FNB 307 Chapter 1
FNB 307 Chapter 1
FNB 307 Chapter 1
Lease Finance
Chapter 1
Lessor: person or party that issues the lease (legally owns and allows the asset to
be rented)
Lessee: the person or party to whom the lease is granted (the person paying rent
to use the asset).
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Example
Lease Financing
Lease financing is one of the alternative 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 the lessor.
• The user is called a lessee.
• The periodical payment made by the lessee to the lessor is known as lease capital.
• Under lease financing, the 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.
Characteristics:
01. Rental payment 02. Maintenance
• The lessor owns the
Clauses
equipment and leases it A lease agreement typically
out. specifies whether the lessee
is responsible for the
• Lessee makes regular maintenance of the leased
scheduled payments to assets.
the lessor
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Features of Operating Lease:
Short-term arrangement for the use of the asset
Total Rent paid during the lease period < cost of the
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asset
Features of Financial Lease:
Under Financial Accounting Standards Board (FASB) Statement
No. 13,"Accounting for leases," a finance or capital lease is defined
as one that has any of the following features:
Transfers ownership of the property to the lessee by the end of the lease
term.
Contains an option to purchase the property at a bargain price. Such an
option must be exercisable at a fair market value.
Leasing term is equal to 75% or more of the estimated economic life of the
property
At the beginning of the lease, the present value of the lease payment is equal
to 90 % or more of the Fair market value of the leased property.
Finance Lease example:
• Company C in engaged in the manufacture of bicycles. It has leased some
specialized production equipment from Company L. The useful life of the
equipment is 6 years and the lease term is 5 years. The fair value of the equipment
is $20 million and the present value of minimum lease payments made by Company
C amounts to $15 million. The equipment is specifically designed for the
operations of Company C and the lease contract contains a provision that allows
Company C to either extend the lease at much lower rates or purchase the
equipment at the end of 5 years for $1 million. The fair value of the equipment at
the end of the lease term is expected to be $4 million.
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Methods of Lease financing :
1. Sales and 2. Direct Lease 3. Leveraged
Leaseback Lease
A lease under which A company acquires A lease arrangement in
the lessee sells an the use of an asset it which the lessor
asset to a prospective did not previously provides an equity
lessor and then leases own. Lessee and the portion (usually 20 to
back the same asset, owner are two 40 percent) of the
making fixed periodic different entities. leased asset's cost, and
payments for its use. third-party lenders
provide the balance of
the financing.
Sales and Leaseback
❑Usually, the asset is sold at approximately its
market value
❑The firm receives the sales price in cash and the
economic use of the asset during the basic
period.
❑In turn, it contracts to make periodic lease
payments and give up title to the asset. Sales &
❑As a result, the lessor realizes any residual value Leaseback
the asset might have at the end of the lease
period, whereas before this value would have
been realized by the firm
❑The firm may realize an income tax advantage if
the asset involves a building on owned land.
❑However, because lease payments are tax
deductible, the lessee is able to indirectly
depreciate (or expense) the cost of the land.
❑ Lessors engaged in sale and leaseback Sales &
arrangements include insurance companies, Leaseback
other institutional investors, finance companies Cont’d
and independent leasing companies.
Direct lease
❑A firm may lease an asset from the
manufacturer. Such as IBM leases computer.
❑Indeed, many capital goods are available today
on a leased-finance basis.
❑The major lessors are manufacturers, finance
companies, banks, independent leasing
companies, special purpose leasing companies Direct
and partnerships. Lease
❑For leasing arrangements involving all but
manufacturers, the vendor sells the asset to the
lessor, who in turn, leases it to the lessee.
Leveraged Lease
Sells Leases
assets assets
Manufacturer Lessor Lessee
Lender
❑It is a special form of leasing which has become
popular in the financing of big-ticket assets,
such as aircraft, oil rigs and railway equipment.
❑In contrast to the two parties involved in a sale
and leaseback or direct leasing, there are three
parties involved in leveraged leasing:
• The lessee, Leveraged
• The lessor (or equity participant) Lease
• The lender
❑ From the standpoint of lessee, there is no
difference between a leveraged lease and any
other type of lease.
❑The lessee contracts to make periodic payments
over the basic lease period and, in return, is
entitled to the use of the asset over that period
of time.
