Module 4Leasing

Leasing:It is an arrangement between two parties 1. Leasing company or lessor 2. The user or the lessee

Whereby the former arranges to buy capital equipment for the use of the latter for an agreed period of time in return for the payment of rent.

Rentals are predetermine and paid at a fixed intervals of time

Definition:

“Lease is a contract whereby the owner of an asset (lessor) grants to another party (lessee) the exclusive right to use usually for an agreed period of time in return for the payment of rent” James C. Van Home

A contract between lessor and lessee for the hire of a specific asset selected from a manufacturer or vendor of such assets by the lessee. The lessor retains the ownership of the asset. The lessee has possession and use the asset on payment of specified retain over the period”

- Equipment leasing association of UK

Terminologies:

The parties:The lessor and the lessee

The Asset: The asset is the property to be leased out.

Leasing is used for financing the use of fixed assets of high value

Eg:It may be an automobile, an aircraft, plant and machinery and building.

During the period of the lease , the ownership of the asset rest with the lessor , while the use is tranferred to the lessee.

The Term: Lease period

The lease rentals:It constitutes the consideration payable by the lessee as specified in the lease transaction.

Types of lease:

1. Financial lease / Capital lease/ Long term lease/ net lease/ Close lease.

• The lease agreement is irrevocable and non cancellable contractual agreement with the leasing company.

• The lessee, in turn, will be able to use the asset throughout the determined leasing period, paying a series of rentals or instalments for the use of that asset.

• Practically all the risks incidental to the asset ownership and all the benefits arising there from are transferred to the lessee who bears the cost of maintenance, insurance and repairs.

• Only title deeds remain with the lessor.

• The lessee also has the option to acquire ownership of the identified asset by, for example, paying the final rental or installment, or by bargaining a final purchase price with the lessor.Eg: Office equipment, textile machinery, containers, diesel generators

Ownership: The lease transfers ownership of the property to the lessee by the end of the lease term. Bargain Price Option: The lease contains an option to purchase the leased property at a bargain price. Estimated Economic Life: The lease term is equal to or greater than 75 percent of the estimated economic life of the leased property.

2. Operating Lease:• 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. • The lessee is not given any uplift to purchase

the asset at the end of the lease period. • Normally the lease is for a short period and

even otherwise is revocable at a short notice as per the agreement.

• Eg: Computers hardware, trucks and automobiles are found suitable for operating lease because the rate of obsolescence is very high in this kind of assets.

Financial Lease Operating Lease

Lease criteria - Ownership

Ownership of the asset might be transferred to the lessee at the end of the lease term.

Ownership is retained by the lessor during and after the lease term.

Lease criteria - Bargain Purchase Option

The lease contains a bargain purchase option to buy the equipment at less than fair market value.

The lease cannot contain a bargain purchase option.

Lease criteria - TermThe lease term equals or exceeds 75% of the asset's estimated useful life

The lease term is less than 75 percent of the estimated economic life of the equipment

Cancelability The lease cannot be cancelled by either of the parties

The lease can be cancelled at the option of the lessee and the lessor does not have the difficulty of leasing the same asset to other willingness lesses

Obsolescence risk The lessee bears the risks of obsolescence

The lessor bears the risk of obsolescence

Maintenance

The cost of repairs and maintenance are borne by the lessee, the lessor is merely a financier in the deal

The cost of repairs and maintenance are borne by the lessor

Tax

Lessee is considered to be the owner of the equipment and therefore claims depreciation expense and interest expense

Lessee is considered to be renting the equipment and therefore the lease payment is considered to be a rental expense

3. Sale and Lease Back:It is a transaction wherein the owner of a property sells that property and then leases it back from the buyer.

The type of property involved can be anything from residential or commercial real estate to equipment or vehicles.

Both the buyer and the seller can benefit from a leaseback.

The seller gets a lump sum of cash quickly, and the buyer gets a lower than market value purchase price, along with a long-term lease at a premium rate.

The lease amount provides periodic income and may even be enough to pay the buyer's mortgage, if he or she borrowed money to obtain the property.

This type of transaction can be a great investment tool that yields a high return, although as with any investment, there are associated risks.

Some leaseback arrangements allow the seller, or current lessee, the option to buy back the property at a future date.

During the life of the lease, however, the buyer derives tax benefits from the arrangement, such as being credited for depreciation of the property.

Sale transaction Sale value

Lease transaction Lease rentals

Structure of a sale and lease back deal

Seller

LessorLessee

Buyer

4. Leverage Lease: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 so purchased is held as security against the loan.

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

Lease Asset

Structure of Leverage lease

Lessor

Lender

Lessee

5. Cross border Leasing/ International leasing/ Transactional leasing:

A lease where the lessor is in one country and lessee in another.

The Jurisdiction of lessors and lessees are in two different countries.Eg. Leasing of airplanes.

