lease ananlysis guidelines -...

LEASE ANALYSISGUIDELINES

Department of Treasury and FinanceGovernment of Western Australia

August 2005

Table of Contents

Chapter 1: Leasing ........................................................................2

1.1 Introduction ........................................................................2

1.2 Operating Leases and Finance Leases ................................3

1.3 Operating Leases in Practice ..............................................4

1.4 Budgetary Implications from Leasing ................................5

1.5 Scope of these Guidelines ..................................................6

Chapter 2: Concepts in Lease Analysis..........................................7

2.1 Introduction ........................................................................7

2.2 The Residual Value ..............................................................9

2.3 Discount Rates....................................................................13

2.4 Decision-Making Guidance................................................16

Chapter 3: The Lease or Buy Calculator ....................................18

3.1 Introduction ......................................................................18

3.2 Disclaimer ..........................................................................18

3.3 Getting Started ..................................................................19

3.4 Overview of Spreadsheet ..................................................19

3.5 The Inputs Worksheet........................................................20

3.6 The Results Worksheet ......................................................23

3.7 Examples ............................................................................24

Chapter 4: Special Issues ..............................................................30

4.1 Lease Terms and Conditions..............................................30

4.2 Tax Issues ............................................................................33

LEASE ANALYSIS GUIDELINES

CO

NT

EN

TS

Table of Figures

Figure 1: Major Components Considered in Lease Analysis ..............................................................8

Figure 2: Accelerated depreciation of a $50,000 asset with an economic life of five years ................11

Figure 3: Comparison of marginal lease or buy options ................................................................17

Figure 4: Inputs worksheet ......................................................20

Figure 5: Results worksheet ......................................................23

Figure 6: Example of completed inputs worksheet,where ownership of the asset does not pass to the agency ....................................................24

Figure 7: Example of completed results worksheet, where ownership of the asset does not pass to the agency ....................................................24

Figure 8: Example of discount rate sensitivity, where ownership of the asset does not pass to the agency..................................................................25

Figure 9: Example of residual value sensitivity, where ownership of the asset does not pass to the agency..................................................................26

Figure 10: Example of Inputs screen, where ownership of the asset passes to the agency ............................27

Figure 11: Example of Results screen, where ownership of the asset passes to the agency ............................27

Figure 12: Example of discount rate sensitivity, where ownership of the asset passes to the agency ..........28

Figure 13: Example of residual value sensitivity, where ownership of the asset passes to the agency ..........29

1

1.1 Introduction Leasing can be a beneficial and cost-effective procurement option over purchasing, when the rightassets are leased, on appropriate terms, for the right reasons.

Some of the potential benefits of leasing are:

• the cost of the asset may be amortised (or spread) over the life of the asset;

• some (or all) risks of ownership can be transferred to the lessor;

• asset disposal is no longer the responsibility of the agency; and

• to allow an agency to acquire the most up-to-date technology and avoid obsolescence, if thatis considered a necessity.

The decision whether to finance the asset through lease or purchase must be assessed carefully.Agencies should ensure that comprehensive analysis of the risks, benefits and costs are conducted,prior to entering into leasing arrangements, to determine whether leasing is preferable to buying,and represents value for money. All alternative options should be considered.

Decisions to purchase assets must also be adequately justified by the analysis of all availableoptions.

Furthermore, the analysis of the financing options should be clearly separated from the decisionwhether the asset is needed and should be acquired, and separated from consideration of the optimal time to replace equipment. It is also important that the financing analysis, andformulation of the most cost-effective recommendation, is not biased by budgeting constraints.

More fundamentally, while the lease-versus-buy analysis solves the financing decision, it is stillessential for this decision to be preceded by the preparation of a sound business case for theinvestment decision, to demonstrate why the assets are being acquired in the first place.

In June 1999, the Office of the Auditor General of Western Australia released a performanceexamination into equipment leasing,1 finding that:

• agencies generally did not conduct a proper analysis of the lease-versus-buy decision;

• lease contracts frequently contained uncommercial terms and conditions; and

• agencies did not monitor the budgetary impacts of increasing levels of equipment leasing.

Chapter 1: Leasing


2

1 Auditor General Western Australia (1999), Lease now – Pay Later? The Leasing of Office and Other Equipment,Report No 3 – June.

The Office of the Auditor-General’s follow-up report of September 2003 acknowledged thatsignificant improvements have been made to address some of the concerns in the 1999 report.2

However, leasing arrangements in the Western Australian public sector remain a concern to theAuditor-General in that:

• a long-term view of the costs, risks and benefits of leasing is still not being taken;

• the lack of comprehensive lease-versus-buy analysis means that some leases will cost more overthe life of an asset, than had the asset been bought; and

• many lease-versus-buy analyses appear contrived to justify decisions to lease – an inappropriateresponse to ongoing budget and debt restraint.

It is clear from these findings that agencies continue to require clear guidance on the analysis of leasing. These guidelines aim to help agencies conduct a proper financial assessment of leaseoptions.

1.2 Operating Leases and Finance LeasesThere are two types of leases – operating leases and finance leases.3 An operating lease is similarto a rental agreement. It is generally short-term, and is usually cancellable by the lessee at shortnotice, with little or no cost. It is likely that the underlying asset will have multiple users. Thelessor, who retains exposure to the risks and benefits of ownership, generally covers themaintenance, insurance and repair costs of the asset.

A finance lease is usually long-term, and usually covers the majority of the economic life of theasset. It is often non-cancellable, unless the lessee is prepared to incur a significant penalty tocancel the lease. The lessee effectively assumes all the risks and benefits of ownership, includingmaintenance, repairs, insurance and obsolescence.

The lessor’s role in a finance lease is primarily to provide finance, and thus, the lessor has littleinterest in the day-to-day use of the asset. At termination, the asset is usually transferred to thelessee for a specified sum, typically by incorporating a guaranteed residual value into the contract.

The distinction between operating leases and finance leases has important implications for theGovernment’s management of the State’s finances3. The lessee treats operating lease paymentsas expenses, and the underlying asset is not recorded on the lessee’s balance sheet (i.e. off-balancesheet). In contrast, a finance lease represents a form of financing from the lessor to the lessee thatultimately leads to the purchase of the asset. An asset and a liability are recorded on the lessee’sbalance sheet where the leased asset is depreciated4, and the lease liability is reduced byrepayments in the form of lease payments over the lease term. 3

2 Auditor General Western Australia (2003), Balancing Act: The Leasing of Government Assets, Report No 6. 3 Australian Accounting Standards Board AASB 117 Leases.4 See Australian Accounting Standards Board AASB 116 Property, Plant and Equipment.

Determining whether a lease should be treated as an operating lease or a finance lease can becomplex, and requires the exercise of value judgement. Therefore, where appropriate, accountingadvice should be sought to determine the proper accounting treatment.

Finance leases, for example, are not generally favoured by the Department of Treasury and Financein relation to the financing of general items of plant and equipment, as there is no incentive topay the interest rate premium over the benchmark rate that this entails. In the absence of anytransfer of ownership risk, analysing a finance lease simply consists of comparing the private sectorlease financier’s lending rate with the Government’s borrowing rate. The private sector’s rate willgenerally be higher than the Government’s rate.