❑The role of the lessor, however, is changed. The
lessor acquires the asset in keeping with the
terms of the lease arrangement and finances the
acquisition in part by an equity investment of,
say 20 %. Leveraged
❑The remaining 80 % of the financing is
provided by a long-term lender or lenders.
Lease
❑Usually, the loan is secured by a mortgage on Cont’d
the asset as well as by the assignment of the lease
and lease payments.
Lessee
Pros 1
Saving of capital
Cons 1
Pros 2
Higher Cost
Flexibility & Convenience Disadvantages Cons 2
Pros 3
Risk
Planning Cash Flows
Cons 3
Pros 3 Advantages
No Alteration in Asset
Improvement in Liquidity
Cons 3
Pros 3
Penalties on termination
Shifting of Risk of of Lease
Obsolescence
Lessor
Advantages Disadvantages
High Risk of
01 Higher profits Obsolescence
01
Long term
03 Quick Returns Investment
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Comparison with ownership
1. Use of 2. Implicit
accelerated interest rates
depreciation are higher
3. Large residual
4. Rapid
values for
Obsolescence
equipment
1. Use of Accelerated
Depreciation:
Argument Overview: It’s often argued that owning equipment should be less expensive than
leasing due to the tax advantages of accelerated depreciation. Accelerated depreciation allows
businesses to claim a larger depreciation expense in the early years of an asset's life, reducing
taxable income and, consequently, tax liability.
Counterpoint: This perspective doesn’t consider the competitive nature of the financial markets.
Leasing companies, due to market competition, may pass tax benefits like accelerated
depreciation and tax credits to the lessee in the form of lower lease payments. This means that
the potential tax advantages of ownership might also be realized by lessees indirectly, as
lessors incorporate these advantages into their lease rates.
2. Implicit Interest Rates Are
Higher in Leasing:
Argument Overview: There is a common perception that leasing involves higher implicit interest rates
compared to loans. This perception is rooted in the idea that lessors charge a premium for leasing
compared to traditional financing.
Counterpoint: This assumption may not always hold true. When accounting for the lessee’s credit
risk and tax implications, the interest rates on leases may be comparable to those on loans.
Additionally, leasing contracts often bundle additional services, such as maintenance, which can
create efficiencies that reduce the total cost of leasing compared to owning.
***The implicit rate in a lease is the interest rate that makes the present value of lease payments
(plus any unguaranteed residual value of the asset) equal to the fair value of the asset at the lease's
inception. Essentially, it is the effective interest rate embedded within a lease agreement.
3. Large Residual Values for
Equipment:
Argument Overview: Since the lessor retains ownership of equipment after the lease term, it
might seem advantageous to own equipment with high residual values. Ownership allows the
buyer to benefit from these retained values, which might appear to reduce long-term costs.
Counterpoint: For assets prone to rapid obsolescence, like computers and aircraft, high residual
values can be uncertain. While these items might initially seem valuable, technological
advancements and wear over time may significantly reduce their actual worth. To reflect this,
leasing companies tend to lower lease rates if high residual values are expected, making leasing
an attractive option even for high-value equipment.
4. Rapid Obsolescence:
Argument Overview: Some believe that leasing costs should be lower for equipment that quickly
becomes obsolete, as the user avoids the financial risk of owning equipment that may lose
value rapidly.
Counterpoint: Leasing companies typically account for obsolescence in their pricing, meaning
higher obsolescence rates can lead to higher leasing costs. The lessor takes on the risk of an
asset becoming outdated and therefore adjusts the lease rates to mitigate this risk. Certain
leasing companies are uniquely equipped to handle rapid obsolescence, which can make
leasing more cost-effective for lessees in specific cases. For example, IBM.
Cost of capital
tied up in
purchase
Chapter 1, page 13
Cost of capital tied
up in purchase
George intends to lease a piece of equipment for $10,000. The required down payment
would be 20% if they were to purchase the asset with financing. The lease will be repaid in
10 equal installments. The implicit interest rate is 10% per annum.
i. Calculate the size of each lease payment.
ii. How much capital is saved and if George has a ROI of 25% how much could he have saved
by leasing instead of purchasing the asset (assuming that the capital saved was reinvested
for 10 years).
Tax
Implication
Leasing may give access to tax deductions.