentation overview

1. LEASING
Prepared By
THAMBALLA KIRAN

2. What is Lease?
Alease is a contract whereby the owner of an asset grants the other party the exclusive right to use the
asset for an agreed period of time in return for payment of rent.
 A lease agreement is a legal contract used when a party conveys land or personal property toanother
party for a specific amount of time in return for payment.
 The lease agreement outlines all of the aspects of the lease arrangement so that each party understands
his rights and obligations under the lease.
 Formal lease agreements are legally binding on both parties, and breach of the agreement, or failureto
uphold the provisions of the agreement, has legalconsequences.

3. Example of Lease
Suppose Fahim leases a house from Sithil, he signs a lease agreement that specifies the location of the
home, the monthly payment amount, the duration of the lease, and any other requirements of the parties,
such as a ban on pets.
 The lease is legally binding, so if Fahim moves out early, he may be held liable to pay for the entire
length of the lease, even though he was no longer livingthere.

4. Lease Financing
Lease financing is one of the important sources of medium and long term financing where the owner ofan
asset gives another person, the right to use that asset against periodicalpayments.
 The owner of the asset is known as lessor.
 The user is called lessee.
 The periodical payment made by the lessee to the lessor is known as leasecapital.
 Under lease financing, lessee is given the right to use the asset but the owership lies with the lessor andat
the end of lease contract, the asset is returned to the lessor or an option is given to the lessee either to
purchase the asset or to renew the leaseagreement.

5. Characteristics of Lease
The characteristics of lease are:
 Rental payment
 Maintenance Clauses
 Cancellation provision
 Renewal option
 Purchase option

6. Characteristics of Lease
Rental payment:
 When a company cannot afford to fully purchase an equipment or expects the equipment to havea
small useful life, it may opt to lease the equipment.
 The lessor owns the equipment and rents it out.
 The lessee makes regularly scheduled payments to the lessor for the use of the equipment.
 The lessee is expected to make a minimum payment during the contractual period that the equipment is
leased out. The minimum payment is known as the minimum lease payments. Minimum lease payments are
rental payments over the lease term including the amount of any bargain purchase option, premium, and any
guaranteed residual value, and excluding any rental relating to costs to be met by the lessor and any
contingent rentals.

7. Characteristics of Lease
Maintenance clauses:
 A lease agreement typically specifies whether the lessee is responsible for maintenance of the leasedassets.
 Operating lease normally include maintenance clauses requiring the lessor to maintain the assets and to make
insurance and tax payments.
 Financial lease nearly always require the lessee to pay maintenance and othercosts.

8. Characteristics of Lease
Cancellation provision:
 Cancellation may occur when, without justification, one of the parties to the lease agreement fails to perform
the obligations arising out of the contract.
 In this situation, the other party has the right to cancel the lease with damages, ifany.
 As a rule, the cancellation of the lease for non-performance of a contractual obligation must be basedon
failure to fulfill a principal obligation
 For example, change of destination of the good, non-payment of rent,etc.

9. Characteristics of Lease
Renewal option:
 The lessee is given the option to renew a lease at its expiration.
 Renewal option, which grant lessee to right to re-lease assets at expiration, are specially common inoperating
leases, because their term is generally shorter than the usual life of the leasedassets.
Purchase option:
Purchase options allowing the lessee to purchase the leased asset at maturity, typically for a pre-specifiedprice,
are frequently included in both operating and financialleases.

10. Different Types of Lease
The two basic types of leases that are available to business are
 Operating lease
 Finance or Capital lease

11. Operating Lease
 Operating lease is a cancelable contractual agreement whereby the lessee agrees to make periodic
payments to the lessor, often for 5 or fewer years to obtain an asset’s services.
 An example of operating lease would be when a person is starting his or her own manufacturingbusiness
but he or she does not have enough cash to buy machinery then the person will take machineryon
operating lease.

