Financial management (6S - 510149) Prepared by Syeda Samzila Atik

Chapter Six
Lease Financing
Define Lease
A lease is an agreement that allows one party to use another’s property for a stated
period of time in exchange for consideration.
Leases are an alternative method used by businesses and consumers to finance the acquisition of
fixed assets. A lease agreement involves at least two parties: a lessor, who owns the
property, and a lessee, who uses the property.
The periodical payment made by the lessee to the lessor is known as lease rental.
Under lease financing, lessee is given the right to use the asset but the ownership lies with the
lessor and at the end of the lease contract, the asset is returned to the lessor or an option is given
to the lessee either to purchase the asset or to renew the lease agreement.

Advantages and Disadvantages of Lease Financing:

At present leasing activity shows an increasing trend. Leasing appears to be a cost-effective
alternative for using an asset. However, it has certain advantages as well as disadvantages.
Advantages:
Lease financing has following advantages
a. To Lessor:
The advantages of lease financing from the point of view of lessor are summarized below
1) Assured Regular Income
Lessor gets lease rental by leasing an asset during the period of lease which is an assured
and regular income.
2) Preservation of Ownership:
In case of finance lease, the lessor transfers all the risk and rewards incidental to
ownership to the lessee without the transfer of ownership of asset hence the ownership lies
with the lessor.
3) Benefit of Tax:
As ownership lies with the lessor, tax benefit is enjoyed by the lessor by way of
depreciation in respect of leased asset.
4) High Profitability:
The business of leasing is highly profitable since the rate of return based on lease rental, is
much higher than the interest payable on financing the asset.
Financial management (6S - 510149) Prepared by Syeda Samzila Atik

5) High Potentiality of Growth:

The demand for leasing is steadily increasing because it is one of the cost efficient forms of
financing. Economic growth can be maintained even during the period of depression.
Thus, the growth potentiality of leasing is much higher as compared to other forms of
business.
6) Recovery of Investment:
In case of finance lease, the lessor can recover the total investment through lease rentals.
b. To Lessee:
The advantages of lease financing from the point of view of lessee are discussed below:
1) Use of Capital Goods:
A business will not have to spend a lot of money for acquiring an asset but it can use an
asset by paying small monthly or yearly rentals.
2) Tax Benefits:
A company is able to enjoy the tax advantage on lease payments as lease payments can be
deducted as a business expense.
3) Cheaper:
Leasing is a source of financing which is cheaper than almost all other sources of financing.
4) Technical Assistance:
Lessee gets some sort of technical support from the lessor in respect of leased asset.
5) Inflation Friendly:
Leasing is inflation friendly, the lessee has to pay fixed amount of rentals each year even if
the cost of the asset goes up.
6) Ownership:
After the expiry of primary period, lessor offers the lessee to purchase the assets— by
paying a very small sum of money.
Disadvantages:
Lease financing suffers from the following disadvantages
a. To Lessor:
Lessor suffers from certain limitations which are discussed below:
1) Unprofitable in Case of Inflation:
Lessor gets fixed amount of lease rental every year and they cannot increase this even if the
cost of asset goes up.
2) Double Taxation:
Sales tax may be charged twice:
First at the time of purchase of asset and second at the time of leasing the asset.
Financial management (6S - 510149) Prepared by Syeda Samzila Atik

3) Greater Chance of Damage of Asset:

As ownership is not transferred, the lessee uses the asset carelessly and there is a great
chance that asset cannot be useable after the expiry of primary period of lease.
b. To Lessee:
The disadvantages of lease financing from lessee’s point of view are given below:
1) Force payment:
Finance lease is non-cancellable and even if a company does not want to use the asset, lessee
is required to pay the lease rentals.
2) Ownership:
3) The lessee will not become the owner of the asset at the end of lease agreement unless he
decides to purchase it.
4) Costly:
Lease financing is more costly than other sources of financing because lessee has to pay
lease rental as well as expenses incidental to the ownership of the asset.
5) Understatement of Asset:
As lessee is not the owner of the asset, such an asset cannot be shown in the balance sheet
which leads to understatement of lessee’s asset.

Types of lease
There are basically four types of lease can be found.
These are depicted in the following figure:

Types of
lease

Financial Operating Sale and Leveraged

lease lease lease back lease
Financial management (6S - 510149) Prepared by Syeda Samzila Atik

1) Finance lease :
This is also called ‘Capital Lease’.
It is a commercial arrangement where:
 the lessee (customer or borrower) will select an asset (equipment, vehicle, software);
 the lessor (finance company) will purchase that asset;
 the lessee will have use of that asset during the lease period;
 the lessee will pay a series of rentals or installments for the use of that asset;
 the lessor will recover a large part or all of the cost of the asset plus earn interest from the
rentals paid by the lessee;
 the lessee has the option to acquire ownership of the asset (e.g. paying the last rental, or
bargain option purchase price);

The finance company is the legal owner of the asset during duration of the lease.
However the lessee has control over the asset providing them the benefits and risks of (economic)
ownership.
Its a long-term lease in which the lessee must record the leased item as an asset on his/her
balance sheet and record the present value of the lease payments as debt. Additionally, the lessor
must record the lease as a sale on his/her own balance sheet.

