LEASE FINANCING

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Lease Defined

• Lease is a contract under which a lessor, the owner of the assets, gives right
to use the asset to a lessee, the user of the assets, for an agreed period of
time for a consideration called the lease rentals.

• In up-fronted leases, more rentals are charged in the initial years and less in
the later years of the contract. The opposite happens in back ended leases.

• Primary lease provides for the recovery of the cost of the assets and profit
through lease rentals during a period of about 4 or 5 years. It may be
followed by a perpetual, secondary lease on nominal lease rentals.

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Types of Leases

1. Operating Lease

2. Financial Lease

3. Sale-and-lease-back

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Operating Lease

• Short-term, cancelable lease agreements are called operating

lease.
• Tourist renting a car, lease contracts for computers, office
equipment and hotel rooms.
• The Lessor is generally responsible for maintenance and
insurance.
• Risk of obsolescence remains with the lessor.

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Financial Lease

• Long-term, non-cancelable lease contracts are known as

financial lease.
• Examples are plant, machinery, land, building, ships and
aircrafts.
• Amortize the cost of the asset over the terms of the lease–
Capital or Full pay-out leases.

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Sale and Lease Back

• Sometimes, a user may sell an (existing) asset owned by him to

the lessor (leasing company) and lease it back from him.
• Such sale and lease back arrangements may provide
substantial tax benefits.

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Cash Flow Consequences of a Financial Lease

• Avoidance of the purchase price

• Loss of depreciation tax shield

• After–tax payments of lease rentals

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Advantages of Leasing

1. Convenience and Flexibility

2. Shifting of Risk of Obsolescence
3. Maintenance and Specialized Services

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LEASE VS BUY: THE BASIC DECISION

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FINANCIAL EVALUATION OF LEASING – Lessee’s perspective:

 Finance lease effectively transfers the risks and rewards associated with the
ownership of an equipment from the lessor to the lessee.

 Since lease rental payments are similar to payments of interest on debt,

leasing is an alternative to borrowing.

 The lease evaluation from lessee’s point of view involves a choice between
debt financing versus lease financing.

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FINANCIAL EVALUATION OF LEASING – Lessee’s perspective (cont.):

 The evaluation of lease financing decisions from the point of view of the
lessee involves the following steps:

1. Determine the present value of after-tax cash outflows under leasing option.
2. Determine the present value of after-tax cash outflows under buying or
borrowing option.
3. Compare the present value of cash outflows from leasing option with that of
buying / borrowing option.
4. Select the option with lower present value of after-tax cash outflows.

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FINANCIAL EVALUATION OF LEASING – Lessee’s perspective (cont.):

Present value of borrowing option can be computed as below:

Purchase price of the asset

Less: Present value of tax saved on depreciation

Less: Present value of net terminal value of the asset

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FINANCIAL EVALUATION OF LEASING – Lessor’s perspective:

1. Calculate the present value of cash inflows after tax.

2. Calculate the present value of cash outflows for the cost of asset.
3. Find the difference between the present value of cash inflows after tax and
the present value of cash outflows.
4. It the difference is positive, then the lessor can go for leasing the asset.

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Any Questions

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