Leasing

Leasing

THE BASICS

A lease is a contractual agreement between a lessee and lessor.

The agreement establishes that the lessee has the right to use an asset and in return must make periodic payments to the lessor.

The lessor is either the asset’s manufacturer or an independent leasing company.

Up – Front Lease

More rental charged in the initial years and less in the later years of the contract.

Back – Ended Lease

Less rental charged in the initial years and more in the later years of the contract.

OPERATING LEASES

Usually not fully amortized. This means that the payments required under the terms of the lease are not enough to recover the full cost of the asset for the lessor.

Usually require the lessor to maintain and insure the asset.

Lessee enjoys a cancellation option. This option gives the lessee the right to cancel the lease contract before the expiration date.

For assets such as computers or office equipment, an operating lease may run for 3-5 years.

Naturally , the shorter the lease period and/or higher the risk of obsolescence, the higher will be the lease rentals.

FINANCIAL LEASES

Long-term, non- cancellable lease contracts.

1. Do not provide for maintenance or service by the lessor.

2. Financial leases are fully amortized.3. The lessee usually has a right to renew the

lease at expiry.4. Generally, financial leases cannot be

cancelled, i.e., the lessee must make all payments or face the risk of bankruptcy.

5. The lessee also bears the risk of obsolescence.

Financial Lease

Leveraged Lease

Sale and buy back

Lease

Cross Border Lease

LEVERAGED LEASES

A leveraged lease is another type of financial lease.

A three-sided arrangement between the lessee, the lessor, and lenders.

The lessor owns the asset and for a fee allows the lessee to use the asset.

The lessor borrows to partially finance the asset. The lenders typically use a nonrecourse loan. This means that

the lessor is not obligated to the lender in case of a default by the lessee.

SALE AND LEASE-BACK

A particular type of financial lease.

Occurs when a company sells an asset it already owns to another firm and immediately leases it from them.

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.

CROSS BORDER LEASE

A particular type of financial lease.

The lessor and lessee are situated in two different countries.

It involves relationships and tax implications more complex than the domestic lease.

When the lease transaction takes place between three parties manufacturer, lessor and lessee in three different countries, it is called foreign-to- foreign lease.

MYTHS ABOUT LEASING

Leasing provides 100 % financing

Leasing provides off the balance sheet financing

Leasing improves performance

Leasing avoids control of capital spending

ADVANTAGE OF LEASING

Convenience and flexibility

Shifting of Risk of Obsolescence

Maintenance and specialized lease

CASH FLOW CONSEQUENCES OF A FINANCING LEASEExample –

BuyingYou have to acquire an equipment costing Rs 8 Crore.Estimated life is 8 years.

LeasingYou can lease it for 8 years at an annual lease rental of Rs 1.6 Crore.Depreciation as per WDV is 25% p.a.Borrowing rate is 14%.Marginal tax rate is 35%.

Note- You will have to bear maintenance, insurance and other operating expenses associated with the use of asset in both alternatives.

YEAR PRICE AVOIDED (Rs in lakhs)

DEPRECIATION LOST

DEPRE. TAX SHIELD LOST

BEFORE TAX LEASE RENTAL

AFTER TAX LEASE RENTAL

NET CASH FLOW

0 800 800

1 -200.00 -70.00 -160 -104 -174.00

2 -150.00 -52.50 -160 -104 -156.00

3 -112.50 -39.38 -160 -104 -143.38

4 -84.38 -29.53 -160 -104 -133.53

5 -63.28 -22.15 -160 -104 -126.15

6 -47.46 -16.61 -160 -104 -120.61

7 -35.60 -12.46 -160 -104 -116.46

8 -26.70 -9.34 -160 -104 -113.34

EQUIVALENT LOAN METHOD

Equivalent loan is that amount of loan which commits a firm to exactly the same stream of fixed obligations as does the lease liability.

These cash flows can be said to service the loan.

Accept if Lease Financing> Loan AmountReject if Lease Financing< Loan Amount