However, in certain circumstances, a finance lease may represent better value for money thanpurchasing. Where an appropriate evaluation of the costs, benefits and risks of any proposedarrangement reveals that leasing represents value for money, and that the appropriate form ofleasing is a finance lease, then the agency should discuss the financial implications with theDepartment of Treasury and Finance.

An alternative option to leasing is to enter into a Public Private Partnerships (PPP) arrangement.PPP provide for joint approaches to infrastructure and service delivery between the public andprivate sectors. Where PPP are being considered, the whole-of-life cost of delivering the proposedinfrastructure and ancillary services should be approximated, using a Public Sector Comparator.5

Financing using PPP is a specialised and complex matter, and advice should be sought from theDepartment of Treasury and Finance if this type of procurement option is being considered.

1.3 Operating Leases in PracticeAn understanding of the nature of risk transfer is crucial in conducting a proper analysis of thelease-versus-buy decision.

Generally, a lessee who enters into an operating lease pays a ‘premium’, to limit the transfer ofrisk incidental to ownership, such as the capacity to return the rented equipment at any time.

In an operating lease, substantially all the risks and benefits of ownership effectively remain withthe lessor. For example, when hiring a car, the rental company retains the risks that the car breaksdown, that second-hand vehicle values fall, or simply, that you no longer require the use of thevehicle.

In practice, many agencies’ leasing arrangements do not meet the definition of an operating lease,and would be classified as finance leases under AABS 117. A typical finance lease arrangementcovers a substantial number of years of the economic life of the leased asset, is not easilycancelled, and requires all maintenance to be conducted by the agency. A standard lease of apersonal computer, covering the life of the personal computer, is an example of this type ofarrangement.

In essence, the only meaningful risk that a lessee can limit through operating leases is the disposalrisk. This is the risk that the lessee is not exposed to on ultimate disposal of the leased asset.


4

5 Department of Treasury and Finance (2002), Partnerships for Growth: Policies and Guidelines for Public PrivatePartnerships in Western Australia.

1.4 Budgetary Implications from LeasingIt is important that the financing analysis, formulation of the most cost-effective financing option,and determination of the appropriate accounting treatment, is not compromised by the budgetaryimplications.

For example, one of the budgetary implications of leasing arrangements is to enable an agency totransform large capital expenditures into smaller recurrent ones, and hence, smooth out asset-related expenditures.

From a budget perspective, unless otherwise approved by Cabinet:

• leases should not be used as a means to circumvent capital budget constraints;

• capital funds released by undertaking a lease procurement option by an agency are notautomatically made available for subsequent reinvestment by the agency in other capitalprojects; and

• leasing is not a mean of allowing overspending on assets, whereby the recurrent budget isused when no allowance has been made for the ongoing commitment created within thelease.

Furthermore, care must be taken to ensure that the whole-of-life cost of leasing is taken intoconsideration when assessing a lease, rather than just those lease payments that fall into thecurrent budget period.

Evaluation of leases centres on delivering a solution that provides the lowest whole-of-life cost tothe State after taking risk transfer into account.

Budgetary considerations should not play a role in the lease or buy evaluation. It is only once thefinancial terms of a lease are deemed acceptable, that budgetary impacts can influence the leaseor buy decision. Where budgetary constraints affect the affordability of the most appropriatesolution, the agency should consult with the Department of Treasury and Finance.

5

1.5 Scope of these GuidelinesOnce the purchasing/investment decision has been made and the finance decision is underconsideration, agencies must determine the appropriate depth of analysis.

These Guidelines, and the Lease or Buy Calculator, are intended to assist agencies undertakingrelatively simple lease or buy analysis. Simple lease or buy decisions are more likely to apply to anindividual, or a small number of inexpensive items. These Guidelines, and the Lease or BuyCalculator, enable agencies to calculate a justifiable result that can assist in the decision-makingprocess, using a relatively simple method. An example of where a simple lease or buy analysis isappropriate would be office equipment valued at less than $100,000. Other examples of simpleassets, and further guidelines on leasing, can be obtained through the Department of Treasury andFinance Buyers Guide for the provision of Common Use Rental Facility.6

It would be expected that a simple lease would conform to the Department of Treasury andFinance Master Rental Agreement and, in most cases, be supplied through the Department ofTreasury and Finance Common Use Arrangements.

Agencies should conduct some analysis, using the Lease or Buy Calculator available fromwww.dtf.wa.gov.au, and seek assistance from the Department of Treasury and Finance ifappropriate. Agencies with extensive experience and good practice in simple lease or buy analysis,may not need to consult with the Department of Treasury and Finance in these circumstances.

If an agency is considering a complex lease or buy decision for expensive or specialised assets, ora large number of items, then it is expected that a significantly greater level of analysis would beconducted.

In complex evaluations, the agency is expected to calculate the potential risk transfer associatedwith lease or buy, and obtain and document a number of written quotes for the residual value ofthe asset(s). These Guidelines, and the Lease or Buy Calculator, provide a robust basis for analysis.However, it is recommended that the Department of Treasury and Finance be consulted on allcomplex lease or buy decisions, to ensure that due process has been followed and documented,and to provide additional financial advice with respect to the proposed transaction.


6

6 www.gem.wa.gov.au/gem/buyersguides/1699.pdf

2.1 IntroductionThis chapter discusses the concepts behind the various factors in the lease or buy analysis, whichare helpful at all levels of financing decision-making, and then provides some guidelines as to howthey could be practically applied in a simple lease or buy analysis. The following chapter providesguidance on the use of the Lease or Buy Calculator, which may be used in the decision makingprocess for simple lease or buy analysis.

The analysis of leases seeks to answer the following questions:

• will an agency be better off leasing an asset or purchasing it, based on the cost of each optionand the allocation of risk? and

• does the premium implicit in the lease payments adequately compensate for a transfer ofownership risks to the lessor?

Lease-versus-buy analysis uses simple discounted cash flow analysis to recognise the two choicesopen to an agency:

• choice 1: purchase the equipment and pay interest (or an equivalent capital user charge) onthese funds. Sell at the end of the term; or

• choice 2: lease the equipment and return it at the end of the term.

Lease payments always include three components:

• the amortised principal payment for the asset;

• a charge for interest; and

• a deduction for the ultimate disposal price of the equipment.

Viewed in this way, choices one and two contain all the same elements; i.e., the purchase price,interest, and a refund for the ultimate disposal. This is illustrated in Figure 1.

The purchase price does not vary between choices. It therefore follows that the decision betweenleasing and buying will depend on a comparison of:

• the residual value offered by the lessor, relative to the agencies unique estimate of the ultimatevalue of the equipment; and

• the interest rate offered by the lessor, relative to the interest rate (or discount rate) applied togovernment purchases of this type.

These are the two key components of any lease analysis, and are covered in further detail in thefollowing sections.