Basic Features of Finance Lease:

 it's not cancelable
 the lessor may or may not bear the cost of insurance, repair, maintenance etc. Usually the
lessee has to bear all cost.
 the lessor may transfer ownership of the asset to the lessee by the end of the lease term
 the lessee has an option to purchase the asset at a price which is expected to be sufficiently
lower than the value at the end of the lease period
 ownership of the asset is transferred to the lessee at the end of the lease term;
 the lease contains a bargain purchase option to buy the equipment at less than fair market
value;
 the lease term equals or exceeds 75% of the asset's estimated useful life;
 the present value of the lease payments equals or exceeds 90% of the total original cost of the
equipment.
Financial management (6S - 510149) Prepared by Syeda Samzila Atik

2. Operating Lease:
Lease other than finance lease is called operating lease. Here risks and rewards
incidental to the ownership of asset are not transferred by the lessor to the lessee. The term of
such lease is much less than the economic life of the asset and thus the total investment of the
lessor is not recovered through lease rental during the primary period of lease. In case of
operating lease, the lessor usually provides advice to the lessee for repair, maintenance and
technical knowhow of the leased asset and that is why this type of lease is also known as service
lease.
Some of the examples of operating lease are leasing of copying machines, certain computer
hardware, world processors, automobiles, etc.
Basic Features of Operating Lease:
 Operating lease is a short term arrangement for the use of asset between the lessee and the
owner of the asset.
 Various costs related to that asset like maintenance, taxes etc…. are paid by the owner of
the asset.
 The term of operating lease is always shorter than the economic life of that asset.
 The lessee can cancel the operating lease prior to the end date of the operating lease by
giving a short notice and no penalty is charged for that.
 The terms related to an operating lease can vary significantly depending upon the
agreement between the lessee and the owner of the asset.
 The rent which is paid by the lessee for the duration of the operating lease is lower than the
cost of asset.
 The lessor provides the technical knowhow of the leased asset to the lessee.
 Risks and rewards incidental to the ownership of asset are borne by the lessor.
 Lessor has to depend on leasing of an asset to different lessee for recovery of his/her
investment.

3. Sale and Leaseback:

It is a sub-part of finance lease. Under a sale and leaseback arrangement, a firm sells an
asset to another party who in turn leases it back to the firm. The asset is usually sold
at the market value on the day. The firm, thus, receives the sales price in cash, on
the one hand, and economic use of the asset sold, on the other.
Financial management (6S - 510149) Prepared by Syeda Samzila Atik

Here, the firm is obliged to make periodic rental payments to the lessor. Sale and leaseback
arrangement is beneficial for both lessor and lessee. While the former gets tax benefits due to
depreciation, the latter has immediate cash inflow which improves his liquidity position.
In fact, such arrangement is popular with companies facing short-term liquidity crisis. However,
under this arrangement, the assets are not physically exchanged but it all happens in records
only.
This is nothing but a paper transaction. Sale and lease back transaction is suitable for
those assets, which are not subjected to depreciation but appreciation, say for
example, land.

4. Leveraged Leasing:
A special form of leasing has become very popular in recent years. This is known as Leveraged
Leasing. This is popular in the financing of “big-tickets” assets such as aircraft, oil rigs
and railway equipments. In contrast to earlier mentioned three types of leasing, three
parties are involved in case of leveraged lease arrangement – Lessee, Lessor and the
lender.
Leveraged leasing can be defined as a lease arrangement in which the lessor provides an equity
portion (say 25%) of the leased asset’s cost and the third-party lenders provide the balance of the
financing. The lessor, the owner of the asset is entitled to depreciation allowance associated with
the asset. In case of any default by the lessor, the lender is entitled to receive money from the
lessee.

