E10 Corporate Finance

Module 3

Leasing
Introduction
Upon completion of this module you will be able to:

 differentiate between an operating lease and a financial (or

capital) lease.
 differentiate between lease and loan.
 differentiate between financial lease and hire purchase.
Outcomes
 determine circumstances when leasing an asset is more
advantageous than purchasing an asset, which may involve
borrowing or issuing new equity or using internally generated
cash instead of issuing dividends.

Leasing: A means of delivering finance, with leasing

broadly defined as “a contract between two parties
where one party (the lessor) provides an asset for
usage to another party (the lessee) for a specified
period of time, in return for specified payments.
Terminology
Operating lease: A lease is of a relatively short-term nature and the
lessee has no obligation to purchase.

Financial lease: A long-term lease and gives the lessee significant

rights over the item being leased which is very
similar in effect to an outright purchase.

Introduction to leasing
The primary purpose of this module is to introduce you to leasing as a source
of financing. In MS-4 you examined capital structure and other forms of
financing that are available to organisations. In recent years, leasing has
become an increasingly important source of funding for the acquisition of
computer equipment, vehicles and aircraft. We will see in this module that
one critical element of lease financing is the tax system, as applied to capital
equipment. Understanding the tax rules regarding lease payments is

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important to your lease versus buy decision. This is similar to understanding

the tax rules related to other types of financing.

According to (International Finance Corporation,2005) leasing in its simplest

form is a means of delivering finance, with leasing broadly defined as “a
contract between two parties where one party (the lessor) provides an asset
for usage to another party (the lessee) for a specified period of time, in return
for specified payments.” Leasing, in effect, separates the legal ownership of
an asset from the economic use of that asset.

Leasing is a medium-term financial instrument for the procurement of

machinery, equipment, vehicles and/or properties. Leasing provides financing
of assets equipment, vehicles more willingly than direct capital. Leasing
institutions (lessors) banks, leasing companies, insurance companies,
equipment producers or suppliers and non-bank financial institutions
purchase the equipment, usually as selected by the lessee, providing the
equipment for a set period of time to businesses. For the duration of the lease,
the lessee makes periodic payments to the lessor at an agreed rate of interest.
At the end of the lease period, the equipment is either transferred to the
ownership of the business, returned to the lessor, discarded, or sold to a third
party. Under financial leasing, the lessee in general acquires or retains the
asset.

Leasing is based on the proposition that profits are earned through the use of
assets, rather than from their ownership. It focuses on the lessee’s ability to
generate cash flow from business operations to service the lease payment,
rather than on the balance sheet or past credit history. This is why leasing is
particularly advantageous for new, small and medium-size businesses that do
not have a lengthy credit history or a significant asset base for collateral. in
addition, the lack of a collateral requirement with leasing offers an important
advantage in countries with weak business environments, particularly those
with weak creditors’ rights and collateral laws and registries, for instance, in
countries where secured lenders do not have priority in the case of default.

It should be noted that, to date, IFC has focused mainly on the development
of financial leasing. This is the primary stage in leasing development in most
emerging and transitional economies. Operating leases (or rent) can be
equally important in the long term, but for a number of reasons are generally
typical of a later stage of development.

A finance lease is a contract that allows the lessor, as owner, to retain

ownership of an asset while transferring substantially all the risks and
rewards of ownership to the lessee. A finance lease is also known as a full
payout lease, because payments made during the term of the lease amortise
the lessor’s costs of purchasing the asset (there may be a residual value that
usually does not exceed 20 per cent of the cost).The payments also cover the
lessor’s funding costs and provide a profit. Despite the legal form of the

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transaction, the economic substance of a finance lease transaction is one of

purchase financing rather than a mere rental.

In contrast, an operating lease is essentially a rental contract for, usually, the

short term or temporary use of an asset by the lessee. The maintenance and
insurance responsibilities (and most risks associated with the ownership of
the asset) remain with the lessor, who recovers the costs and profits from
multiple rentals and the final sale of the asset.

According to both the United Nations and the World Bank, “in 1994 an
eighth of the world’s private investment was financed through leasing; a third
of the OECD countries’ private investment is financed through leasing; in
both middle and low-income countries, leasing doubled between 1988 and
1994.” (Leasing – Lessons of Experiences, the United Nations Economic
Commission for Europe.)

Before you start studying different types of leases you need to have an
understanding of the terminology used in leasing.

Operating versus financial leases

Although lease agreements can be very complex, they fall into two
categories. The first is an operating lease. Where a lease is of a relatively
short-term nature and the lessee has no obligation to purchase, then, typically,
it will be considered to be an operating lease. The second category is a
financial or capital lease. A financial lease is a long-term lease and gives the
lessee significant rights over the item being leased. Financial leases are leases
in legal terms but are very similar in effect to an outright purchase.

Table of Differences between Finance and Operating Leases

Finance Lease Operating Lease

Risks and rewards of ownership are Economic ownership with all

transferred to, and borne by, the corresponding rights and
lessee. This includes the risks of responsibilities are borne by the
accidental ruin or damage of the lessor. The lessor buys insurance
asset (although these risks may be and undertakes responsibility for
insured or otherwise assigned). maintenance.
Thus damage that renders an asset
unusable does not exempt the
lessee from financial liabilities
before the lessor.