Chapter 2: Concepts in Lease Analysis

7

The main components assessed in the lease-versus-buy analysis are summarised in this comparatortable, as follows:

Figure 1: Major Components Considered in Lease Analysis


8

Purchase Lease where Lease where ownership does ownership

not pass to lessee passes to lessee

Purchase price √

Lease payments (regular) √ √

Lease payments at end of lease for guaranteed lease residual payment, or bargain purchase √option payment (if applicable) (Note 1)

Residual value of the asset to agency at end of the lease term (only required under leasing if √ √the lessee obtains ownership at the end of the lease – see Note 1)

Residual value assessed by lessor (if applicable) (Note 2) √

Interest rate or discount rate √ √ √

Note 1 - Some lease arrangements may provide for the lessee to purchase the asset at the endof the lease term, under a guaranteed lease residual or bargain purchase option payment. Theamount will be set out in the lease contract. Where ownership passes to the lessee at the endof the lease, this suggests a finance lease arrangement.

Note 2 – Where the lease provides for the asset to be passed to the lessor at the end of thelease, the analysis requires an estimate of the residual value assessed by the lessor, in order tocalculate the implicit interest rate incorporated in the lease.

2.2 The Residual ValueThe asset’s residual value is a significant factor in the lease-or-buy analysis. As set out above, theanalysis takes into account the residual value to the agency at the end of the lease term, wherethe agency has the ownership disposal risk for the asset (purchase or some leases). If the lessorretains the ownership disposal risk, estimate the lessor’s assessed residual value to calculate theimplicit interest rate incorporated in the lease (as discussed further below).

2.2.1 Disposal Risk

Under many leases generally considered by agencies, the lessee can avoid the risk of assetownership, and in particular, the risk that proceeds from the disposal of assets will be less thanexpected; that is, residual value risk. In general, a low estimate for residual value by the agencywill tend to favour leasing the asset, while a higher estimate of residual value to the agency at theend of the lease will favour purchasing the asset.

Leases where the lessor retains ownership disposal risk, can offer a cheaper method of acquisitionto the lessee, if there is a high risk of obsolescence for the asset being leased. In somecircumstances, lessors have developed specialised distribution channels for disposing of assets and,therefore, may obtain higher resale prices for second-hand assets than could be achieved by theagency. This benefit can be passed on to the agency in the form of reduced lease payments, andthe net present value of leasing may by lower than outright purchase.

On the other hand, leasing may not offer any significant financial benefits if ownership disposalrisk is retained by the lessor, and the residual value of the asset to the agency, at the end of thelease term, is greater than the value placed on the asset by the lessor in pricing the lease payments;for example, where an asset has a useful life to the agency what is longer than the lease term.

2.2.2 Importance of Asset Management and Replacement Policies

The estimate of the residual value of an asset to the agency, at the end of the lease term, is largelydependent on the agency’s asset management and replacement policies and practices. The usefullife of an asset will vary among agencies, and depend upon the conditions that exist in a particularagency. It is important to note that the second-hand market value may not necessarily representthe value of the asset to the agency at the end of the lease term. The agency’s expected use forthe asset at the end of the lease is the most critical factor to consider in establishing the agency’sresidual value.

It is important that agencies have clear optimal use and replacement strategies for assets, and thatthese strategies are documented in an asset management and replacement policy. Such policiesthen provide the framework for establishing the asset’s residual value in the context of a lease-or-buy decision. Some further guidance on asset management policies, including practices to applyat the expiry of leases, is set out in the Master Rental Agreement7 and Buyer’s Guide.8

9

7 Department of Treasury and Finance, Master Rental Agreement.8 Department of Treasury and Finance, Buyer’s Guide for the Provision of Common Use Rental Facility (Contract No.

1699), 2004. Available from: http://www.gem.wa.gov.au.

2.2.3 Estimating Residual Values

The estimation of the residual value needs to take into account the type of asset, and itsimportance to the agency, and the way the asset will be used by the agency. Some of the keyconsiderations are summarised below.

Type of asset

Where an asset is highly specialised, or integral to the operations of the agency, there may be alimited second-hand market, and, therefore, the lessor is less likely to efficiently assume disposalrisk, and the government may provide the only likely market for such items after the lease term.In these circumstances, it is more likely that private sector leasing will only be available in the formof finance leases, and additional care is required in the evaluation of the lease-versus-buy decision.For example, large-scale office accommodation in small rural towns has been demonstrated to beinappropriate for leasing, as there are few likely tenants other than government agencies. On theother hand, some specialist medical equipment retains high values in offshore markets, even whenconsidered obsolete by local agencies, and leasing arrangements may be financially attractive.

Economic life of the asset to the agency compared with lease life

Where the optimal replacement period or the asset’s economic life to the agency is greater thanthe lease period, the asset is likely to have a residual value-in-use to the agency that exceeds thesecond-hand market value. For example, some agencies have a ’cascade’ policy for personalcomputers, whereby new equipment is provided first to high-need individuals, and then rotatedthrough the agency as it ages, such that the asset is still used long after the expiry of a lease.

Where assets have a short economic life (due to the high rate of obsolescence or rapidly changingrequirements), the asset may lose saleability quickly, which makes disposal difficult. In this case, alessor may be able to offer a better residual value via the lease arrangements than that availableto the agency.

2.2.4 Benchmarks for Estimating Residual Values

Approach

The types of assets covered by this lease-versus-buy guidance are the more generic types of assets,as discussed in Section 1.5. Highly specialised equipment or large projects are not covered bythese guidelines, and should be subject to separate evaluation in consultation with theDepartment of Treasury and Finance. If there are any doubts on whether these guidelines areappropriate for a particular asset, please contact the Asset Planning and Management Division ofthe Department of Treasury and Finance on (08) 9222 9380.

The residual value of the asset to the agency should be assessed as the higher of thesecond-hand market value and the value-in-use to the agency at the end of the leaseterm, (net of the costs of disposal such as dismantling, transport and selling costs suchas commissions). Where assets have a longer economic life to the agency than the lease term,it is likely that the value-in-use will provide a higher value than the second-hand market value.Where the economic life for an asset is similar to the lease term, and the agency has no furtheruse for the asset, the second-hand market value (net of disposal costs) should be used as theasset’s residual value. Support for the asset residual value estimate should be properlydocumented and consistent with the agency’s asset management policy.


10

Guide for Second-Hand Market Value

Agencies should obtain an auctioneer assessment of the second-hand value, as a percentage ofthe original cost of the asset for the term of the lease being considered. These details should befully documented by the agency. Should the agency, for any reason, consider that one assessmentis not sufficient (for example, because the assessment of second-hand value is particularlysubjective or material amounts are involved), then further assessments should be obtained, and anaverage of the values taken.

Guide for Value-in-Use to the Agency

The value-in-use to the agency at the end of the lease term (where the economic life for the assetexceeds the lease period) will depend on the circumstances. A broad benchmark for the types ofassets that are expected to fall within these guidelines, is the depreciated cost using an acceleratedmethod of depreciation over the asset’s economic life.

For example, an asset costing $50,000, with a five year economic life, would have a depreciatedcost over its life, as follows:

a Using an accelerated method based on the number of years life – in year 1 depreciation based on 5/15ths of cost,year 2 based on 4/15 of cost and so on.

