LEASING[1][1]

LEASINGLease defined

Lease is a contract between a lessor, the owner of the asset, and a lessee, the user of the asset.

Lessor (owner) gives the lessee (user) the right to use the asset over an agreed period of time for a consideration called lease rental.

Lease rentals: are fixed regular payments by the lessee over a period of time at the beginning or at the end of a month, quarter, half year, or year.

In up-fronted leases, more rentals are charged in the initial years ad less in the later years of the contract, while the opposite is the case in back-ended leases.

Ownership of Leased AssetAlthough the lessor is the legal owner of a leased

asset, the lessee bears the risk and enjoys the returns. The lessee benefits if the leased asset operates profitably, and suffers if the asset fails to perform. Leasing separates ownership and use as two economic activities, and facilitates assets use without ownership.

TYPES OF LEASESTwo types of leases can be distinguished:(a)Operating lease and (b) finance leaseOperating Lease – is a short-term, cancellable lease

agreement. Convenience and instant services are the bases of operating leases. For example, car rentals, hotel rooms and lease contracts for computers. The lessor is generally responsible for maintenance and insurance, and may also provide other services.

• A single operating lease contract may not fully amortize the original cost of the asset; it covers a period considerably shorter than the useful life of the asset. Due to the short duration and the lessee’s option to cancel the lease, the risk of obsolescence remains with the lessor. Naturally, the shorter the lease period and/or the higher the risk of obsolescence, the higher will be the lease rentals.

Finance Lease – are long-term, non-cancellable lease contracts e.g. machinery, aircrafts, land, building etc. finance leases amortize the cost of the asset over the term of lease; they are therefore also called capital, or fully-payout leases. Most finance leases are direct leases. The lessor buys the asset identified by the lessee from the manufacturer and signs a contract to lease it out to the lessee. In finance lease, the lessee is normally responsible for the maintenance and insurance.

• The lessee also bears the risk of obsolescence. A finance lease agreement may provide for renewal of contract or purchase of the asset by the lessee after the contract expires.

Accounting Treatment of Operating and finance Leases.

In operating leases, the rental payments are charged as expenses in the income statement and, there is no obligation in the balance sheet of the lessee.

In finance leases, the amortized value of the underlying asset over its useful life and the interest component of the lease payment are charged to the income statement. And the unpaid capital outstanding on the lease is treated as long term liability in the balance sheet.

Tax Treatment of Leases

Both the leessee and the lessor benefits from tax payment on a lease.

On the part of the leasee, all lease payments are deducted from income before charging the appropriate corporate tax, whether it is an operating or a finance lease.

The leassor on the other hand receives all the lease payments as income and also entitled to capital allowance (i.e. amortization) of the leased asset for tax proposes.

finance LeaseLet us take a look at the effect of a manufacturing concern (Triangle Corporation) leasing processing equipment. Let us make the following assumptions about the equipment to be leased:

Table 3 – 2 Triangle Corporation Leasing Assumptions

•Note: Initial contribution of $79,500 towards the purchase of the asset

We will further assume that the interest rate implicit in the lease is 11% and that Triangle amortizes capital assets using the straight-line method. Notice in the data the presence of a bargain purchase option. Furthermore, if you were to discount all the lease payment and the final payment to buy the equipment, the result would be very close to the fair market value of the asset to be acquired.

Fair market value of equipment $375,000

First lease payment due January 1, 1,1998

Economic life of the equipment 10 years

Lease term 6 years

Annual lease payments (at the end of each year)

$79,500

Bargain purchase price at end of lease $3,120

Therefore, this clearly has to be treated as a capital lease. Managers need to understand the accounting treatment of such leases. This is because the effect on reported earnings is radically different from what we would see with an operating lease. In this case there will be two items to report in the income statement as follows:1.Amortization of $37,500 per year ($375,000 x10% since the economic life is ten years and assuming use of the straight line method of amortization).2.Interest expense – this will vary over the term of the lease as set out inn the table below.

The finance lease is effectively treated as a long-term loan and allocates the lease payments between principal and interest:

Table 3 – 3 CICA treatment of a finance lease

Balance at Beginning

Payment Interest Reduction of Principal

Balance at end

1/1/98 375,000 79,500 79,500 295,500

12/31/98 295,500 79,500 32,505 46,995 248,505

12/31/99 248,505 79,500 27,336 52,164 196,341

12/31/00 196,341 79,500 21,597 57,930 138,438

12/31/01 138,438 79,500 15,228 64,272 74,166

12/31/02 74,166 79,500 8,158 71,342 2,824

12/31/02 2,824 3,120 296 2,824

On the first day of 1998 there is no interest as the payment is made on the first day of the lease. Therefore, the entire payment ($79,500) is applied to reducing the value of the effective loan represented by the lease.In the first year, interest at 11% = 0.11 x 295,500 = $32,505. therefore, the principal paid back in year 1 (over and above the first payment) is 79,500 – 32,505 = $46,995, leaving an outstanding balance at the end of 1998 of $248,505. Note that interest diminishes each year, while amortization (using the straight line method) will be constant at $37,500 per year. Therefore, all things being equal, reported earnings should increase over time.