Difference table is adapted from LeasingNotes

https://classshares.student.usp.ac.fj/AF203(DFL)/ date accessed/10/13/2009
This table is given here to differentiate between two main type of lease contract.

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The distinction between the two types of leases is very important as the
accounting varies significantly between the two lease types. The key
differences in the two different accounting treatments are summarised in the
table below:

Two Different Accounting Treatments

Lease type Income Statement Balance Sheet

Operating Total lease payments are No balance sheet obligation

expensed.

Financial Amounts Expensed are: A liability is set up on the

balance sheet for the unpaid
a) Amortisation of the
capital portion of the lease.
underlying asset based
This liability is displayed
on its useful life and
with other long-term debt. In
b) Interest component of the other words, the financial
lease payment. lease is treated like long-term
debt.

For both operating and financial leases, total future commitments have to be
disclosed (in the notes to the financial statements) along with the payments
required for each of the next five years.

When you take a look at the previous table you can see that accounting for a
financial lease will be very similar to an outright purchase of the asset. More
to the point, a financial lease results in balance sheet debt just as if the cost of
the asset had been borrowed. The criteria used in Canada (CICA handbook
section 3065) to determine whether a lease is operating or financial, states
that a capital lease exists if one of the four following conditions is met:
1. The lease transfers ownership of the property to the lessee at the end
of the lease term.
2. A bargain purchase option exists in the lease. This is an option to
purchase the leased asset below the fair market value of that asset.
3. The lease term is at least 75 per cent of the economic life of the asset
being leased.
4. The present value of the minimum lease payments equals or exceeds
90 per cent of the fair value of the property.

If at least one of these criteria is met, then technically the lease is a financial
lease. Major leasing companies such as GE Capital are very adept at working
with accounting rules, such that many leases are structured as operating
leases. The reason for this is that the asset base of a company will be lower

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when operating leases cover some of its assets. If the asset base is lower, then
the return on assets will, all else being equal, be higher as will the return on
equity. More to the point, ratios such as debt to equity will be more
favourable due to the impact of operating leases. As financial analysts and
other users of financial information are aware of this, the practice of banks,
debt rating agencies, and most analysts is to estimate the capitalised value of
future payments and to add this number in to the balance sheet as a capital
asset and debt. This ensures that realistic judgments are made concerning a
company’s debt levels and its capacity to increase its debt load. Hence, while
there may be differences in the accounting treatment for operating and capital
leases, most analysts will recognise this fact and take into account the
liability and risk on all leasing undertaken by the enterprise.

Difference between financial leasing and loans

From the lessee’s perspective, there is only one substantive difference
between a loan and a lease:

With a loan, the asset belongs to the borrower, whereas with a lease, the asset
belongs to the lessor.

The many similarities between a loan and a financial lease include:

 The lessee and borrower have the choice over the acquisition of the
asset. The borrower and lessee (providing the terms of the lease are
met) would be able to retain the asset once payments are complete.
 Over the period of both, a loan and a lease, interest and capital
(equipment cost) are repaid.
 Should there be default on either a loan or a lease, as long as the loan
is secured, both the lender and lessor have legal rights to
reclaim/repossess assets.
 The risks and costs of ownership, including maintenance and
obsolescence, remain with the borrower and lessee. Also, under both
a loan and a financial lease, if the asset appreciates, neither the lender
nor the lessor benefits.
 The agreements are non-cancellable until either the lessor or the
lender has recovered its outlay.
 The borrower or lessee can either settle the agreement (in the case of
the lease) or repay the loan early.

Financial leases and hire purchase

In some countries, a distinction is made between lease and hire-purchase
transactions. A hire-purchase transaction is usually defined as one where the
hirer (user) has, at the end of the fixed term of hire, an option to buy the asset

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at a token value. In other words, financial leases with a bargain buyout option
at the end of the term can be called a hire-purchase transaction.

Hire purchase is decisively a financial lease transaction, but in some cases it

is necessary to provide the cancellation option in hire-purchase transactions
by statute. That is, the hirer has to be provided with the option of returning
the asset and walking away from the deal. If such an option is embedded, hire
purchase becomes significantly different from a financial lease as the risk of
obsolescence gets shifted to the hire vendor. Under these circumstances, if
the asset were to become obsolete during the hire term, the hirer may off-hire
the asset and close the contract, leaving the owner (the lessor) with less than
a full payout from the lease.

Hire purchase is of British origin – the device originated long before leases
became popular – and spread to countries that were then British dominions.
The device is still popular in Australia, Britain, India, New Zealand, Pakistan
and in several African countries. Most of these countries have enacted, in line
with the United Kingdom, specific laws addressing hire-purchase
transactions.

How leasing can help achieve stakeholder objectives

Following are different stakeholders of leasing sector in any developing or
modern economy
1. Stakeholders of leasing
2. Government
3. Lessors (including banks)
4. Lessees/SMEs
5. Equipment manufacturers
6. Legal/accounting
7. Investors.