Figure 2: Accelerated depreciation of a $50,000 asset with an economic life of five years

If the lease alternative was for a three year period, the residual value-in-use to the agency at theend of the lease term would be $10,000, or 20% of the original cost, (assuming no residual valueor disposal costs at the end of the asset’s economic life).

11

Opening Annual Closingbalance depreciationa balance

Year 1 50,000 16,667 33,333

Year 2 33,333 13,333 20,000

Year 3 20,000 10,000 10,000

Year 4 10,000 6,667 3,333

Year 5 3,333 3,333 0

Example for Estimating Agency Residual Value

If the agency’s policy is to replace the asset on a three year cycle (which coincides with the leaseterm), the second-hand market value of the asset would be used as the agency residual value inthe lease-versus-buy analysis. In the above example, if the second-hand market value for the asset(net of disposal costs) is 10% of original cost after three years (consistent with, say, many types ofcomputer and office equipment), the agency residual value would be $5,000.

If the agency has a ‘cascade’ policy, so that the asset has a five year economic life, the agencyresidual value in the preceding example would be $10,000, being the higher of the residual value-in-use at the end of the lease term (depreciated cost), and the second-hand market value at theend of the lease term ($5,000).

2.2.5 Lessor’s Residual Value

Where ownership disposal risk is not passed onto the lessee, an estimate of the lessor’s residualvalue is used in the Lease or Buy Calculator to derive the implicit interest rate in the lease.

In many cases, the lessor will not disclose the residual value applied in its pricing of the lease. Inthis case, the estimated second-hand market value of the assets can be applied as an estimate ofthe lessor’s residual value in the Lease or Buy Calculator.

2.2.6 Breakeven Analysis for Residual Values

The Lease or Buy Calculator calculates the breakeven residual value at which point the lesseewould be indifferent between leasing the equipment and buying the equipment. This can be usedto compare with the agency’s estimated residual value for reasonableness.

If leasing is the higher cost outcome, then the breakeven agency residual value will be less thanthe estimate used in the analysis. In other words, the agency would have to achieve a lowerresidual value on buying the asset, in order to benefit from leasing. It is possible for the breakevenresidual value to be negative. This would apply where the costs of disposal exceeded the residualvalue. This is illustrated and explained further in the examples discussed later in this guidance.


12

2.3 Discount Rates

2.3.1 Overview

The Department of Treasury and Finance supports the approach to ensure that a risk premium istaken into consideration in any lease-versus-buy analysis. The evaluation of a lease-versus-buydecision involves discounting the future cash-flows associated with these two financingalternatives, to arrive at the net present value of buying and leasing the assets. The discount rateapplied in a lease-versus-buy evaluation is the cost of funds of the organisation. An estimate ofthe value of risk transfer must then be added; in this model it is added as a premium at the endof the net present value analysis.

For agencies in the Western Australian public sector, the appropriate discount rate toapply to the types of assets covered by these guidelines is the Western AustralianTreasury Corporation’s (WATC) fixed lending rate to public sector agencies for a periodthat corresponds to the lease term. This rate represents the cost of funds from a whole-of-government perspective, and provides the appropriate benchmark for determining whether theuse of lease finance involves higher costs than internally funding the purchase of the asset.

The rationale for using the WATC’s lending rate considers the following key matters, which arediscussed in further detail below:

• financing decisions differ from investment decisions;

• relevance of Capital User Charge to agencies;

• transparent cost and benefit analysis.

As the principal lending authority to State agencies, WATC provides the best assessment of thecost of borrowing. The Government is interested in obtaining what the value of leasing is to it,not the leasing costs. In using the WATC rate as the discount rate, an assessment can be madeby comparing purchasing and leasing, as if the Government were also the lessor. Under thisassumption, the borrowing rate of the lessor becomes less relevant, as it is the value of purchasingversus leasing that is relevant.

13

2.3.2 Financing Decision-Making

The decision whether to buy or lease an asset is a financing decision which is made after (andindependently of) the decision to invest in an asset. The Department of Treasury and Finance hasseparate detailed guidelines for the investment evaluation of projects.9 Broadly, the investmentdecision (that is, the decision whether to acquire the asset or not) involves an assessment of thenet benefit to government, and requires an evaluation of the costs, benefits and risks associatedwith the asset and any available alternative projects or courses of action. An investmentevaluation, therefore, includes consideration of the risks for different types of projects and theapplication of a risk premium, depending upon whether the alternatives being considered fall in alow, medium or high-risk category.

The focus of the lease-versus-buy evaluation is to determine how to finance the asset acquisitionin a way which represents the best value. This involves both financial and non-financial matters(such as the transfer of asset disposal risk).

The types of assets covered by this lease-versus-buy guidance will not impact on the WesternAustralian Government’s risk profile and overall cost of funds. Therefore, the WATC’s lending rateis the appropriate rate to represent the benchmark cost of funds for these evaluations. As notedpreviously, highly specialised or large projects are not covered by these lease-versus-buy guidelines,and the appropriate discount rate in such circumstances must be subject to separate evaluation inconsultation with the Department of Treasury and Finance.

2.3.3 Capital User Charge to Agencies

On 1 July 2001, the Department of Treasury and Finance introduced an 8% Capital User Chargeon the net assets held by an agency. The Capital User Charge is intended to represent theopportunity cost of holding an asset, and is deemed to be the rate of return that could be achievedif the funds tied up in an asset were realised and placed in a comparable investment. One of thepurposes of the Capital User Charge is to encourage more efficient use of capital by agencies.

The Capital User Charge is higher than the WATC’s lending rate, and reflects the average levelof risk to government of the portfolio of assets, projects and investments typically undertakenby agencies.

It is not appropriate for agencies to use the Capital User Charge as the discount rate in the lease-versus-buy evaluations for the types of assets covered by these guidelines.

As the Capital User Charge is higher than the whole-of-government cost of funds, the net presentvalue of the leasing alternative will be lower, and leasing may then appear to be more favourablethan purchasing the asset. However, this does not represent the true financial outcome from awhole-of-government perspective. A key objective of these lease-versus-buy guidelines is toensure that the methodology for evaluation of financing decisions reflects the proper cost andvalue for money to government as a whole.


14

9 Project Evaluation Guidelines

2.3.4 Transparent Cost and Benefit Analysis

The net present value evaluation using the WATC’s lending rate to public sector agenciestransparently quantifies the extra cost to government (if any) associated with leasing. Suchadditional cost can then be compared with the benefits from leasing which have not beenexplicitly quantified in the net cashflow analysis, (such as the removal of the disposal risk for theresidual value of the asset at the end of the lease, where the lease terms provide for the lessor toretain ownership of the asset), which will allow the agency to perform a value for moneyassessment of the additional cost of lease financing, compared to the level of risk transferred. Theguidelines for this assessment are set out in Section 2.4.

2.3.5 Implicit Interest Rate in the Lease

The Lease or Buy Calculator provides an estimate of the implicit interest rate in the lease. This iseffectively a fixed rate over the period of the lease.