Differences between Operating and finance lease

Aspects of Operating Lease Financial Lease

Difference
1) Definition A lease in which all risks and rewards
related to asset ownership remain with
the lessor for the leased asset is called
operating lease. In this lease, the asset is
returned by the lessee after using it for
lease term agreed upon.
2) Ownership Ownership of the asset remains with the
lessor for the entire lease period.
In financial lease (Also
known as capital lease), the
risks and rewards related to
ownership of asset leased are
transferred to the lessee.
Ownership transfer option at
the end of the lease period is
Financial management (6S - 510149) Prepared by Syeda Samzila Atik
3) Accounting Operating lease is treated generally like
Effect renting. That means, the lease payments
are treated as operating expenses and
the asset does not show on the balance
sheet.
4) Purchase In operating lease, the lessee does not
Option have any option to buy the asset during
the lease period.
5) Lease Term Lease term extends to less than 75% of
the projected useful life of the leased
asset.
6) Expenses Lessee pays only the monthly lease
Borne payment in operating lease.
7) Tax Benefit Since operating lease is as good as
renting, lease payment is considered as
expense. No depreciation can be
claimed.
8) Running Cost In operating lease, no running or
administration costs are to be borne for
example: registration, repairs etc. since
it gives only right to use the asset.
9) Example Normally, A Projector, Computers,
Laptops, Coffee Dispensers etc
there with the lessee. Title
might or might not be
transferred eventually.
Financial lease is treated like
loan generally. Here, the
asset ownership is
considered of the lessee and
so asset appears on the
balance sheet.
Financial lease allows the
lessee to have a purchase
option at less than the fair
market value of the asset.
Lease term is generally more
than or equal to estimated
economic life of the asset
leased.
In financial lease, lessee
bears insurance,
maintenance and taxes.
Lessee can claim interest and
depreciation both as
financial lease is treated like
a loan.
In a financial lease, running
cost and administration
expenses are higher.
Normally, Plant and
Machinery, Land, Office
Building etc
Financial management (6S - 510149) Prepared by Syeda Samzila Atik

Differences between Hire Purchase and lease

BASIS FOR HIRE PURCHASING LEASING

COMPARISON
1) Meaning The deal in which one party
can use the asset of the other
party for the payment of equal
monthly installments is known
as Hire Purchasing.
Leasing is an agreement
where one party buys the
asset and allows the other
party to use it by paying
consideration over a specified
period is known as Leasing.

2) Depreciation The depreciation claim is The depreciation is

allowed to the hirer. claimed as an expense in
the books of lessor.
3) Down Payment Required Not Required
4) Installments Principal plus interest Cost of using the asset
5) Asset type Car, trucks, lorries etc. Land and Building, Property.

6) Ownership the hirer has the option to Transfer of ownership

purchase. The hirer becomes depends on the type of lease.
the owner of the
asset/equipment
immediately after the last
installment is paid.

7) Repairs & Responsibility of hire Depends upon the type of

Maintenance purchaser. lease
8) Consideration Initial payment plus Lease Rentals
installment.
9) Duration Short Term Comparatively Long term
10) Extent of finance It’s a partial finance like loans It’s a complete financing
as 20-25% margin money is option in which no
required to be paid by the downpayments is required.
Financial management (6S - 510149) Prepared by Syeda Samzila Atik

hirer.

Why Lease is often considered as a source of long term

financing?
A lease is a method of obtaining the use of assets for the business without using debt or equity
financing. It is a legal agreement between two parties that specifies the terms and conditions for
the rental use of a tangible resource such as a building and equipment. Lease payments are often
due annually. The agreement is usually between the company and a leasing or financing
organization and not directly between the company and the organization providing the assets.
When the lease ends, the asset is returned to the owner, the lease is renewed, or the asset is
purchased.
A lease is considered as a source of longterm financing because it does not tie up funds from
purchasing an asset.

Evaluation of lease by the lessee

The lease - versus - purchase decision involves application of the capital budgeting methods.
Financial management (6S - 510149) Prepared by Syeda Samzila Atik

First we determine the relevant cash flows then apply present value techniques.
The following steps are involved in the analysis :
1. Determine the After Tax Cash Outflows for each year under the lease alternative. This is
arrived at by multiplying the Lease Rental payment (L) by ( l - tax rate ,t ) .

2. Determine the after - tax cash outflows for each year under the buying alternative based on
borrowing . The amount is equal to :
Loan Installment ( Gross cash outflows, GCO )
Less tax (t) advantage on interest , r i.e. ( I × t )
Less tax shield due to depreciation (D) allowance ( D×t)

3. Compare the present value (pv) of the cash outflows associated with leasing (step 1 ) and
Buying (step 2 ) alternative by employing After Tax Cost Of Debt (Kd) as the discount rate
for the purpose.

4. Select the alternative with the Lower present value of cash outflows. Thus, the decision
criterion is :
Scenerio 1 :

PV OF CASH PV OF CASH

OUTFLOWS UNDER OUTFLOWS AS PER BUY THE ASSET

LEASING BUYING

ALTERNATIVE ALTERNATIVE

Scenerio 2 :

PV OF CASH PV OF CASH

OUTFLOWS OUTFLOWS AS
LEASE THE
UNDER PER
ASSET
LEASING BUYING

ALTERNATIVE ALTERNATIVE