Leasing helps all its stakeholders in achieving their goals.

How Leasing Can
Help Achieve
Stakeholder Possible Objectives
Stakeholder
Objectives
 Domestic production  Leasing aids the
 Government development of local
 Industrial diversification processing and
 Capital investment production.

 Government budget  While manufacturing

equipment may come
from overseas; this

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How Leasing Can

Help Achieve
Stakeholder Possible Objectives
Stakeholder
Objectives
 SME development equipment enables
domestic processing of
 Infrastructure locally produced raw
improvements materials, thus
replacing imported
items.
 Leasing lowers the
overall costs of
economic development.
 Leasing provides a
diversified source of
capital (equity, debt, tax
revenue)
 Leasing further
contributes to the
development of
domestic financial
markets.
 As leasing develops,
there will be increased
domestic liquidity
through access to
global markets
 For reasons listed
below (see
Lessees/SMEs), the
development of leasing
aids the growth of the
domestic SME sector.
 Leasing can help
increase the levels of
public transport and the
depth of
communications
networks, and allow
municipal authorities
the means to acquire
quality construction and
maintenance
equipment.

 Risk management/  The lessor maintains

 Lessors (including reduction legal ownership of the
banks) asset.
 Leasing market
 The lessor is able to

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How Leasing Can

Help Achieve
Stakeholder Possible Objectives
Stakeholder
Objectives
development exert greater control
over the investment.
 Product portfolio
diversification  The lessor can monitor
assets more easily.
 Customer base
expansion  Lessors can actively
apply specialised
knowledge, such as
equipment
specialisation.
 Leasing provides not
just an opportunity to
extend product lines,
but also to deepen the
organisational structure.
 In some cases, leasing
may allow businesses
to access both lease
financing and additional
bank financing without
increasing their
collateralised debt.
 Leasing can provide
additional marketing
channels for financial
services.

 Access to finance  No/low collateral

 Lessees/SMEs required.
 The cost of lease
finance is competitive
with traditional credit,
given the increased
security held by lessors
and the low transaction
costs of processing a
lease.
 Leasing also offers
matched maturity of
assets/liabilities, since
debt in emerging
countries is often
limited to short-term
maturities.
 Islamic compliance: in

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How Leasing Can

Help Achieve
Stakeholder Possible Objectives
Stakeholder
Objectives
Muslim countries,
leasing is seen as an
interest-free product
and considered the
same as a rental. In
Islamic finance, “Ijara”
is a kind of leasing, and
especially relevant
within the Middle East
and North Africa.

 Access to equipment  Leasing increases

and production assets flexibility and
diversification of
financing sources.
 Leasing enables
investment in
equipment that can
modernise production
and improve
productivity and
profitability.
 Leasing reduces
maintenance cost,
since equipment is
newer.
 Due to reduced upfront
costs, leasing frees up
capital for other
business needs.

 Ability to plan  Leasing enables

companies to match
 Timeliness and flexibility income and
 Negotiability expenditure.
 Leasing also has
advantages of a quick
decision-making
process, flexibility, and
negotiability. This is in
large part because the
lessors operate in a
less-regulated, more
proprietary environment
than bankers or
traditional lenders. It

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How Leasing Can

Help Achieve
Stakeholder Possible Objectives
Stakeholder
Objectives
may also owe
something to the fact
that, since leasing is a
comparatively new
development, lessors
have to be fast and
flexible to claim this as
their unique selling
proposition.
 Leasing deals may
make less use of the
restrictive covenants
that appear in more
traditional forms of
lending.
 Where lessors have
asset knowledge or
relations with suppliers,
lessees may
“outsource” certain
tasks (such as
negotiating with
suppliers), reducing
costs and risks.
 Independence from
bank borrowing:
through leasing, SMEs
have alternative funding
opportunities and are
able to use a mix of
funding options to
finance their
businesses.

 Expanded market base  Leasing allows access

 Equipment for products to new equipment, by
manufacturers providing businesses
 Increased purchase with a mechanism to
options for clients purchase equipment
without incurring
significant upfront
costs.
 Development of the
leasing sector opens up
significant after-market
products and services

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How Leasing Can

Help Achieve
Stakeholder Possible Objectives
Stakeholder
Objectives
for equipment
manufacturers.
 Leasing often provides
an effective marketing
channel for equipment,
as leasing companies
are also interested in
increasing sales.
 Effective leasing
companies may bear
some of the burden of
dealing with
inexperienced
equipment purchasers,
thus reducing costs and
improving efficiency.

 Lessors/banks may be  In terms of compliance,

 Legal/ accounting clients of professional professional advisors
services companies should be contracted by
lessors to ensure that
 Tax planning and all agreements comply
accounting with local legislation
opportunities and permit the lessor to
 Systems development utilise tax or other
opportunities benefits.
 Lessors, in order to
reduce transaction
costs and because of
the nature of leasing,
will aim to utilise credit
management systems
for the monitoring and
control of their lease
portfolios. Professional
advisors have an
excellent opportunity to
assist in the
development of
business processes
and systems.