12. Features of Operating Lease
Given below are some of the features of operating lease:–
 Operating lease is a short term arrangement for the use of asset between the lessee and the owner ofthe
asset.
 Various costs related to that asset like maintenance, taxes etc are paid by the owner of the asset.
 The term of operating lease is always shorter than the economic life of thatasset.
 The lessee can cancel the operating lease prior to the end date of the operatinglease.
 The terms related to an operating lease can vary significantly depending upon the agreement between the
lessee and the owner of the asset.
 The rent which is paid by the lessee for the duration of the operating lease is lower than the cost ofasset.

13. Finance Lease
Finance or capital lease is a longer term lease than an operating lease that is noncancellable and obligatesthe
lessee to make payments for the use of an asset over a predefined period of time.
 The total payment over the term of lease are greater than the lessors initial cost of the leasedasset.

14. Finance Lease
Example:
Company C in engaged in the manufacture of bicycles. It has leased some specialized production equipment from
Company L. The useful life of the equipment is 6 years and the lease term is 5 years. The fair value of the
equipment is $20 million and the present value of minimum lease payments made by Company C amounts to $15
million. The equipment is specifically designed for the operations of Company C and the lease contractcontains a
provision which allows Company C to either extend the lease at much lower rates or purchase the equipment at
the end of 5 years for $1 million. The fair value of the equipment at the end of the lease term is expected to be $4
million.
 This is definitely a finance lease as indicated by the following:
 The lease term is more than 75% of the useful life of the equipment;
 The lease contains a bargain purchase option;and
 The equipment is customized and cannot be used by another party without significantmodifications.

15. Features of Finance Lease
Under FinancialAccounting standards Board (FASB) Statement No. 13,“Accounting for leases,” a finance or
capital lease is defined as one that has any of the followingfeatures:
1) The lease transfers ownership of the property to the lessee by the end of the leaseterm.
2) The lease contains an option to purchse the property at a bargain price. Such an option mustbe
excerciseable at a fair market value.
3) The lease term is equal to 75 per cent or more of the estimated economic life of the property(exception
exists for property leased toward the end of its useable economiclife).
4) At the begining of the lease, the present value of the lease payment is equal to 90 percent or more ofthe
fair market value of the leased property.

16. Methods of Lease Financing
 Lessors use three primary methods for obtaining assets to be leased.
 The methods depend largely on the desires of prospective lessee.
 The methods are:
1. Sales and leaseback
2. Direct lease
3. Leveraged lease

17. Sales and Leaseback
A lease under which the lessee sells an asset to a prospective lessorand then leases back the same asset, making
fixed periodic payments for its use.
 Usually the asset is sold at approximately its marketvalue
 The firm receives the sales price in cash and the economic use of the asset during the basicperiod.
 In turn, it contracts to make periodic lease payments and give up title to theasset.
 As a result, the lessor realizes any residual value the asset might have at the end of lease period,whereas
before, this value would have been realized by the firm
SALETRANSACTION
SALEVALUE
LEASETRANSACTION
LEASERENTALS
SELLER BUYER
LESSEE LESSOR

18. Sales and Leaseback
 The firm may realize an income tax advantage if the asset involves a building on owned land. Land
is not depreciable if owned outright.
 However, because lease payments are tax deductible, the lessee is able to indirectly depreciate (or
expense) the cost of the land.
 Lessors engaged in sale and leaseback arrangements include insurance companies,otherinstitutional
investors, finance companies and independent leasingcompanies.

19. Direct Lease
Under direct leasing, a company acquires the use of an asset it did not own previously.Adirect lease
can be defined as any lease transaction which is not a "sale and leaseback" transaction. In other
words, in a direct lease, the lessee and the owner are two differententities.
 A firm may lease an asset from the manufacturer. Such as IBM leasescomputer.
 Indeed , many capital goods are available today on a leased-financebasis.
 The major lessors are manufacturers, finance companies, banks, independent leasing
companies,special purpose leasing companies and partnerships
 For leasing arrangements involving all but manufacturers, the vendor sells the asset to thelessor,
who in turn, leases it to the lessee.