This rate can be compared with the discount rate applied in the analysis; that is, the WATC’slending rate, to assess the reasonableness of the lessor’s implicit interest rate in the lease. Animplicit interest rate which is significantly higher than the discount rate (for example, a margin of300 basis points or more), may suggest that the lease terms are punitive, and indicate that therisks associated with the asset are being passed to the lessee through a higher cost of financeand/or that the lease is, in substance, a finance lease. It is important to note that this analysis willbe impacted by the lessor’s estimated residual value.

2.3.6 Sensitivity Analysis of Discount Rate

The Lease or Buy Calculator provides a sensitivity analysis of the net benefit (cost) of leasing,compared with purchasing for different discount rates. The breakeven discount rate is the rate atwhich the net cost of leasing and buying are the same. This can be used to compare with theagency’s discount rate and the lessor’s implicit interest rate in the lease terms, as illustrated in theexamples set out below.

15

2.4 Decision-Making Guidance

2.4.1 Risk Allocation

A lease will represent value for money if the net additional cost of leasing is commensurate withthe transfer of risk to the lessor. The decision to lease or buy the asset will normally depend onweighing up the net additional cost of leasing (if any), and risks of ownership that are borne andretained by the lessee and lessor. The risks of ownership of an asset include:

• maintenance and operation;

• breakdown;

• unsatisfactory performance;

• idle capacity;

• obsolescence; and

• losses in realisable value.

Many leasing arrangements contemplated by agencies will typically involve only the transfer of thedisposal risk for the residual value of the asset from the agency to the lessor. Leases that providefor all the risks and benefits of ownership (including disposal risk) to be borne by the lessee, arein the nature of a financing arrangement (i.e. a finance lease).

2.4.2 Guidelines for Weighing Up Risk and Net Lease Costs

Where the lease-versus-buy analysis derives a net cost for leasing, compared with purchasing theasset, this premium cannot be justified in circumstances where all the risks and benefits ofownership are still borne by the agency.

Where only the disposal risk for the residual value of the asset is transferred from the agency tothe lessor, as a guide, a net cost of leasing of up to 5% of the capital cost of the asset wouldgenerally be considered an acceptable cost. Part of the reasoning is that a difference of up to 5%between the costs of leasing, versus outright cash purchase (eg. $100,000 versus up to $105,000),is not considered material in the context of the asset financing decision. That is, if the additionalcost relates to the transfer of disposal risk, the additional cost of up to 5% is likely to be justifiable.

The premium of 5% is based on an accounting definition of materiality, and is consistent with thelevel of materiality used for this type of analysis in other Australian jurisdictions. This may not besuitable in all instances, and should an agency have any concerns over its application, the AssetPlanning and Management Division of the Department of Treasury and Finance should becontacted.

If the lease being considered involves a different profile of risk-sharing between the agency andlessor, the level of the premium should be amended appropriately, to ensure a valid decision ismade. Importantly, in these circumstances, care is required to ensure that all costs of the purchaseand lease alternatives are properly included in the analysis. For example, if the lessor bears the riskof breakdown, the purchase alternative must also incorporate an allowance for the breakdownrisk that the agency would bear if the asset were purchased, (such considerations are not requiredwhere the agency bears this risk as a lessee, because the costs are common in both alternatives).Agencies must consult the Department of Treasury and Finance in these circumstances.


16

2.4.3 Cost /Benefit Comparison in the Lease or Buy Calculator

The Lease or Buy Calculator sets out guidelines for the cost/benefit comparison of the lease andbuy alternatives for the following circumstances:

• where all the risks and benefits of ownership are retained by the lessee; or

• where the disposal risk is transferred to the lessor, and all other risks of ownership are retainedby the lessee.

The Lease or Buy Calculator does not accommodate the analysis of other risk-sharingarrangements in lease agreements. Agencies must seek assistance from the Department ofTreasury and Finance about the appropriate analysis in such circumstances.

The cost/benefit comparison incorporated in the Lease or Buy Calculator:

• compares the net present value of the lease and purchase options, and determines whetherthe leasing option is more or less expensive than the purchase option, and by how much;

• calculates the net benefit (or cost) of the lease, as a percentage of the asset purchase price;

• provides a recommendation, depending on the outcome as summarised in Figure 3.

Figure 3: Comparison of marginal lease or buy options

Where leasing is more costly, and the lessee retains all the risks of ownership, purchasing the assetis more likely to give a net benefit to the agency. Similarly, where the disposal risk is transferredto the lessor, (that is, the asset is returned to the lessor at the end of the lease) and the net costof leasing is more than 5% of the asset purchase price, purchasing the asset is more likely to givea net benefit to the agency. If the net cost of leasing in these circumstances is between 0% and5% of the asset purchase price, leasing is more likely to be the preferred alternative.

Other decision-making tools

The other decision-making tools provided by the Lease or Buy Calculator are:

• the implicit interest rate in the lease;

• the sensitivity of net cost/benefit to different discount rates; and

• the breakeven residual value at which the lessee is indifferent between leasing and buying.

17

Comparison of cost in present value terms Recommendation

Lease < Purchase � Lease

Lease > Purchase

All risks of ownership borne by lessee � Buy

Disposal risk transferred to lessor and net cost is over 5%

of asset purchase price � Buy

Disposal risk transferred to lessor and net cost is 0% to 5%

of asset purchase price � Lease

3.1 Introduction This chapter provides a guide to using the Lease or Buy Calculator to perform a lease-versus-buyanalysis for a relatively generic lease arrangement. The analysis of specialised assets and largeprojects, and long-term leases with lives over 10 years, must be referred to the Department ofTreasury and Finance for guidance.

The Lease or Buy Calculator is available from www.dtf.wa.gov.au. Should agencies have anyquestions or queries on the use, application or results of this model, they should contact the AssetPlanning and Management Division of the Department of Treasury and Finance.

Please note that the Lease or Buy Calculator cannot be used to compare tenders for leasefinancing. Before using the Lease or Buy Calculator, the best value lease must be identified bycomparing the total cost of the leasing proposals, after considering the net present values andrisk/benefit profiles of the alternative proposals. The Department of Treasury and Finance canprovide advice on comparing tenders for lease financing, if necessary.

Once the best value lease is selected, the Lease or Buy Calculator uses the data for that lease toassess whether leasing is preferred to purchasing.

The Lease or Buy Calculator is designed to compare a standard lease with an outright purchasedecision. A lessor may sometimes provide a bundled quote for a lease transaction. A bundledquote includes the cost of additional services, such as maintenance or insurance, together with thefinance cost under one lease costing. This can make it difficult to independently assess the servicesand finance component of the lease. Lease quotes should be obtained on an unbundled basis,excluding additional services, so that the service and finance components can be assessedseparately.

The results of any lease-versus-buy analysis, and decisions taken, should be clearly documented.

3.2 DisclaimerThe Department of Treasury and Finance has prepared this model for use solely by WesternAustralian Government agencies, to assist in analysing the merits of leasing versus buying.

This model is intended to be used as a guide. Legal, tax and/or accounting advice should besought from an independent, expert practitioner before applying the information to particularcircumstances.

The accuracy of the outputs of the model is significantly determined by the accuracy, currency andcompleteness of the information entered by the agency. Markets are volatile and unpredictable.The actual rentals payable under the proposed lease, and actual interest under any proposed loan,will depend on market conditions and on the final agreed terms.