 Increased ability to  Improved credit scoring

 Investors invest within a country and processing
systems can be applied
 Development of across all elements of
financial sector the finance sector, from

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How Leasing Can

Help Achieve
Stakeholder Possible Objectives
Stakeholder
Objectives
 Growth in investee leasing through to
company opportunities banking, there-by
allowing the whole
sector to take a more
prudent and controlled
approach to finance.
 Leasing improves the
local investment climate
for all companies,
increasing opportunities
for investment and
reducing/allocating risks
more efficiently.
 The development of
non-bank lessors
increases competition
within the financial
sector, introducing the
need for finance
companies to reduce
transaction costs,
improve business and
credit management,
and source funding at
cheaper levels. This
has the effect of
reducing the cost of
finance throughout the
sector at the same time
as increasing its level of
sophistication and
ability to optimise risk.
 As lessors develop,
they may expand to
issuing commercial
paper and to
securitising lease
receivables, which can
assist in deepening the
securities market and
creating new
investment products.

Different parties get different benefits frome lease contract. To elaborate the
advantages of leasing for different stakeholders of leasing contract this table is
formulated and some parts are adapted from LeasingNotes

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https://classshares.student.usp.ac.fj/AF203(DFL)/ date accessed /10/13/2009, Ross,

Stephen A., Randolph W. Sesterfield & Bradford D. Jordan (1993) Fundamentals of
Corporate Finance (2nd Edition) and Horne, James C. Van and John M. Wachowicz,
JR (2000): Fundamental of Financial Management (11th Edition) Indian, Prentice-
Hall of India.

Examples of accounting for operating and financial leases

Operating lease

Suppose a discount airline leases a Boeing 737 to cope with anticipated

additional package holiday business to Mexico. The lease payment is
$100,000 per month and the term is 12 months. The estimated remaining
useful life of the aircraft is 15 years. Under CICA rules this clearly ranks as
an operating lease. The lease payments will be recorded as expenses in the
books of the airline. There will be no asset to capitalise and no special
obligation to record on the balance sheet.
Financial Lease

Let us take a look at the effect of a manufacturing concern (Triangle

corporation) leasing processing equipment. Let us make the following
assumptions about the equipment to be leased:

Triangle Corporation leasing assumptions

Fair market value of equipment $375,000

First lease payment due January 1, 1998

Economic life of the equipment 10 years

Lease term 6 years

Annual lease payments (at beginning of each year) $79,500

Bargain purchase price at end of lease $3,120

We will further assume that the interest rate implicit in the lease is 11per cent
and that Triangle amortises capital assets using the straight-line method.
Notice in the data the presence of a bargain purchase option. Furthermore, if
you were to discount all the lease payments and the final payment to buy the
equipment, the result would be very close to the fair market value of the asset
to be acquired. Therefore, this clearly has to be treated as a capital lease.
Managers need to understand the accounting treatment of such leases. This is
because the effect on reported earnings is radically different from what we
would see with an operating lease such as in the above airline example.

In this case there will be two items to report in the income statement:

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1. Amortisation of $37,500 per year ($375,000 x 10 per cent since the

economic life is ten years and assuming use of the straight line
method of amortisation).
2. Interest expense – this will vary over the term of the lease as set out
in the table below.

The CICA treatment effectively treats a financial lease as a long-term loan

and allocates the lease payments between principal and interest:

CICA treatment of a financial lease

Balance at Reduction Balance

Date Payment Interest
beginning of principal at end

1/1/98 375,000 79,500 - 79,500 295,500

12/31/98 295,500 79,500 32,505 46,995 248,505

12/31/99 248,505 79,500 27,336 52,164 196,341

12/31/00 196,341 79,500 21,597 57,903 138,438

12/31/01 138,438 79,500 15,228 64,272 74,166

12/31/02 74,166 79,500 8,158 71,342 2,824

12/31/03 2,824 3,120 296 2,824 -

On the first day of 1998 there is no interest as the payment is made on the
first day of the lease. Therefore, the entire payment ($79,500) is applied to
reducing the value of the effective loan represented by the lease. In the first
year, interest at 11% = 0.11 x 295,500 = $32,505. Therefore, the principal
paid back in year 1 (over and above the first payment) is 79,500 – 32,505 =
$46,995, leaving an outstanding balance at the end of 1998 of $248,505.
Notice that interest diminishes each year, while amortisation (using the
straight line method) will be constant at $37,500 per year. Therefore, all
things being equal, reported earnings should increase over time. In the final
year, we calculate interest ($296) by taking the difference between the capital
outstanding at the end of the fifth year ($2,824) and the final payment of
$3,120.

As mentioned earlier in thismodule, the effective amount owed to the leasing

company (the principal) will be displayed on the lessee’s balance sheet.
Based on the Triangle example, the following shows an extract from the
balance sheet at December 31, 1998.

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Triangle Corporation balance sheet extract

Current liabilities (12/31/98):

Short term portion of long term debt 52,164

Long term debt 196,341

Notice that $52,164 is shown under current liabilities because this is the
amount of principal to be repaid during the coming year (i.e., 1999). Total
lease debt is $248,505 (52,164 + 196,341).