20. Leveraged Lease
A lease arrangement in which the lessor provides an equity portion(usually 20 to 40 percent) of theleased
asset’s cost, and third party lenders provide the balance of thefinancing.
 It is a special form of leasing which has become popular in the financing of big-ticket assets, suchas
aircraft, oil rigs and railway equipment.
 In contrast to the two parties involved in a sale and leaseback or direct leasing, there are threeparties
involved in leveraged leasing:
The lessee , the lessor(or equity participant) and the lender
Sells Asset
Manufacturer
Leases Assets
Lessor Lessee
Lender

21. Leveraged lease
 From the standpoint of lessee, there is no difference between a leveraged lease and any other typeof
lease.
 The lessee contracts to make periodic payments over the basic lease period and, in return, is entitled
to the use of the asset over that period of time.
 The role of the lessor however, is changed.The lessor acquires the asset in keeping with the termsof
the lease arrangement and finances the acquisition in part by an equity investment of, say 20
percent.
 The remaining 80 percent of the financing is provided by a long term lender orlenders
 Usually the loan is secured by a mortgage on the asset as well as by the assignment of the leaseand
lease payments.

22. Advantages of Lease
Financing
Advantages of ‘LEASE FINANCING’ to‘LESSEE’
 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 purposese.g.
purchase of inventories.
 Flexibility And Convenience: The lease agreement can be tailor- made in respect of leaseperiod
and lease rentals according to the convenience and requirements of alllessees.
 Planning Cash Flows: Leasing enables the lessee to plan its cash flows properly. The rentals canbe
paid out of the cash coming into the business from the use of the sameassets.
 Improvement In Liquidity: Leasing enables the lessee to improve their liquidity positionby
adopting the sale and lease back technique.

23. Advantages of Lease
Financing
 Shifting of Risk of Obsolescence: The lessee can shift the risk upon lessor by acquiring the use ofasset
rather than buying the asset.
 Maintenance And Specialized Services: In case of special kind of lease arrangement, Lessee canavail
specialized services of lessor for maintenance of asset leased. Although lessor charges higher rentalsfor
providing such services, lessee’s overall administrative and service costs are reduced because of
specialized services of the lessor.
 Off-The-Balance-Sheet-Financing: Leasing provides "off balance sheet" financing for the lessee, in that
the lease is recorded neither as an asset nor as a liability.

24. Advantages of lease financing
Advantages of ‘LEASE FiNANCING’ to ‘LESSOR’
 Higher profits: The lessor can get higher profits by leasing the asset.
 Tax Benefits: The lessor being owner of asset can claim various tax benefits such as depreciation.
 Quick Returns: By leasing the asset, the Lessor can get quick returns than investing in other projects of long
gestation period.

25. Disadvantages of Lease
Financing
Disadvantages of ‘LEASE FINANCING’ to ‘LESSEE’
 Higher Cost: The lease rental include a margin for the lessor as also the cost of risk of obsolescence, it
is, thus regarded as a form of financing at highercost.
 Risk of being deprived the use of asset in case the leasing company winds up.
 NoAlteration InAsset: Lessee cannot make changes in asset as per his requirement.
 Penalties On Termination Of Lease: The lessee has to pay penalties in case he has to terminatethe
lease before expiry of lease period.

26. Disadvantages of Lease
Financing
Disadvantages of ‘LEASE FINANCING’ to ‘LESSOR’
 High Risk of Obsolescence: The lessor has to bear the risk of obsolescence as there are rapid
technology changes.
 Price Level Changes: In case of inflation, the prices of asset rises but the lease rentals remain fixed.
 Long term Investment: Leasing requires the long term investment in purchase of an asset, and takes
long time to cover the cost of that asset.