Chapter 3: The Lease or Buy Calculator


18

3.3 Getting StartedThe Lease or Buy Calculator is contained in an Excel file (Department of Treasury and Finance Leaseor Buy Calculator.xls). In order for the Lease or Buy Calculator to run correctly, the followingstandard Excel Add-Ins must be included in your Excel set-up:

• Analysis ToolPak

• Analysis ToolPak – VBA

To include the Add-Ins in your Excel set-up, complete the following steps:

• go to the ‘Tools’ menu;

• select ‘Add-Ins’ from the drop down list;

• check the ‘Analysis ToolPak’ and ‘Analysis ToolPak – VBA’ boxes; and then

• select ‘OK’.

Before starting your analysis, it is recommended that you verify the integrity of the Lease or BuyCalculator by conducting a brief test exercise. Enter the inputs from the Excel input screen print-out in Sections 3.7.1 and 3.7.2 into the Lease or Buy Calculator and compare the results withthose from the Excel screen print out. If your results differ from the Excel result screen print outin Sections 3.7.1 and 3.7.2, please contact the Asset Planning and Management Division of theDepartment of Treasury and Finance to check your version of the Lease or Buy Calculator.

3.4 Overview of SpreadsheetThe Lease or Buy Calculator consists of four worksheets:

• Inputs - This sheet allows you to enter the details of the lease and purchase options that youare considering (see Section 3.5).

• Results - This sheet displays the results of the Lease or Buy Calculator analysis, and provides arecommendation to either lease or purchase. You will not be able to make changes to thissheet. It is for your information purposes only (see Section 3.6).

• Discount Rate Sensitivity - This sheet displays a graph depicting the sensitivity of the net costor benefit from leasing, to changes in the discount rate. You will not be able to make changesto this sheet. It is for your information purposes only (see examples in Section 3.7).

• Residual Value Sensitivity - This sheet displays a graph depicting the sensitivity of the netcost or benefit from leasing to changes in the residual value. You will not be able to makechanges to this sheet. It is for your information purposes only (see examples in Section 3.7).

19

3.5 The Inputs WorksheetThe inputs worksheet in the Lease or Buy Calculator is shown below:

Figure 4: Inputs worksheet

The following inputs must be reviewed, and details entered into the Lease or Buy Calculator toperform the analysis:

• date of assessment;

• asset purchase price;

• asset residual value to the agency at the end of the lease period;

• lessor residual value (if applicable);

• lease term;

• asset economic life to the agency;

• number of lease payments per year;

• payment timing (either in advance or in arrears);

• lease payment per period;

• guaranteed residual payment, or bargain purchase option payment, at the end of the leaseterm (if applicable);

• discount rate; and

• whether ownership will pass to the agency at the end of the lease term.


20

The name of the preparer, department and brief description of the asset should also be entered.

Before entering any inputs into the Lease or Buy Calculator, press the Start/ Clear Inputs button toclear the worksheet.

3.5.1 Date of Assessment

This is the date at which the present value of the lease and purchase options will be assessed.

Enter the date of assessment in order of the day, month and year.

3.5.2 Asset Purchase Price

This is the actual amount payable for the asset, and should be obtained from the supplier. Theasset purchase price should be exclusive of GST, to the extent that it can be refunded. It shouldinclude the cost of acquiring the asset only, not installation and other costs, which will not differbetween leasing and purchasing. Care should be taken to ensure that the value of any trade-inavailable is treated consistently.

Enter the asset purchase price, as a dollar value.

3.5.3 Asset Residual Value to the Agency

This is the net value of the asset to the agency at the end of the lease term. This amount may bezero or negative if there are net costs associated with disposal of assets. Guidance on theassessment of the agency’s asset residual value is set out in Section 2.2. This information isrequired for the purchase alternative and is also relevant to the lease option where the lease termsprovide for ownership of the asset to pass to the lessee at the end of the lease term.

Enter the asset residual value, as a dollar amount.

3.5.4 Lessor Residual Value

This information is required where the lease terms provide for ownership of the asset to remainwith the lessor at the end of the lease term. This information will be used to estimate the implicitlease rate and is helpful in determining whether a lease is a finance lease or an operating lease.Guidance on the assessment of the lessor’s residual value is set out in Section 2.2.

The Lease or Buy Calculator asks if ownership will pass to the agency at the end of the lease term.Select ‘Yes’ or ‘No’ from the drop down box. If your response is ‘No’, you will be prompted toenter the lessor residual value amount as a dollar value.

3.5.5 Lease Term

Enter the lease term, in years.

3.5.6 Asset Economic Life to the Agency

This is the period over which an asset is expected to be economically useable by the agency. Asdescribed in Section 2.2.2, if the asset’s economic life to the agency exceeds the lease term, theasset residual value to the agency at the end of the lease term must consider the value-in-use tothe agency, as well as the second-hand market value.

Enter the asset economic life, in years.

21

3.5.7 Number of Lease Payments per Year

Lease payments are generally made annually, semi-annually, quarterly or monthly. For leasepayment periods longer than quarterly, agencies will need to consider whether there are materialinterim rentals associated with the lease (see below). The Lease or Buy Calculator does allow anon-standard number of lease payments per year to be entered.

Enter the number of lease payments per year as a whole number. The Lease or Buy Calculator willautomatically indicate the frequency of the payments.

3.5.8 Payment Timing

The lease contract may provide for payments to be made in advance, at the beginning of thepayment period, or in arrears, at the end of the payment period.

Select ‘In Advance’ or ‘In Arrears’ from the drop down box, to enter the payment timing.

3.5.9 Lease Payment per Period

This is the actual amount payable per period, as quoted by the lessor. The lease payment perperiod should include any stamp duty on-charged by the lessor, as this is a cost specific to theleasing option. The lease payment per period should also be exclusive of GST.

The Lease or Buy Calculator does not take into account any interim rentals that may be payableunder a lease agreement. An interim rental can arise at the commencement of a lease, if thelessee takes delivery of an asset on a date before the first nominated lease payment date. In thiscase, the lessee is required to make an additional pro-rata lease payment, to cover the interveningperiod. Provided interim rentals are minimal no adjustment is required. However, where interimrentals are significant, agencies must consider the additional cost in their analysis. Agenciesshould seek to minimise interim rentals where possible.

Enter the lease payment per period, excluding any additional services, as a dollar value.

3.5.10 Guaranteed Residual Payment or Bargain Purchase Option Payment at the Endof the Lease Term

If the lease terms provide for ownership of the asset to pass to the lessee at the end of the leaseterm, the lease contract may provide for a guaranteed residual payment, or bargain purchaseoption payment, to be made.

The Lease or Buy Calculator asks if ownership will pass to the agency at the end of the lease term.If your response is ‘Yes’ you will be prompted to enter any guaranteed residual payment, orbargain purchase option payment, that is included in the lease contract. Enter the guaranteedresidual payment, or bargain purchase option payment, as a dollar value.

3.5.11 Discount Rate

This is the WATC’s lending rate for a period equivalent to the lease term. Please contact the WATC for the updated rate at the date of assessment, as an outdated or incorrect rate will notprovide a proper comparison with current leasing rates, and may result in an inappropriatedecision being made.