Advantages of lessee:Saving of capital:• The lessee is not to pay or provide any

margin money as there is no concept of down payment

• So, hundred percent financing is assured to the lessee.

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 the lessee

Boom to small industries:The firms which are either small or have uncertain records of earning are able to obtain the use of asset through lease financing

Planning Cash flows:• Leasing enables the lessee to plan their cash

flows properly.

• The rentals can be paid out of the cash coming into the business from the use of the leased assets.

Permit alternative use of funds:• A leasing arrangement provides a firm with the

use and control over asset without incurring huge capital expenditure.

• The firm is required to make periodical rental payments.

• It saves considerable funds for alternative uses which would otherwise be tied up in fixed capital

Protecting against obsolescenceA firm can avoid risk of obsolescence by entering into operating lease agreement.Tax Benefits:• Operating lease – Rentals (Exemption)• Financial lease – Depreciation (Deduction)Better Liquidity:• In case of sale and lease back• Provides the advantage of better liquidity,

since it enables the lessee to make the sale of the asset owned to the prospective lessor, and then take the asset back on lease

• This helps a lessee firm to overcome a liquidity crunch by being in a position to sell and realize cash.

• This helps overcome working capital crises.

Advantages to Lessor:1.Stable business• Provides stable and continuous manufacturing

business for the lessor• It is possible for the lessee to acquire the asset

even in times of depression, thus contributing to the growth of the manufacturers sales even in times of depression

2.Sale of supplies:Depending upon the nature of the leasing arrangement , the lessor has to ensure the supply of spare parts and components required for the maintenance of the leased asset.

3.Second hand marketIn the case of the operating lease , where the asset leased by the lessee is reverted to the lessor, it is possible for the lessor to either lease out the asset again or to sell it in the open market

4. Tax benefits:• In case of operating lease – depreciation• In case of Financial lease- Rentals

5. Absorbing obsolescence risk – only in case of operating lease

Importance:

The main advantage of leasing – the initial outlay of cash to gain the use of an asset is generally less for leasing than it is for purchasing.

The main advantage of purchasing - is that the buyer ends up paying out less in the long term than he would have paid if he leases the same asset. Purchasing an asset helps in enjoying the benefits of appreciation in value – land

Factors to be considered: PurchaseControl of the property:The buyer may intend to make substantial additions or renovation to the property - landlord permission is required - If he rents the property.

However if the property is purchased there is no one to question the buyers move. Effects of long term Cost:Initial years- Lease may beat out purchase in terms of cash flowBut over a long period of time – purchase is usually cheaper because a landlord – in addition to paying all of the costs associated with purchasing and maintaining the property, will attempt to build in a profit for himself

Paying of profit premium can be avoided by purchasing the asset

No Suitable property to lease

Appreciated Land values

Tax savings:Although, unlike rent , the money used to purchase an asset is not deductible , the same can be recovered over time by yearly depreciation deductions. If the purchase is financed , interest payments can be claimed as a deduction.

Factors influence lease:

Avoidance of maintenance duties

Retain mobility:A buyer may not be sure that asset selected will serve his need s in the future years.Hence it is better to lease Rather than to purchase.

Declining Real estate values:A property may meet a buyers need, but he is concerned with the real estate values of that locality.Hence it is better option to lease the property and to let the landlord suffer the effects of declining values.

Availability of funds

Nature of asset : For those assets which become obsolete at a faster rate ‘buying’ that asset is not preferable.

The best solution is to go for operating leasing

Liquidity consideration:A firm has to maintain sufficient liquidity for meeting any sudden shortfall in cash flows – If sufficient liquidity is not available , leasing is the solution

  Buying Leasing

  Advantages Disadvantages Advantages Disadvantages

1

Outright asset ownership Major capital is required

No major cash outlay is required No asset ownership

2 Asset can be modified at any stage

Entity incurs maintenance and repairs cost which increases as

assets age

Entity does not incurs maintenance and

repairs cost as it may fall under the

warranty of lessor

Asset cannot be modified to the

changing business requirements

3 Asset can be replaced or modified

any time

Incurs cost Will not incur cost

Lease terms are generally fixed so

asset replacement or early termination at the request of the entity may attract

penalties

Tripartite lease:Such type of lease involves 3 different types of parties in the leasing agreement:

Equipment supplier, lessor and lessee.

An innovative variant of this type is the sales-aid lease under which the equipment supplier arranges for lease finance in various forms by:

• Providing reference about the customer to the leasing company.

• Negotiating the terms of lease with the costumer and completing all the formalities on behalf of the leasing company.

• Writing the lease on his own account and discounting the lease receivables with the designated leasing company.

The effect is that the leasing company owns the equipment and obtains an assignment of lease rentals.

The sales-aid lease is usually with recourse to the supplier in the event of default by the lessee either in the form of offer from the supplier to buy back the equipment from the lessor or an agreement on behalf of the lessee.