Leasing

BySudarshan Kadariya

“Why own a cow when the milk is so cheap? All you really need is milk and not the cow.”

-By Donald B. Grant

Theme

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.

Leasing – ‘the act of lease’

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.

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.

Parties involve in lease

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.

Lease

“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.”

Institute of Chartered Accountants of India

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.

Issues/contents in leasing

Types of Lease

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.

CAPITAL/FINANCIAL LEASE

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;

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.

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.

OPERATING/SERVICE LEASE

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.

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.

SALE AND LEASE BACK

• 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.

• 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.

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.

LEVERAGED LEASING

Leveraged Lease framework

For example, popular for big-ticket assets such as aircraft, oil rigs, and railway equipments, vehicles, etc.

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.

DIRECT LEASING

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.

ADVANTAGES OF LEASING

Why has Leasing Grown so Fast

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.

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.

Reasons for Leasing

• 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

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:

Financial evaluation of a lease

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.

Cost of leasingLt = 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 buyingCost = 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 assetIf NAL is negative, buy the asset

Calculation

Given,Borrowing and buyinglife = 10 yearsCost = $ 10 millionPlan to use only for 5 yearsBorrowing 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%

Leasinglease period = 5 yearsRental/ lease payment = $ 2,750,000 at the beginning of each year

Required: Make the lease evaluation.

Lease analysis, lessee’s point of view(Amt in thousand) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5A. 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 leasing1. 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

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 0.11Dep. 2000 3200 1900 1200 1100Dep. Tax saving 800 1280 760 480 440

Cost 10000Less: Depn 9400Book value 600

Thank you