Determining the magnitude of lease payments

The math of leases is very similar to the math of determining the blended
repayments on a loan or mortgage. As is the case with mortgages, some are
fully amortised (or paid off) during the loan term and some are only partially
amortised (indeed in Canada almost all residential mortgages are partially
amortised). Leases can be the same: some leases continue until the asset is
worthless, others continue for less time and the asset has value at the end of
the lease. In this case, either the lessee can purchase the remaining asset
value or return it to the lessor, a point that should be made clear in the lease.
The only difference is that unlike a loan, there is usually an amount
outstanding at the conclusion of the lease term. Let’s demonstrate this with
an example.

Consider a lessor who is leasing an asset that costs $20,000 today. The term
of the lease is three years and payments are to be made on a monthly basis.
Let’s assume that the lessor needs to charge 10 per cent interest to cover the
cost of funds and to make a profit and that the fair market value of the asset is
70 per cent of the original cost at the conclusion of the lease term. We can
determine the lease payment with either Excel or a financial calculator by
using the PMT function. The table below shows the entries that you would
need to make:

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Determining lease payments

Lease - value of asset = Lease - value of asset =

Item Function 70% of cost 60% of cost

Cost PV 20,000.00 20,000.00
Term n 36.00 36.00
BV % 70% 60%

BV in 3 years FV (14,000.00) (12,000.00)

Monthly
i 0.83% 0.83%
interest rate
Monthly
payment PMT $(310.27) $(358.14)
(Excel)
Monthly
payment PMT $(309.69) $(357.59)
(calculator)

This table was derived using Excel functions. To get the result of $310.27
monthly payment made by the lessee, notice that you need to enter the value
at the end of the three-year period as a negative value; the logic here is that
the $20,000 cost is a loan (cash inflow) and when you return the asset to the
lessor you are effectively repaying the balance ($14,000), which is a cash
outflow. The value for i is 0.1/12 = 0.0083. Excel requires that interest rates
be entered as decimals; many calculators use the same logic. Notice in the
right hand column, the effect of a lower value after three years – 60 per cent
of the cost. The lower this value, the higher the payment required under the
lease. Incidentally, the logic in this section explains why you can get lower
payments by leasing a new vehicle for yourself as opposed to a direct
purchase financed by a loan. The results are slightly different when you use a
calculator as indicated. Many websites, for example Dell Computer, have
calculators that allow you to determine the lease payment based on given
parameters.

Tax treatment of leases

In general, the tax treatment in Canada of leases is as summarised in the table
below:

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Tax treatment of leases

Lessee Lease payments are fully deductible in the year they are made
irrespective of whether the lease is operating or financial.

Lessor The lease payments are income in the hands of the lessor; the
lessor is entitled to claim Capital Cost Allowance (CCA), which
is the equivalent of amortisation for tax purposes, on the related
asset since the lessor is the legal owner.

Legal, tax and accounting treatment of leasing

Hire
Operating Finance Purchase / Conditional
Structure
Lease Lease Lease Sale
Purchase

Legal Title Lessor Lessor Passes to Passes to

lessee on lessee on
payment of payment of
bargain final installment
purchase
option price

Lessor Full lease Actuarial rate Interest Interest

rent on of return received less received less
straight-line after-tax interest interest
basis less investment in payable payable
interest lease
expense and
depreciation
Profit & of fixed asset
Loss

Lessee Full lease Finance Finance Finance charge

rent on charge at charge at at implicit rate
straight-line implicit rate implicit rate, and
basis over in lease & depreciation depreciation of
lease period depreciation of fixed asset fixed asset
of fixed asset

Lessor Fixed asset Lease Hire Receivables

Balance receivables Purchase
Sheet receivables
Asset
Lessee No asset Fixed asset Fixed asset Fixed asset

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Hire
Operating Finance Purchase / Conditional
Structure
Lease Lease Lease Sale
Purchase

Lessor Taxed on rent Taxed on Taxed on Taxed on

on straight- accrued rent finance finance charge
line basis less less interest charge less less interest
interest expense and interest expense
expense & capital expense
capital allowances
Tax allowance

Lessee Full rent Rent Finance Finance charge

deduction on deduction, as charge expensed,
straight-line per P & L. expensed, capital
basis over capital allowances
lease period allowances

 It is possible to have asymmetrical treatment, – finance lease for

lessor and operating lease for lessee, for instance where the lessor
removes its risk in the asset by taking a residual value guarantee from
a third party; or operating lease for lessor and finance lease for
lessee, where the perception of risk is different for the two parties.
 Any sale to a lessee contemplated at the outset could result in loss of
lessor’s right to capital allowances and is usually restricted in
documentation. Therefore, on expiry of a fully amortised lease, the
lessor typically grants a secondary period to the lessee at low or
peppercorn rentals, for all or the majority of the asset’s remaining
useful life.
 Assuming that assets qualify for allowances.

