Fundamentals of Leasing

( Online Lecture-1)
Prepared by
Urmi Das
Lecturer, Department of Finance & Banking, Jahangirnagar University
Lease Financing ??
• Lease financing is one of the important sources of medium- and long-
term financing where the owner of an asset gives another person, the
right to use that asset against periodical payments.
• The owner of the asset is known as lessor and the user is called lessee.
• The periodical payment made by the lessee to the lessor is known as
lease rental.
• 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.
STEPS IN LEASING DECISION ON
ASSET
• DECISION ON LESSEE:
The lessee makes a decision on the type of asset required for the business activities.
For instance, if machinery is required, he has to decide about the design
specifications and other features of the machine.

• DECISION ON LESSOR :
The lessor has to make a list of prospective lessor.
He may conduct cost benefit analysis of selecting of particular lessor.
He will select that lessor who is most cost effective in terms of delivery of machinery,
rentals, etc.
Lease agreement terms and conditions
• The lease period
• The timing and amount of lease rentals
• Penalty for default
• Repairs and servicing stipulations as to who is responsible, either
lessee or lessor
• Renewal of lease agreement
Tax Motivations of Leasing
• Leasing Vs Debt financing!!!

When the lessor and the lessee have the same borrowing rate capabilities,
leasing may not be the most economic way.

Leasing will be effective only when the lessor is able to use available
ownership tax benefits, takes them into account as a lease profit ingredient,
and passes them on to a lessee through reduced rental rates.
Tax Motivations of Leasing
• Lessor’s Tax Benefit:
 The tax benefits for the lessor today are the depreciation deductions available under
the Modified Accelerated Cost Recovery System (MACRS), introduced by the 1986 TRA.
 Certain qualified property placed in service after September 10, 2001, there is an
additional 30% special depreciation allowance for the first year the property was
placed in service.
 Under MACRS, a lessor generally can write off its equipment costs over a period
significantly shorter than the equipment’s useful life and at an accelerated rate.
 A lessor can deduct the cost of leased computer equipment over a six-year period with
the percentages for each year as 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76%,
respectively.
 In a typical lease, the lessor’s deductions in the early years will exceed the rental
income, permitting the lessor to offset other income with those excess deductions.
Tax Motivations of Leasing
• Lessee’s Tax Consequences:
Basically, an equipment user decreases its tax benefits by becoming a lessee
rather than an owner. As lessee, the user can deduct its rental payments, but
those will be less than the depreciation it could have deducted in earlier
years.
Leasing is also particularly attractive to equipment users who cannot take
timely advantage of the depreciation deductions. Two types of users fall into
this category:
#First are those who have negative taxable income or carryover losses

#Second, to a lesser extent, are those subject to the AMT

Prospective Lessees
• Any equipment user is a prospective lessee.
• Example: Multinational corporations, sole proprietorships, individuals
using equipment for personal reasons.
Potential Lessors
1.Individuals
2.Independent Leasing Companies
2.1. Finance Leasing Companies
 Long-term lease
 Lessee must assume substantially all the equipment ownership responsibilities such as maintenance, taxes, and
insurance
 The total amounts received under these leases, including the rents payable and the equipment residual value
proceeds, are usually sufficient to provide lessors with a full return of their equipment investment and a profit.
 If the equipment purchase is leveraged with third-party debt, then the rents will generally be enough to cover the
full repayment of the debt.

