Financial Analysis of Leasing
Financial Analysis of Leasing
Financial Analysis of Leasing
FINANCIAL ANALYSIS
OF LEASING
Definition
◦ A lease is a contractual arrangement by which the owner of an asset
(the lessor) rents the assets to a lessee
◦ A lease can be defined as a right to use equipment or capital goods on
payment of a periodical amount (lease rent)
◦ We analyze long-term leases, in which the asset spends most of its
useful life with the lessee
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Definition
◦ There are two principal parties to any lease transactioin:
◦ The Lessor is the actual owner of the equipment who is permitting its use by
the other party on payment of the periodical amount
◦ The Lessee is the party acquiring the right to use the equipment on payment of
the periodical amount
Definition
◦ In economic terms, the leases we examine are considered by the
lessees as alternatives to purchasing an asset
◦ This analysis fits many long-term equipment leases but not short-term
leasing (car rentals, for example)
◦ Financial theory regards such leases as being essentially debt contracts:
◦ For the lessee, the lease is an alternative to purchasing the asset with debt, and
the lessor is essentially providing financing for the lessee
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Types of Leasing
◦ Many variants based on type and nature of leased equipment,
amortization period, residual value of equipment, period of leasing,
option for termination of lease, etc.
◦ They may be categorized as follows:
◦ Operating lease
◦ Financial lease
◦ Sale and Lease Back Lease
◦ Sales-Aid lease
◦ Most consider only the first two categories, operating and financial
Operating Lease
◦ The primary lease period is short and the lessor would not be able to
realise the full cost of the equipment and other incidental charges
during the initial lease period
◦ The lessor bears not only the initial cost of the machinery, but also
the cost of insurance, maintenance, and repair
◦ The lessee acquires the right to use the asset for a short duration
◦ The lease agreement can be terminated at short notice by both parties
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Operating Lease
◦ Operating leases may be preferred by the lessee under the following
circumstances:
◦ When the long-term suitability of the asset is uncertain
◦ When the asset is subject to rapid obsolescence
◦ When the asset is required for immediate use to tide over a temporary problem
◦ Computers and other office equipment are commonly leased under
such arrangements
Financial Lease
◦ A financial lease is a long-term arrangement which is irrevocable during the
primary lease period, generally the economic life of the leased asset
◦ Under this arrangement, the lessor is assured of realizing the full cost of
purchasing the leased asset, including the cost of financing it and other
administrative expenses, and perhaps a profit too
◦ All the risks incidental to the ownership and benefits arising from the
ownership except for the legal title are transferred to the lessee against an
irrevocable undertaking to make unconditional payments to the lessor as
per the agreed schedule
◦ The lessee has to bear the cost of insurance, maintenance and repair
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Example
◦ We consider a company that is faced with the choice of either
purchasing or leasing a piece of equipment
◦ We assume that the operating inflows and outflows from the
equipment are not affected by its ownership—irrespective of how the
asset is held (whether owned or leased), the owner/lessee will have the
same sales and must bear the responsibility for maintaining the
equipment
◦ According to Statement 13 of the Financial Accounting Standards
Board (FASB 13), the lease we are considering is one that “transfers
substantially all of the benefits and risks incident to the ownership of
property” to the lessee
Example
◦ The analysis concentrates exclusively on the cash flows from the lease
◦ It is assumed that the lessor pays taxes on the income from the lease
rentals and gets a tax shield on the depreciation of the asset, and that
the lessee can claim the rent as an expense
◦ The analysis assumes that the tax authorities treat the lessor as the
owner of the asset and the lessee as the user
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Leasing Example
◦ A company has decided to acquire the use of a machine costing $600,000
◦ If purchased, the machine will be depreciated on a straight-line basis to a
residual value of zero
◦ The machine’s estimated life is six years, and the company’s tax rate TC is
30%
◦ The company’s alternative to purchasing the machine is to lease it for six
years
◦ A lessor has offered to lease the machine to the company for $115,000
annually, with the first payment to be made today and with five additional
payments to be made at the start of each of the next five years
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Leasing Example
◦ One way of analyzing this problem is to compare the present values
of the cash flows to the company of leasing and of buying the asset
◦ The company believes that the lease payment and the tax shield from
depreciation are riskless
◦ Suppose, furthermore, that the risk-free rate is 5%
◦ Based on the following calculation, the company should lease the asset
because the leasing alternative has higher (less negative) net present
value (NPV)
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Leasing Example
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Leasing Example
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Leasing Example
◦ This analysis suggests that leasing the asset is preferable to buying it
◦ However, it is misleading because it ignores the fact that leasing is very
much like buying the asset with a loan
◦ The financial risks are thus different when we compare a lease (implicitly a
purchase with loan financing) against a straightforward purchase without
loan financing
◦ If the company is willing to lease the asset, then perhaps it should also be
willing to borrow money to buy the assets
◦ This borrowing will change the cash flow patterns and could also produce
tax benefits
◦ Hence, our decision about the leasing decision could change if we were to
take the loan into account
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The table shows the principal of a hypothetical bank loan bearing a 5% interest rate
At the beginning of year 0 (that is, at the time when the firm either purchases or leases the
asset), for example, the firm borrows $523,318 from the bank
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Leveraged Lease
◦ In a leveraged lease, the lessor finances the purchase of the asset to be
leased with debt
◦ From the point of view of the lessee, there is no difference in the
analysis of a leveraged or a non-leveraged lease
◦ From the lessor’s point of view, however, the cash flows of a
leveraged lease present some interesting problems
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Leveraged Lease
◦ At least six parties are typically involved in a leveraged lease:
◦ the lessee
◦ the equity partners in the lease
◦ the lenders to the equity partners
◦ an owner trustee
◦ an indenture trustee, and
◦ the manufacturer of the asset
◦ In most cases, a seventh party is also involved:
◦ a lease packager (a broker or leasing company)
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Leveraged Lease
◦ The two major problems related to the analysis of leveraged leases are
these:
◦ The straightforward financial analysis of the lease from the point of view of
the lessor
◦ This concerns the calculation of the cash flows obtained by the lessor and a
computation of these cash flows’ net present value (NPV) or internal rate of return
(IRR)
◦ The accounting analysis of the lease
◦ Accountants use a method called the multiple phases method (MPM) to calculate a
rate of return on leveraged leases
◦ The MPM rate of return is different from the IRR
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