27. Long Term Debt Vs. Leasing
 leasing makes it easier to get the usage of an asset for less money.
 It sounds advantageous for the entrepreneurs who are not cashingrich.
 But if we take the long-run view, we see that we will always have a payment to make but no ownership.
 In time of doing business it is needed to be considered whether to choose lease financing or longterm
debt /loan to run business activities. Some differences are stated here considering longterm debt and
leasing.

28. Long Term Debt Vs. Leasing
 Down Payment:While taking an asset on a lease, down payment is not required. Only a periodic lease
rental payment is required which is lower as compared to the percentage of down-payment. Whereas in
the case of a long term loan, the borrower has to pay a small percentage in the form of down-payment
(margin money) at the beginning of the transaction and an installment amount at the required time and the
balance amount is financed by the loan.
 The option of Buying the Asset: The lessee uses the asset up to the lease period and pays the rentals. He
has the option of buying the asset at the end of the lease. Whereas in the case of long term loan financing,
it is compulsory for the user to buy the asset as soon as he gets theloan.

29. Long Term Debt vs Leasing
 Security:No security, in any form, is required for lease financing. Whereas the borrowers need topledge
his existing assets as primary /collateral security in case of a long termloan.
 Presentation in Financial Statements: In Lease, the value of the asset is not included in the financial
statements. Whereas in the case of long term loan financing, the asset appears on the asset side and a
corresponding liability for loans appear on the liabilityside.
 Tax Implication: In the case where the asset is purchased on long term loan, the user can claim interest on
loan payment (which decreases every year due to part payment of principal also) and the depreciation of
the asset (which decrease every year due to written down value effect). Whereas in the case of lease
financing, the user can claim only lease rentals which are uniform during the leaseperiod.

30. Long Term Debt vs Leasing
 Cash Flow: Since there is no purchase of an asset in lease financing, the cash flow is limited up to the
lease rentals. Whereas in the case of the long term loan, the cash flow includes down payment, loan
received purchase of asset and installment paid at the requiredtime.
 Transfer of Risk Due to Asset Devaluation: In the case of lease financing, the ownership of an assetis
not attached to the user, so the risk of asset devaluation is transferred to the lessor. Whereas in the case
of long term loan financing, the user of the asset has to bear all the risk of asset devaluation due to
change in technology

31. Consequences of Lease
Financing
Accounting treatment:
 Accounting for leases has changed dramatically overtime.A few years ago lease financing was attractive to
some because the lease obligation did not appear on the company’s financial statements.As a result,
leasing was regarded as a hidden or off balancesheet method of financing.
 However aaccounting requirements have changed so that many long term leases must be shown on
balancesheet as capitalized asset with an associated liability being shown as well.For these leases, the
reporting of earning is affected. Other leases must be disclosed in footnotes of financial statement.

32. Consequences of Lease
Financing
Tax consequences of leasing:
 From a fiscal point of view, leasing has several advantages. The payment of VAT is spread over the full lease term
and VAT is pre-financed by the leasing company. Leasing may give access to tax deductions. There are 2 possible
scenarios:
 the lessee is the tax owner of the asset. In this case, the asset is shown in the assets of the lessee's balance sheet and
the lease payments are broken into 2 parts:
 a part made up of the interest, which is deductible from the user's tax base;
 a part made up of debt repayments, which is non-deductible.
 the lessee is not the tax owner of the asset: lease payments are fully tax deductible from its tax base. Tax ownership
is determined according to the type of lease contract.

33. Conclusion
 However, the near future for the Leasing companies seems to be far from satisfactory. Given the
present state of the economy and industry, lack of confidence by investors, apathy from banks,
chaotic and multiple tax regime, non existence of effective recovery mechanism and unfair
competition provided by multinational corporations, financial institutions, the surviving leasing
companies have a tough time before them. However, the country is at a turning point and the
requirement of capital equipments, for industrial expansion and huge infrastructural projects will
once again lead to the spurring demand for lease and hire purchase finance and the efficient and cost
effective leasing companies therefore, could have a brightfuture.