2.2. Service Leasing Companies

 Typically short term
 Nonfinancial services to lessees in addition to the equipment financing
 Service lessors typically limit their activity to a single type of equipment, such as computers, or to a single type of
industry, such as mining industry
Potential Lessors
3. Lease Brokers
Also referred to as lease underwriters or syndicators.
Charge a fee for their service, usually ranging from 0.75% to .80% of
the leased equipment’s cost, typically paid for by the lessor-investors.
May occasionally invest some of its own funds in the equipment with
other third-party lessor-investors.
Potential Lessors
4. Captive Leasing Companies
Equipment vendors are setting up their own leasing companies
Some captive leasing companies also may be willing to buy and lease
equipment sold by a nonaffiliated company.
Potential Lessors
5. Banks
They usually are lessors in net finance leases.
There is a hidden risk in dealing with banks. Leasing is not considered
their main line of business, so if banks experience general financial
difficulties, their leasing departments are usually the first to go.
The terms and rates offered by bank lessors often vary significantly
from one transaction to the next.
Types of Leases
• Finance Lease :
Involving payment over a longer period.
In this type of leasing the lessee has to bear all costs and the lessor does not render any service.
The lessor’s basic responsibilities are to pay for the equipment, lease it to the lessee for the agreed-
on term, and not interfere with its use.
The total cash flow over the term—from rents, tax savings, and the end-of-lease equipment
(residual) resale or re-lease value—will be sufficient to pay back the lessor’s investment, take care of
the administrative expenses, pay off any equipment-related debt obligations and commissions, and
provide a profit.
Finance lessors usually impose a substantial repayment penalty for a lessee’s early lease termination.
Finance lease can also be generated by a nonrecourse loan.
In a nonrecourse loan, the lender agrees to look only to the lessee’s rent payments and the
equipment for a return on investment.
Types of Leases
• Risk in Finance Lease :
• Obsolescence risk:
 Lessee bears the primary risk of the equipment obsolescence.
 The degree of obsolescence risk that the finance lessor assumes depends on the equipment’s
anticipated residual value.
 As a practical matter, however, a lessor must generally use a residual value greater than zero
to be price competitive.
• Lease default or equipment casualty:
 One of a financial lessor’s principal concerns is the protection of its investment in the event of
a lease default or an equipment casualty.
 The lease may include stipulated loss value provisions.
 The amount of the stipulated loss value is intended to guarantee the lessor a return of its
investment, reimburse it for any tax benefit losses, and assure it of at least some profit.
Types of Leases
• Operating Lease:
Lease’s primary term is significantly shorter than the equipment’s useful life typically
span a few months to a few years, although some are as short as a few hours.
Because the lease terms are relatively short, thus, it must either sell or re-lease the
equipment on attractive terms to be profitable.
Typically charging higher rent than a finance lessor.
There is an option to either party to terminate the lease after giving notice.
Their short lease terms and easy cancellation provisions make operating leases
attractive to users in several situations.
The lessor bears the risk of obsolescence.
This kind of lease is preferred where the equipment is likely to suffer obsolescence.
Types of Leases
• Leveraged Lease:
In a leveraged lease, a bank or other lender loans a percentage of the
funds to buy the equipment, usually 60% to 80%.
Frequently, net finance leases are structured as leveraged leases.
The debt used to leverage a lease transaction is usually nonrecourse
debt.
The lessor must assign to the lender its rights under the lease,
including the right to the rental payments.
Types of Leases
• Non leveraged Lease:
A non leveraged lease occurs when the lessor pays for the equipment
from its own funds.
A distinct advantage in using a non leveraged lease structure is
because of the limited number of parties, saving time and
documentation costs such as legal fees.
One disadvantage for a lessee, however, is that the rent is usually
higher than it would be if the lease were leveraged.
Types of Leases
• Service Lease:
Lessor assumes equipment ownership responsibilities, such as
maintenance, repair, insurance, record keeping, or payment of
property taxes, in addition to providing the asset financing.
Service leases generally have relatively short lease terms.
Advantages of Leasing
• Minimizes Obsolescence Concerns:
Works for both lessee and lessor
Typically high-technology equipment users face the obsolescence issue
Cost of replacing it would be expensive
• Ideal for Limited Use Needs:
It eliminates the remarketing & resale risk an owner would have at the end of
a short use period equipment. Example: Excavator, Grader for a plant.
• Preserves Capital:
A user must carefully consider the real cost of borrowed funds.
For example, a high compensating balance requirement or high collateral.
Advantages of Leasing
• Obtains Value-Added Technical or Administrative Services:
 Users lacking the staff or expertise to attend to specialized equipment needs can lease equipment
as a way to acquire those necessary technical or administrative services.
 Through service leases, users can avoid tying up time and manpower in activities that are outside
of their normal operations.