The tax deductibility of lease payments is a significant element in the

decision on whether or not to lease. This differs from the treatment of loan
payments for tax purposes, where only the interest portion is tax deductible.
We will see the effect of this when we look at the lease/buy comparison in
the next section.

The effect of leasing is to generate more tax deductions (in total $) for the
parties to the lease. There are occasions when it is not feasible for a company
to use (in the foreseeable future) the tax amortisation (CCA in Canada)
generated by capital additions. Large tax losses carried forward may be
present or losses may be being incurred. In such cases, the after-tax cost of
borrowing is equal to the full interest rate. Since the lessor can utilise the tax
amortisation by owning assets, this may result in a cheaper financing cost
being available from a lease. By the same token, not-for-profit organisations

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that are not subject to taxes may benefit from leasing since the lessor receives
the tax amortisation, which is not available to the not for profit.

Lease or buy?
You need to understand this process but don’t need to be able to reproduce it.
We will use Lancelot Distribution to show the calculations involved in lease
versus buy decisions. Assume the company wants to invest $50,000 in trucks,
but wishes to evaluate whether leasing is worthwhile. We make a further
assumption: Lancelot drivers are very hard on their trucks such that they are
worn out and have no residual value at the end of seven years. Ajax Leasing
has offered to lease the vehicles over a seven-year term for $10,000 per year.
The company may also borrow the necessary funds using a seven-year term
loan with an interest rate of 10 per cent. We will ignore the issue of
insurance, maintenance, and other costs of ownership as these are typically
borne by the user in either case and, therefore, they are not relevant to the
lease/buy decision. If Lancelot buys the trucks outright, they will be able to
claim CCA each year (and obtain a corresponding tax shield) in accordance
with the table below:

CCA Claim

UCC for CCA @ 30% Tax shield @40%

Year Purchase
CCAA B = 0.3 x A C = 0.4 x B

1 50000 25000 7500 3000

2 - 42500 12750 5100

3 - 29750 8925 3570

4 - 20825 6248 2499

5 - 14578 4373 1749

6 - 10204 3061 1224

7 - 7143 - 2857

Note that UCC is the un-depreciated capital cost, which is similar to net book
value for accounting purposes. It represents the amount on which tax
amortisation – CCA may be claimed. In the first year it is 50 per cent of the
purchase price due to the fact that under Canadian tax laws a company can
only take 50 per cent of the normal CCA in the first year of purchase of an
asset.

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In year seven, $7,143 remains in the asset pool but the assets are scrapped
without obtaining any value. In this situation, provided Lancelot was not
going to buy any more trucks, they could claim what is called a terminal loss
(the value of any remaining UCC ($7,143)). This loss would generate a tax
shield of 7,143 x 40% = $2,857.

Now that we have established the CCA arising from ownership, we can
compare the cash flows arising from ownership to the cash flows arising if
we lease. If we buy a truck, then we would have a $50,000 cash outflow and
cash inflows derived from the tax savings in the above table. If we lease, we
will have outflows equal to the lease payments and tax savings achieved from
the lease, i.e., 10,000 x 40% = $4,000. In the table below, we examine the
differential cash flow of leasing versus an outright purchase.

Differential cash flow – lease versus buy

Payment Payment
Truck shield Lease shield Net Cash
Year
Purchase from payment from Flow
CCA lease

1 50,000 (3,000) (10,000) 4,000 41,000

2 (5,100) (10,000) 4,000 (11,100)

3 (3,570) (10,000) 4,000 (9,570)

4 (2,499) (10,000) 4,000 (8,499)

5 (1,749) (10,000) 4,000 (7,749)

6 (1,224) (10,000) 4,000 (7,224)

7 (2,857) (10,000) 4,000 (8,857)

Per the table in year 1, we would be $41,000 to the good if we decided to

lease as opposed to an outright purchase.

We can complete our analysis by calculating the so-called net advantage of

leasing (NAL) by determining the NPV of the above cash flows and using the
after tax cost of borrowing as the discount rate (for example, 6 per cent). If
we do this, we can determine that the NAL in the above case is minus $2,741.
In other words, there isn’t a net advantage to leasing. NAL would need to be
positive for the lease to be less costly than a loan. We can also use trial and

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error to determine what lease rate would produce an NAL of zero. This is
another way of saying: what lease rate do we require to at least equate with
the bank financing? If we use the NPV function to do this, the result based on
Lancelot’s numbers is about $9,825. As long as the rate we can negotiate is
less than $9,825 we achieve a saving by going to a lease arrangement.