• In the final year, we calculate interest ($296) by taking the difference between the capital outstanding at the end of the 5th year ($2,824) and the final payment of $3,120.

• As mentioned earlier in this block, the effective amount owed to the leasing company (the principal) will be displayed on the lessee’s balance sheet. Based on the Triangle example, the following shows an extract from the balance sheet at December 31, 1998.

Figure 3 - 1 Triangle Corporation balance sheet extract.

Notice that $52,164 is shown under current liabilities because this is the amount of principal to be repaid during the coming year (i.e. 1999). Total lease debt is $248,505 (52,164 + 196,341).

Current liabilities (12/31/98

Short term portion of long term debt

52,164

Long term debt 196,341

Sale and Lease-BackCompanies sometimes will sell their assets and turn again to lease these assets from those they sold the asset, e.g. buildings. This is sale and lease-back. The company immediately gets funds after the sale and, the only cash out flow is the rental payments which are tax deductible expenses.

However, in the process of the sale the company may be subject to capital gains tax if the sale price is in excess of the written down value as agreed by the tax authorities.

IllustrationAB Limited has decided to acquire some new plant and machinery and is now considering whether to buy or lease it. The machinery in question has a useful life of 4 years with residual value of GH¢6,000 at the end of that time. It will cost GH¢17,600 to buy which will be financed buy borrowing. Alternatively, it could be leased for 4 years at an annual rent of GH¢4,500 payable annually in advance. The company’s tax rate is 33%.

If purchased the machine will attract a writing down allowance of 25% (reducing balance basis per annum).

A balancing allowance or charge will be made on disposal. If leased the rental will be allowed fully against company tax. Tax is paid (and allowances received) one year in arrears. The after tax cost of borrowing to AB Limited is estimated to be 13%.

RequiredAdvice AB Limited whether to buy or lease the machine on the assumption that the company has sufficient taxable profit to fully absorb all tax allowances rising from the buy or lease decision.

Solution: Computation of capital Allowance

Year CostGH¢ Tax Relief

GH¢ 1 17,600.00 CA 4,400.00 @ 33% 1,4522 13,200.00 CA 3,300.00 @ 33% 1,0893 9,900.00 CA 2,475.00 @ 33% 8174 7,425.00 CA 1,856.00 @ 33% 612 Residual 5,569.00 Sold 6,000.00 431.00 @ 33% ( 142)

Balancing charge 470

i. Lease Option

ii. Purchase Option

YearGross Cash

FlowsGH¢

Tax ReliefGH¢

NetCash Flows

GH¢

DCF - 13%

Present ValueGH¢

0 (4,500) @33% (4,500.00) 1,000 (4,500)

1 (4,500) @33% 1,485.00 (3,015.00) 0.885 (2,668)2 (4,500) @33% 1,485.00 (3,015.00) 0.783 (2,361)

3 (4,500) @33% 1,485.00 (3,015.00) 0.693 2,089)

4 1,485.00 1,485.00 0.613 910

Net Present Value (10,708)

YearGross Cash

FlowsGH¢

Tax ReliefGH¢

DCF - 13%

PresentGH¢

0 (17.600) - 1.000 (17.600)1 - - 0.885 - 2 - 1,452.00 0.783 1,137.00 3 - 1,089.00 0.693 755.00

4 6,000.00 6,817.00 0.613 4,179.00

5 470.00 0.543 255.00

Net Present Value (11,274)

Advice: The net present value cost of leasing is lower than buying outright using a bank loan and it is therefore financely more advantageous to the company.

Advantages of Leasing

1.To avoid the cost of repurchasing new equipment as a result of obsolescence.

2.Less restrictions as compared to a loan.3.When an asset is required for a relatively short

period.4.Sale and lease-back provides immediate funds

for a company.

5. Operating leases have the effect of improving finance ratios of a company since there is no increase in liabilities on the balance sheet as again total assets do not include leased assets.

6. Leasing provides 100% finance of an asset as against a bank loan which could be less.

7. Leasing could provide less cost to lessee in the form of lease payments since most leasing companies do bulk purchases of their assets and obtain lower prices.