• Avoids Certain Borrowing Problems:

 Users with credit or borrowing problems may have an easier time getting leasing companies to
fund their equipment needs, because these companies often impose less stringent financial
requirements than traditional lenders.

 Leasing companies are willing to take greater risks because they actually own the equipment and
they can more readily handle used equipment than can traditional lenders, if they must take
possession from a defaulting lessee.
Advantages of Leasing
• A Way to Trade Tax Benefits for Lower Rent:
A lessor takes tax benefits into account when calculating the transaction’s
economic return, in effect it passes these benefits through in the form of a
relatively lower rent.
• Bypasses Capital Budget Restrictions:
Lease equipment are sometimes made to avoid a user’s internal capital
budget restrictions.
For capital equipment purchases above a certain amount, a manager may be
required to obtain prior approval, which may be difficult or impossible.
If the equipment is leased, management may be able to account for the
rental payments as an operating expense.
Advantages of Leasing
• Hedges Inflation
 Lease gives the equipment user the ability to acquire equipment it needs at today’s
prices, and then pay for it from tomorrow’s earnings.
• Provides Possible Increased Cash Flow
 The less the user has to pay to acquire necessary equipment, the more cash it has
available; that is, its cash flow is increased.
• Off Balance Sheet Benefit:
 It helps the lessee to avoid burdening their balance sheet with long-term debt liabilities.
 The lease, regardless of its duration, was basically treated in such a manner that its rent
payments were deemed to be an operating expense. As a result, a company’s profit to
fixed asset ratios were improved that, in turn, generally permitted a greater bank
borrowing capability.
Advantages of Leasing
• Provides Flexible Financing:
 A variety of lessee options are available: Fair market or fixed price equipment
purchase options, fair market or fixed price lease term renewal options, early
lease termination options, equipment upgrade options, and sublease options.
 Leases can be set up with varying rent payment structures, such as low/high or
high/low rent payments and skipped rent payments during industry down
cycles.
 Varying rent periodicity such as payments monthly, quarterly, semiannually or
annually, in advance or arrears.
 Master lease arrangements are available, which permit equipment delivered at
varying times in the future to be simply added to an existing lease contract.
 Leases can include equipment maintenance and repair.
Disadvantages of Leasing
• Eliminates Residual Upside:
Lessee typically forgoes the possibility of realizing a gain if the equipment
appreciates in value during the lease term. Any such gain instead goes to the
lessor.
Many leases give lessees the option to buy the leased equipment at the lease
term’s end for its fair market value at that time. If the fair market value turns
out to be high, the purchase price, coupled with the rent paid, can result in an
expensive transaction.
• Limits Equipment Control:
Suitable replacement equipment is not readily available and the lessor
refuses to re-lease or sell it to the lessee.
 When to Consider Leasing?

• If an equipment user must pay high interest rates for money borrowed, then
leasing can be an economically attractive equipment funding alternative.
• If implicit lease interest rates are about the same as debt interest rates and
there are significant ancillary costs to borrowing, such as high compensating
balances or commitment fees, then leasing should be considered.
• An equipment user who cannot use a significant part or all of the equipment
ownership tax benefits.
• When the equipment involved has unusual service problems that cannot be
handled by a company internally, for example, because of the technical nature
of the equipment or the company’s inadequate staffing.
Assignment
• List down the leasing companies currently operating in Bangladesh
• Mention the types of leasing services provided by them
 Thank You !!
Any Question ??