Advantages of leasing
1. Obsolescence is a significant issue for many types of equipment;
leasing of computers is such a big business that many large
companies such as IBM and Dell operate leasing subsidiaries.
Therefore, companies will often lease this type of equipment to avoid
the cost of repurchasing new equipment. Under a lease arrangement
it is sometimes much easier to return your leased product for a new
and improved model, especially if you have been a “good” lessee and
you have paid all rents on time.
2. Many loan arrangements have included restrictive covenants that
have requirements for an organisation to meet or maintain certain
liquidity levels or restrict dividend payouts. In other words,
covenants attached to either bank loans or bond issues can
significantly reduce financial flexibility by restricting capital
expenditures and dividend payments; with leases, in general,
obligations are restricted to making payments on time and ensuring
the underlying asset is insured; with certain types of assets, such as
aircraft, additional payments may be required to ensure that the asset
is being appropriately maintained but on balance there are likely
fewer restrictions on the lease option.
3. There are many instances where a company may require an asset for
only a relatively short period for example, acquisition of an aircraft
to meet a temporary increase in passenger traffic. Leases are ideal for
these situations as they are easier to arrange than purchasing an asset
and reselling it at a later date.
4. If companies are in need of working capital they will sometimes use
sale/leaseback arrangements. This is an arrangement where an
organisation owns an asset and sells it to a leasing company and then
leases that asset from the leasing company. These are popular with
land/buildings – tax deductions are improved significantly since land
cannot be amortised under Canadian tax law but the full lease
payment can be expensed.
5. Operating leases have the effect of improving financial ratios for an
organisation as there is no visible increase in liabilities on the
balance sheet and the total assets do not include leased assets.
Therefore, leverage ratios and profitability ratios will be higher than
if debt was incurred to purchase an asset. It is important to note that
analysts and bankers take into account the impact of both operating
and capital leases when completing an analysis of an organisation,
hence it is unlikely the enterprise would get any real value from the

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fact the operating lease is not disclosed in the same manner as capital
leases. From the analyst’s point of view both leases involved
financial commitments and risk.
6. Leasing allows you to finance an asset 100 per cent where traditional
borrowing often limits the percentage of the asset’s value you can
borrow. Therefore, often you can only borrow up to 90 per cent of
the value of asset you purchase.
7. Often major lease companies are able to acquire equipment and
vehicles at lower prices due to bulk purchases than most
organisations can negotiate. The effect of this better pricing can
allow an organisation to pay less for an asset under a lease aspart of
the lower price may be passed through to the lessee as a better lease
rate.

Disadvantages of leasing
1. The rate implicit in a lease is often not stated in commercial leases –
therefore the cost can be quite high versus traditional borrowing
costs, and the financial officer needs to do some careful analysis.
2. In the case of a lease, the ownership rights are limited to the value of
the leasehold interest and this is generally less than the outright
ownership value. The relative value of the leasehold interest and
outright ownership will depend upon the lease payments and the
value of the asset returned to the lessor at the end of the lease term.
There is no ownership position in the asset. Therefore at the end of
the lease term the asset is returned to the lessor. If there is any value
left the lessor reaps the rewards of this through the sale of the asset.
3. Most lease agreements have a provision that improvements or
changes to the leased property cannot be made without the
permission of the lessor. If the equipment were owned by the
organisation, they would not need to seek approval of an outside
party to make such improvements. Of course if the improvement is
seen to add value to the asset then the lessor is not likely to withhold
this approval.
4. If an asset leased becomes obsolete during the lease term, the lessee
must continue to make lease payments to the end of the lease term
regardless of whether the asset is being used. However, if the asset is
purchased using debt and becomes obsolete, the owner is faced with
a potentially similar problem of owing money on the debt when the
asset is obsolete.

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Module summary
In this module you learned:
 Leasing is an alternative financing option that has an important
role to play in the overall capital structure of firms. Its relative
Summary importance varies over time and across firms and assets. Leasing
is becoming more popular with organisations.
 Leases can be categorised as either operating leases or financial
(capital) leases.
 Operating leases are short-term and have no balance sheet
impact, but do have impact on the income statement.
 Financial leases are longer term than operating leases and in
effect transfer some of the risks and rewards of ownership to the
lessee.
 Financial leases have both a balance sheet and income statement
impact. Their treatment for financial statement purposes is
similar to the treatment that would be given an asset purchased
and financed with traditional borrowing vehicles.
 The tax implication of leases can make leasing more
advantageous than traditional borrowing, but in addition to tax
considerations, leasing can be attractive for other reasons such as
obtaining a higher level of financing than is possible by way of
direct borrowing, etc.
 There are many advantages to leasing and a few disadvantages;
however, it is important to analyse each leasing decision
separately, ensuring the purchase-lease option is properly
analysed.
 The lease vs. buy decision is often not a straightforward number-
crunching exercise. There are many qualitative factors that must
be considered in your analysis.

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Assignment
1. Discuss how leasing can function effectively as a financing tool in
the company’s capital structure.

2. Discuss why leasing is becoming a popular financing option for

companies.
Assignment
3. Discuss why financial leasing has an impact on the financial
statements whereby operating leasing does not.