Disadvantages of Leasing

1. Lease rental payments could include high implicit rates as compared to borrowing cost.

2. No ownership position in leasing as the lessor retains ownership and associate benefits.

3. Improvements or alterations to the leased asset needs the approval of the lessor which is not the case in outright purchase.

4. If a leased asset becomes obsolete during the leased period the lessee must continue to pay the rental amounts to the end of the lease.

INTERNATIONAL MANAGEERIAL FINANCE

INTRODUCTION:

Today, due to limited or dwindling domestic markets, companies have ventured into more growth by entering into new markets internationally. This requires different strategies from the domestic markets since companies face varied economic policies and indicators. Companies involved in international business are exposed to different forms of risks which require different managerial approach and capabilities.

Borderless TradingVarious Countries the world over have organized themselves into economic blocs or regional groupings to promote trade amongst themselves.

This is to ensure that artificial borders are eliminated and there is free –flow of trade. In West Africa, there is the Economic Community of West African states (ECOWAS).

The objective of ECOWAS is to remove barriers to trade among its member countries and, also to allow the free movement of its citizens.

However, one major setback of these economic groupings is that member countries are more tied to their sovereignty and domestic laws and regulations such that the objectives of these blocks are not achieved.

WORLD TRADE ORGANIZATION (WTO)

The WTO was established in 1994 under the General Agreement on Tariffs and Trade (GATT).

OBJECTIVES OF WTO

To reduce barriers to international trade by reducing tariffs, enhancing copyright protection internationally and other efforts that encourage trade.To promote trade among member countries.To resolve trade disputes among number countries.To assist in the development of new trading agreements.

The International OrganizationIn vesting in different countries will require different laws and regulations that a company might have to contend. Laws pertaining to taxation and finance reporting might differ from the domestic country.

TAXATIONTaxation is one of the key issues that might confront companies operating internationally. For example, in Ghana companies pay various taxes ranging from corporate tax, withholding tax, Value Added tax and Excise duty. Again, companies need to know, apart from the tax agencies in the country whether they have to pay taxes to the locality in which they operate e.g. district, municipal or metropolitan assemblies.

ACCOUNTINGWhen a company is purchased one of two issues may arise, that is goodwill or capital surplus. Goodwill arises when the purchase price is above the net assets and, the vice versa gives rise to capital surplus.In a parent – subsidiary relationship there is likely to be the need for currency translation if the currency of the subsidiary is different from that of the parent company. This can result to differences which require the application of certain accounting principles.

RISKRisk is a measure of uncertainty about the outcome of a given event.Companies face numerous risks in their operations. However, in the global arena the most critical risks that confront companies are political and exchange risks.

Political risk arises as a result of change inn government policies and regulations that are likely to have negative effects on the company. Where there is a stable government or there is a smooth change of government then there is likely to be less changes in policies and regulations and the vice versa. Africa and for that matter developing countries most often do not have stable governments or the changes are violent possibly due to coup d’tats.

In these instances, companies are either expropriated or inimical policies are introduced forcing these companies to fold up. For example, the seizure of land from the White Commercial Farmers in Zimbabwe.In facts, most countries have developed Investment Codes. These codes spell out the guidelines and incentives for foreign investment. Possible areas covered by these codes are the level of local ownership required, the number or percentage of local managers, the level of borrowings, and the level of profits that can be transferred or repatriated to the parent company.

• In Ghana, the Free Zone Act has very juicy incentives for those investing in the designated Free Zone Areas.

Mitigating Political RiskUsing local managementBorrowing from the local finance marketsPartnership and or joint venture with local firmsUsing local suppliers and distributorsSocially responsible by improving the local areaLobbying

Exchange RiskCurrency differences affects the preparation of

consolidated finance statements if a company has subsidiaries. This could result in losses and the performance of the company. Multinational companies are more exposed to exchange risk due to the fact that their assets are scattered in various countries with their attended exchange risks.

Factor Affecting Exchange Rate1.Inflation2.Balance of payment 3.Interest rates4.Government policies5.Sport rates and Forward rates

Financing DecisionsEven though international companies have the goal of

maximizing shareholders wealth, they will do this by taking into consideration the risk and return on various sources of finance.

Impact on Capital ProjectsAs international companies are financed by varied

capital sources it is prudent that the weighted averaged cost of capital (WACC) be used to appraise their investments. This WACC should be adjusted with the appropriate risk factors, i.e. political and currency risk factors in the particular environment in which it operates. In some environments, the political risk may be higher than in others and, the vice versa. Using a blanket risk factor may not give the right information for efficient decision-making.

Personnel and ManagementLanguage differences/barriersSocial customs and tradition.Preparation of management to meet these

challenges.The employees can make and unmake

organizations.