22

3.6 The Results WorksheetOnce all the necessary details have been entered into the Inputs worksheet, the Lease or BuyCalculator will calculate the present value of the lease and purchase options. The results of thisanalysis will be presented in the Results worksheet, as shown in Figure 5.

The Results worksheet indicates:

• the present value cost of the lease option;

• the present value cost of the purchase option;

• whether the leasing option is more or less expensive than the purchase option, and by howmuch;

• the net benefit (or cost) of the lease, as a percentage of the asset purchase price;

• the estimated lease rate implicit in the lease option;

• the breakeven discount rate, where the agency should be financially indifferent betweenleasing the asset and purchasing the asset; and

• the breakeven asset residual value, where the agency should be financially indifferent betweenleasing the asset and purchasing the asset.

The Lease or Buy Calculator will also provide a recommendation in the Results worksheet. The recommendation may be ‘This asset should be LEASED’ or ‘This asset should bePURCHASED’ depending on the criteria outlined in Section 2.4.

Figure 5: Results worksheet

23

3.7 Examples

3.7.1 Example – Ownership of the Asset Does Not Pass to the Agency

An example of the Lease or Buy Calculator, where ownership of the asset does not pass to theagency is shown below:

1. Inputs

Figure 6: Example of completed inputs worksheet, where ownership of the asset does not passto the agency

As ownership of the asset does not pass to the agency in this example, an estimate of the lessorresidual value must be entered, and the guaranteed residual/bargain option payment field shouldbe left blank.

2. Results

Figure 7: Example of completed results worksheet, where ownership of the asset does not passto the agency


24

This example shows the leasing alternative is $5,579 cheaper than the purchase alternative,therefore, it is recommended that the asset be leased. The interest rate implicit in the lease is7.8%, compared with the WATC lending rate of 6.5% (representing the cost of funds at a wholeof government level for a two-year term). Leasing is the financially preferred option in thisexample, because the lessor is estimated to achieve a higher residual ($85,000) than the agency($75,000), which offsets the higher interest rate payable in the lease.

The results indicate that the WATC lending rate would need to fall to less than 4.1%, or theagency would need to be confident of achieving a residual value at the end of the lease term ofat least $81,347, for the agency to consider purchasing. These factors support the Lease or BuyCalculator’s recommendation to lease.

3. Discount Rate Sensitivity

Figure 8: Example of discount rate sensitivity where ownership of the asset does not pass to theagency

The discount rate sensitivity chart displays graphically the relationship between the discount rateand the lease-versus-buy decision. The graph shows where the discount rate is less than 4.1%there will be a net cost of leasing, and purchasing the asset is recommended. Conversely, wherethe discount rate is greater than 4.1%, there will be a net benefit of leasing, and this isrecommended. In this example, the discount rate is higher than 4.1%, at 6.5%, and thereforeleasing is recommended. 25

4. Residual Value Sensitivity

Figure 9: Example of residual value sensitivity, where ownership of the asset does not pass to theagency

The residual value sensitivity chart displays graphically the relationship between the residual valueand the lease-versus-buy decision. The results indicate that in this example, the agency wouldneed to be confident of achieving a residual value, at the end of the lease term, of at least$81,347, for the agency to benefit by purchasing the asset, rather than leasing. The graph showswhere the residual value is greater than $81,347, there will be a net cost of leasing, andpurchasing the asset is recommended. Conversely, where the residual value is less than $81,347there will be a net benefit of leasing, and this asset is recommended. In this example, the residualvalue is lower than $81,347, at $75,000, and therefore leasing is recommended.


26

3.7.2 Example – Ownership of the Asset Passes to the Agency

An example of the Lease or Buy Calculator, where ownership of the asset passes to the agency isshown, below:

1. Inputs

Figure 10: Example of Inputs screen, where ownership of the asset passes to the agency

As ownership of the asset passes to the agency in this example, the guaranteed residual/bargainoption payment must be entered, and the lessor residual value field is left blank.

2. Results

Figure 11: Example of Results screen, where ownership of the asset passes to the agency

27

This example shows the leasing alternative is $5,158 more expensive than the purchasealternative and, as there is no transfer of the risks of ownership to justify payment of a premiumfor leasing, it is recommended that the asset be purchased. The rate implicit in the lease is 8.8%,which is higher than the WATC lending rate of 6.5% (representing the cost of funds at a wholeof government level for a two-year term). The results indicate that the WATC lending rate wouldneed to increase to 8.8% for the agency to consider leasing. These factors support the Lease orBuy Calculator’s recommendation to purchase. In this example, the concept of a breakevenresidual value is meaningless, as the agency is able to obtain a residual under both the leasing andpurchasing alternative.

3. Discount Rate Sensitivity

Figure 12: Example of discount rate sensitivity, where ownership of the asset passes to the agency

In this example, the graph shows where the discount rate is less than 8.8%, there will be a netcost of leasing, and purchasing the asset is recommended. Conversely, where the discount rate isgreater than 8.8%, there will be a net benefit of leasing, and this is recommended. In thisexample, the discount rate is lower than 8.8%, at 6.5%, and, therefore, purchasing isrecommended.


28

Residual Value Sensitivity

Figure 13: Example of residual value sensitivity, where ownership of the asset passes to the agency

In this example, the graph shows that, because ownership passes to the agency, and, therefore,the agency is able to obtain a residual value under both the leasing and purchasing alternatives,the net benefit or cost of leasing is the same, whatever the residual value. Hence, there is noresidual value amount that would make leasing more attractive than purchasing.

29

4.1 Lease Terms and ConditionsThe commercial leasing industry is highly competitive. Agencies should not automatically acceptlessor’s proposed terms and conditions without questioning the impact of these contracts,otherwise a potentially expensive and commercially unbalanced arrangement could result.

The former Department of Contract and Management Services established a common-use rentalfacility, with lease terms that are commercially balanced and fair to government agencies.

The Office of the Auditor General’s recent performance examination into leasing (2003), identifiedthat while there were differences in the lease agreements used across the sampled agencies, mostdid not contain unfavourable terms and conditions. Only one of the sampled agencies used thecommon-use rental facility.

The Department of Treasury and Finance strongly recommends that all agencies makeuse of the common-use rental facility.

Where the common-use rental facility is not used, care must be taken to ensure that leaseconditions do not unduly favour the lessor, or expose agencies to avoidable risks. The lessor’sproposed terms and conditions should not be accepted automatically.

The following section presents a series of lease terms and conditions commonly advocated by leasefinanciers, that should be avoided by agencies. The common-use rental facility has beenexpressly designed to avoid these types of terms. However, the list has been included to providean indication of why leasing can be made unattractive by standard commercial contracts.

4.1.1 Interim Leases

An interim lease is a practice whereby a pro-rata payment is made to get the lease into line witha common billing cycle, usually quarterly. This results in additional payments for up to threemonths on the lease, based on the full price of the asset, such that a 36-month lease can, in effect,be up to 39 months. This small and seemingly innocuous feature can magnify the effective costof the lease by over 50%, per annum. This practice is not considered acceptable.