4. What are the perceived benefits of ownership (buy) and leasing?

5. What information or data is needed to make a lease/buy comparison?

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Assessment
1. Sheila Cash, the CFO of Gamma Technologies is looking at the
financing alternatives for a major new piece of manufacturing
equipment. Sheila has rates on a 10-year lease that she believes are
attractive versus the cost of borrowed funds. The equipment in
Assessment question will be obsolescent after ten years. Jo Lightweight, the
leasing company salesperson has told Sheila that the lease is
structured as an operating lease. Is Jo’s assertion correct?
a. Yes
b. No
2. Which of the following statements is not true regarding leases:
a. Lease payments are generally tax deductible.
b. The CCA on an asset is only claimable by the company using
the asset – lessor’s do not qualify.
c. The accounting treatment for financial leases is similar to that
used when an asset is purchased outright.
d. Leases taken out by businesses that are generating profits
(and have no available tax losses) can never be evaluated
without taking taxes into account.
3. Cicero Ltd.’s effective tax rate is 45 per cent. In 1999, the company’s
CCA claims for buildings totaled $40,000.The corresponding claim
for trucks was $87,000. Taxes saved on account of the claims for
buildings and trucks amounted to:
a. $57,150
b. $27,700
c. $13,850
d. $28,575
4. When a not-for-profit society evaluates a lease proposal to finance
new computers, which of the following factors will not be relevant:
a. federal and provincial corporate tax rates
b. the CCA rate for new computers
c. buy out options contained in the lease
d. all of (a) through (c)
e. (a) and (b).
5. Centaur Corporation is considering two options:
i. Purchase $1 million in new computers financed by a five-year

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term loan.
ii. Lease the same number of computers utilising a three-year
operating lease.

A financial analysis indicates a NAL (net advantage of leasing) of

minus $1,500. Centaur recorded a net income of $3.5 million in its
latest financial statements. Which of the following statements best
applies to Centaur’s decision:
a. They must choose the purchase option as the NAL is
negative.
b. They should examine the options in the lease, such as the
option to trade in equipment before the term is up and then
decide.
c. They should review their debt covenants to determine the
potential impact of further borrowing.
d. Both of (b) plus (c).
6. Ajax Finance Corp has received a request from a customer to lease a
fire truck. If the cost of the vehicle is $1,000,000, determine the
monthly lease payments based upon the following parameters:
 Lease term – five years
 Interest rate – 10 per cent
 Estimated salvage value at the end of the lease – $500,000.

Determine the monthly payment assuming that payments are made at

the end of the month.
7. Hyperion Limited leases an executive jet for two years at a monthly
rental of $75,000. The leased jet has a fair market value of $9 million
and an estimated remaining service life of 15 years. There is no
bargain purchase option contained within the lease. The lease runs
from January 1, 2002 to December 31, 2003. Discuss the impact of
the aircraft lease on the income statement of Hyperion for the fiscal
year ended on December 31, 2002.
8. Gentry Riding Equipment Company has entered into two lease
arrangements. One is an operating lease on an office copier requiring
annual payments of $2,000 for the next three years. The other is a 15-
year financial lease on a building requiring annual payments of
$150,000. How should each lease be presented on the firm’s balance
sheet?

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Answer Key to Assessment

Questions
1. b – The lease term equates with the economic life of the asset
and will therefore be considered a financial lease.
2. b – The lessor can always claim the CCA on a leased asset as
they are the legal owner.
3. a – Total CCA claim was 40,000 + 87,000 = 127,000 Tax
saved = 45% x 127,000 = $57,150
4. e – Not for profit societies do not pay tax, therefore (a) and (b)
are both irrelevant as there is no tax shield effect.
5. d – A positive or negative NAL is never sufficient justification
for a lease/buy decision. Other factors such as debt covenants
and lease options should be factored into the decision. In this
case, the NAL is small, so comparative cost is a very minor
issue.
6. PV 1,000,000
n 5.00
FV (500,000)
Annual interest 10.00%
Monthly interest 0.0083
PMT (14,790)
7. Lease payments would be charged as an expense against
income since the lease will almost certainly to be classified as
operating lease since it is only for 2 years and there is no
bargain purchase option. Since the monthly rental is $75,000,
then the overall effect in 2002 is additional expense of
$900,000.
8. Operating lease: The basic features such as the annual
lease payment and the term of the lease should be
disclosed in a footnote.
Financial lease: The building will be listed as an asset and
there will also be a corresponding liability on the balance
sheet.

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References
Leasing – Lessons of Experiences, The United Nations Economic
Commission for Europe. A conference-room paper prepared
within the framework of the Regional Advisory Services
Programme of the Coordinating Unit for Operational
References
Activities of the United Nations Economic Commission for
Europe for the Project Group on “Financial Policies for
Strengthening SMEs through Microcredit and Credit
Guarantee Schemes” of the Southeast European
Cooperative Initiative (SECI), Geneva, June 1997, at page
4.
Canadian Finance and Leasing Association. (Sept. 2001). Leasing
Glossary. http://www.cfla-acfl.ca/glossary.cfm
Canadian Finance and Leasing Association. CFLA Backgrounder
on the Asset-based financing, equipment & vehicle leasing
industry in Canada. http://www.cfla-
acfl.ca/backgrounderdec2000.cfm
Duff, C. (2002). Corporate Finance. Royal Roads University.
GE Vendor Financial Services.
http://www.ge.com/capital/vendor/glosterm.html
Ross, S. A., Westerfield, R. W., Jordan, B. D., & Roberts, G. S.
(1993). Fundamentals of Corporate Finance, 1st Edition.
Irwin.

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