LEASE FINANCING

Dr.R.Vasanthagopal University of Kerala

Lease

A lease contract is an agreement where the owner conveys to the user the right to use an asset in return for a number of specified payments over an agreed period of time. Lessor is the owner of the asset Lessee is the user of the asset

Types of Lease
Operating Leases Usually not fully amorti ed. !his means that the payments re"uired under the terms of the lease are not enough to recover the full cost of the asset for the lessor. Usually re"uire the lessor to maintain and insure the asset. Lessee en#oys a cancellation option. !his option gives the lessee the right to cancel the lease contract before the e$piration date.

Types of Leases
Financial Leases (capital or full payout leases) !he e$act opposite of an operating lease. Do not provide for maintenance or service by the lessor. %inancial leases are fully amorti ed. !he lessee usually has a right to renew the lease at e$piry. &enerally' financial leases cannot be cancelled' i.e.' the lessee must ma(e all payments or face the ris( of ban(ruptcy.

Types of Leases
)riteria for a )apital Lease *f one of the following criteria is met' then the lease is considered a capital lease and must be shown on the balance sheet

Lease transfers ownership by the end of the lease term Lessee can purchase asset at below mar(et price Lease term is for +, percent or more of the life of the asset -resent value of lease payments is at least ./ percent of the fair mar(et value at the start of the lease

Types of Leases
Ta$le %&'% Operating (ersus Financial Leases O)E*ATING Lessee
Asset 0ot on balance s heet 123456 disclose in footnotes 7$pense the full amount as rental e$pense

FINANCIAL Lessee
Report on 234

Lessor
Report on 234

Lessor
0ot on 234

Lease payments

)laim as rental income

Depreciation e pense (associate! "it# lease! asset)

)annot claim

)laim

Decompos e into interes t and principal repayment' and e$pense the interest portion )laim

)laim the interest portion of payments received as interest income )annot claim

Types of Leases
Sale an! Lease'+ac, A particular type of financial lease. 8ccurs when a company sells an asset it already owns to another firm and immediately leases it from them. !wo sets of cash flows occur9 !he lessee receives cash today from the sale. !he lessee agrees to ma(e periodic lease payments' thereby retaining the use of the asset.

Types of Leases
Le(erage! Leases

A leveraged lease is another type of financial lease. A three:sided arrangement between the lessee' the lessor' and lenders. !he lessor owns the asset and for a fee allows the lessee to use the asset. !he lessor borrows to partially finance the asset. -opular in U.4. because lessor puts up only a portion of the asset purchase price' but receives all of the ta$ benefits of ownership

Ta Aspects of Leasing
Lessee can deduct lease payments for income ta$ purposes

;ust be used for business purposes and not to avoid ta$es !erm of lease is less than </ percent of the economic life of the asset 4hould not include an option to ac"uire the asset at the end of the lease at a below mar(et price Lease payments should not start high and then drop dramatically ;ust survive a profits test Renewal options must be reasonable and consider fair mar(et value at the time of the renewal

Accounting for Lease

%inancial

leases are essentially treated as debt financing

-resent value of lease payments must be included on the balance sheet as a liability 4ame amount shown on the asset as the =capitali ed value of leased assets>

8perating

leases are still =off:balance:sheet> and do not have any impact on the balance sheet itself

Accounting for Leases

Financial Statement Effects of Lease Classification

)apital3%inancial3%ull -ayout Leases9

*ncome 7ffects ?. 0et income will generally be lower for capital leases in the early years and higher in the later years. @. )%8 will be higher with capital leases. ))A may be deducted in measuring 0et *ncome after ta$' however' ))A is added bac( when determing )%8. )apital3 financial leases e$pense only the interest portion of the payments in determining 72!. 2alance 4heet 7ffects ?. Lower current ratios' higher debt and leverage ratios' lower asset turnover and lower profitability ratios 1especially in the early years of asset life5

Accounting for Leases

Financial Statement Effects of Lease Classification

8perating Leases9 *ncome 7ffects ?. 0et income will generally be higher for operating leases in the early years and lower in the later years because interest e$pense charged for the financial lease declines as the liability is amorti ed by the lease payments. @. )%8 will be lower with operating leases since the full lease payment is subtracted from )%8' unli(e financial leases where only the interest portion of the payments is subtracted. 2alance 4heet 7ffects ?. Aigher current ratios' lower debt and leverage ratios' higher asset turnover and higher profitability ratios 1especially in the early years of asset life5

E(aluating t#e Lease Decision

Lease -ersus +uy

Leasing is an alternative means of obtaining the use of an asset. !here are four main differences in the cash flows for a company that leases an asset instead of buying it9 ?. *t does not have to pay for the asset up front @. *t does not get to sell the asset when it is finished with it' if it is an operating lease' or if title is not transferred through a financial lease B. *t ma(es regular lease payments. *f the lease is an operating lease' then the full amount of the lease payments is ta$ deductible6 only the interest portion is deductible for capital leases C. 8perating leases are not depreciated.

E(aluating t#e Lease Decision

Lease -ersus +uy E(aluati(e Frame"or,s

*RR of Leasing Analysis

7stimate incremental cash flows that result from leasing 4olve for the discount rate 1*RR5 that e"uates the incremental cash flows with the initial value of the asset. 1!his is the after-tax IRR or cost of leasing5

*f *RR of leasing D after:ta$ cost of borrowing 1borrow and buy the asset5 *f *RR of leasing E after:ta$ cost of borrowing 1lease the asset5

E(aluating t#e Lease Decision

Lease -ersus +uy E(aluati(e Frame"or,s

0-V of Leasing Analysis

7stimate incremental cash flows that result from leasing )alculate 0-V using after:ta$ cost of borrowing as the discount rate.

*f 0-V of leasing is : 1borrow and buy the asset5 *f 0-V of leasing F after:ta$ cost of borrowing 1lease the asset5

.oti(ation for Leasing

)heaper financing Reduce the ris(s of asset ownership *mplicit interest rates ;aintenance )onvenience %le$ibility )apital budgeting restrictions %inancial statement effects