4.1.2 Inertia Clauses

Some lease contracts automatically roll over at termination, at full price. The net result is that newasset prices are being paid for three-year-old assets. This is extremely profitable for the lessor. Thistype of clause relies on agencies forgetting the expiry date, or not properly managing end-of-termpractices. Clauses of this nature are not considered acceptable.

Chapter 4: Special Issues


30

4.1.3 End-of-Term Options

Leases that allow for re-negotiation of the payments, at a discount, are generally not acceptable.Many leases contain extension options at around 80% of the original lease payment. Given thatthe assets could be now worth typically 15% of its original value, this does not provide value tothe agency.

Best results are achieved from termination arrangements that provide the option to:

• purchase the equipment at market value;

• renegotiate the lease at six-monthly intervals, based on market value; or

• have the equipment removed by the lessor.

Furthermore, the onus must be on the lessor to provide warning of the imminent expiry of thelease, and automatic cancellation, in the event of non-response from the agency.

Note that it is the actions of the lessee (or agency) at the end of a leasing arrangement thatgenerally determines the overall financial performance of the lease. This underscores theimportance of:

• close monitoring by agencies of end-of-term planning; and

• appropriate contract terms and conditions, that provide sufficient warning of the impendingtermination, do not roll over automatically and generally protect the lessee from adverseoutcomes.

At the end of the lease term, a financial evaluation of all options available should be undertaken,and, where necessary, agencies should negotiate with lessors at the expiry of the lease.

4.1.4 Cancellation Penalties

An operating lease should enable the agency to exit the lease, in the event that the asset becomeseither obsolete, or surplus to the agency’s requirements. Because the equipment is depreciatingmore rapidly than ‘repayment’ of the lease, there will be a commercially balanced adjustment dueon cancellation. Cancellation penalties are not considered acceptable.

4.1.5 Fixed versus Floating Payments

Leasing arrangements should be fixed, such that inflation or interest rate risk is passed to thelessor. Any contract that seeks to escalate lease payments is not likely to be acceptable.

4.1.6 Stamp Duty

Leasing arrangements with the State are exempt from stamp duty. For a fixed dollar-value of anasset, lessors should therefore be able to provide State Government agencies with a higherresidual (lower lease payment) than an equivalent private sector lease.

31

4.1.7 Insurance

Some leases include insurance coverage, for which there will be an implicit premium incorporated in the lease payment. Many agencies are already insured in accordance withTreasurer’s Instructions TI 825 Risk Management and Security, and TI 812 Insurance. This ‘extra’can lead to unnecessary excess payments. Insurance should generally be excluded from a leasecontract, unless specifically requested by the agency.

4.1.8 Asset Management

Some leasing arrangements include asset management regimes. The cost of this is implicitly builtinto lease payments. Like insurance, a decision needs to be made at an agency level, as towhether this service is desirable or required.

4.1.9 Optional Extras

Lease financiers will often try and distinguish themselves on the basis of non-cost features such asasset management. There are no features offered by one company that will not be offered by allothers. The decision to lease should be based on price alone.

4.1.10 Lease Tenders from the Equipment Supplier

Note that tenders for the procurement of the equipment should be conducted separately fromtenders for lease financing. While many equipment suppliers also provide lease financing, this isoften not the cheapest form of financing available. This is, once again, consistent with conductingthe financing decision separately from the investment decision.

As a final note, the following points address some of the common misconceptions about leasing.

4.1.11 Government Can Borrow More Cheaply

By relying on its sovereign guarantee, the State can borrow more cheaply than any corporate leasefinancier. However, the cost of funds must be adjusted for the risk relating to the type of assetbeing acquired. For example, if the Government invested all its assets in information andcommunications technology, its borrowing costs would increase significantly. It is, therefore,erroneous to assess a lease on the basis of the Government’s cost of borrowing alone.

Furthermore, gains from leasing are reflected in the discount provided to Government for leases,relative to the market-based assessment of the risk inherent in the underlying asset. The businesscase shows that some lease financiers are so well placed to assume residual value risk, that theeffective lease rate is competitive with the State’s borrowing costs.

4.1.12 Why Should You Lease, Just to Pay the Extra Margin to Provide the Lessor witha Profit?

The lessor builds in a profit margin to reflect the risks assumed. In other words, this profitcompensates the lessor for taking risk. It is important to examine whether the risk removed byleasing is worth paying a premium for, and whether acquiring the asset is worthy of theinvestment of scarce capital resources.


32

4.2 Tax IssuesIn an ideal world, where all parties face the same borrowing costs, tax rates and levels of risk fora particular asset, leases would not exist.

Under current tax legislation, there are two areas of tax law that are of interest to Governmentagencies in seeking to understand the tax implications of leasing arrangements with the privatesector. These two areas relate to Section 51AD and Division 16D of the Income Tax AssessmentAct 1936 (Cth):

• Section 51AD is an anti-avoidance provision relating to situations where the lessee is a publicsector agency, particularly a tax-exempt body, or the Government. Section 51AD is intendedto prevent a Government agency (as a tax-exempt body) from accessing the benefits of taxdeductibility of depreciation, simply by transferring legal ownership to a tax-paying entity,while not relinquishing control, or passing any ownership risk.

If triggered, this provision may operate to deny the asset ‘owner’ deductions for depreciation,interest, financing fees, maintenance, repairs and building allowance, while all income remainsassessable for tax purposes.

• In contrast, Division 16D seeks to determine the extent to which transactions are, in substance,financing arrangements (or loans), and taxes them as such. It applies to situations where thereis no non-recourse debt, so that Section 51AD does not apply, but where the risks and benefitsassociated with ownership are, nonetheless, transferred to the lessee.

Unlike Section 51AD, this provision denies only those deductions relating to capitalexpenditure, while still allowing most normal deductions on interest and other expenses to theextent that they apply.

The Federal Government proposes to amend this existing taxation treatment of leasing and similararrangements between taxpayers, and tax exempt and non-resident end users, for the financingand provision of infrastructure and other assets. The Federal Treasury has detailed the proposedamendments in its exposure draft of the New Business Tax System (Tax Preferred Entities – AssetFinancing) Bill 2003. These amendments will replace Section 51AD and Division 16D with a newprovision, Division 250 of the Income Tax Assessment Act.

As these tax laws pertaining to leasing arrangements are complex, and potentially punitive in thefinancial impact they may bring to a leasing deal, and the proposed legislative reforms andassociated tax rulings may alter the way in which the Australian Tax Office views variousarrangements, it is advised that legal advice be sought in material cases.

33

Contacts

Further information is available from the following sources:

Issue Contact

General Queries Assistant DirectorAsset Planning and ManagementDepartment of Treasury and Finance(08) 9222 9380

Budget Formulation and Monitoring Agency ResourcesDepartment of Treasury and FinanceReception - (08) 9222 9336

Building Procurement Evaluation and Risk Management BranchDepartment of Housing and Works(08) 9440 2256

Asset Disposal Land Asset Management ServicesDepartment for Planning and Infrastructure(08) 9216 8911

Department of Treasury and FinanceGovernment of Western Australia

ISBN 0 7307 4545 7

lease ananlysis guidelines -...

Documents