Chapter 8
Lease Financing
Definition of Lease Financing
A lease is a contract under which one party the lessor (owner of asset) gives another parry (the
lessee) the exclusive right to use the asset usually for a specified period of time, in return of
the payment of rent.
Lease is a contract that enables a lessee to secure the use of tangible property for a specified
period by making payments to the owner (Lessor). -Benton.
Most of us are familiar with leases of houses, apartments, offices or automobiles. An obvious
advantage to the lease is the use of an asset without having to buy it.
The Features/ Elements of Lease Financing
The contract: there are essential two parties to a contract of lease financing, namely the
owner and the user, called the lessor & the lessee.
Assets: The assets, property to be leased are the subject matter of lease financing
contract.
Lease Period: The basic lease period during which the lease is no cancelable.
Rental payments: The lessee pays to the lessor for the lease transaction is the lease
rental.
Maintain: Provision for the payment of the costs of maintenance and repairs, taxes,
insurance and other expenses appertaining to the asset leased.
Term of lease: The term of lease is the period for which the agreement of lease remains
in operation. In financing lease period may over and operating lease period shorter than
useful life of the assets.
Ownership: During the lease period, ownership of the assets is being kept with the
lessor and its use is allowed to the lessee.
Terminating: At the end of the period, the contract may be terminated.
Renew or Purchase: An option to renew the lease or to purchase the asset at the end of
the basic period.
Default: In that case, the lessee may be liable for all furniture payments at once,
receiving title to the asset in exchange.
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Types of lease financing
On the basis of nature:
(1) Operating Lease:
- Operating lease is a cancellable contractual arrangement whereby the lessee agrees
to make periodic payment to the lessor (owner).
- Generally the total payments over the term of the lease are less than the lessor's
initial cost of the leased asset, often for five or fewer years to obtain in asset service
.so, operating lease is a short term lease used to finance assets such as computers
equipment, bus and truck.
- It is relatively short term and is often cancellable at the option of the lease with
proper notice.
- Operating lease are sometimes called service lease, cancellable lease and short
term lease.
(2) Financing Lease:
- Financing lease is longer term lease than an operating lease that is non-cancellable
and obligates the lessee to make payments for the use of an asset over a predefined
period of time;
- The total payments over the term of the lease are greater than the lessor's initial
cost of the leased asset. So, financial lease is longer term in nature and is non-
cancellable.
- The lease used in connection with financing long term assets.
- The lessee is responsible for maintained, service, taxes, insurance and other
expenses that arise in connection with the -use of the asset.
- Financial lease are sometimes called capital lease, non-cancellable lease and long
term lease.
On the basis of using method:
(1) Direct Lease:
- The direct leasing, the asset to be leased does not belong previously to the lessee.
The lessor buys the asset from the manufacturer and leases it out to the lease.
- If the manufacturer is the lessor, the lessor and the vendor are the same person. So,
under direct leasing, a company acquires the use of an asset it did not own
previously.
- A firm may lease an asset from the manufacturer.
(2) Sale and Leaseback:
- Under the sale and leaseback arrangement, the firm sells an asset that it owns and
then leases to same asset back from the buyer. This way the lessee gets the asset for
use and at the same time it gets cash which could be used for other purposes.
- This type of arrangement is more common in case of those firms which need cash
but do not get it easily from other sources. So, in sale leaseback arrangement,
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lessor's acquire leased assets, by purchasing assets already owned by the lessee and
leasing them' back'.
- This technique is normally initiated by a firm that needs fund for operations.
(3) Leveraged Lease
- Leveraged lease is the same as the direct lease, except that a third Party, the lender
is involved in addition to the lessee and lessor. A leveraged lease is a lease
agreement that is partially financed by the lessor through a third-party financial
institution.
- This type of lease does not make any difference for the lessee as he has to make
periodic payments for the use of the asset. But since the purchase of the asset to be
leased is partly financed by the lender, the lessor turns to be a borrower.
- Typically a large financial institution or lender; provides the balance of the purchase
price and is paid by the lessor. The creditor holds the title to the property until the
loan is repaid.
- There are three parties involved in leveraged leasing: (a) Lessee, (b) Lessor and (c)
Lender.
Advantages of Lease Financing
The advantages from the viewpoint of lessee:
Availability of Credit: Leasing eases the availability of credit. Even the firms with poor
credit rating are able to secure assets through leasing when they do not get funds from
other sources for buying assets.
Adequate Financing: No cash is required to acquire the asset, lease helps a firm a
arranging a full financing.
Less Costly: Leasing as a method of financing is less costly than other alternatives
available.
Flexibility: Lease can be arranged more quickly and the rental payment schedule can be
designed with revenue generated from the asset.
More convenient: There is no need to prepare subsidiary fixed asset schedule for tax
purpose. Nor the management has to bother about the maintenance of the asset.
Avoid Conditionality: Lease finance is considerable to institutional finance as in the
former case there are no strings attached. It is beneficial since it is free from conditions.
Risk of Obsolescence: Leasing allows a firm to avoid the risk of obsolescence because
the lessor provides the lessee with better service in order to maintain the resale value of
the asset.
Ownership Preserved: Leasing provides finance without diluting the ownership or
control of the promoters.
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Tax Benefit: A lease payment is deductible as an expense for corporate tax purpose. If
the lessee in a tax paying position, the rental may be increased to lower his taxable
income.
Simplicity: A leasing arrangement is simple to negotiate & free from cumbersome
procedures with faster and simple documentation.
Shifting of Risk: Lease financing enables a firm to shift the risk in ownership to the
lessor. The lessor holds the title on the property although it is used by the lessee and
thus bears all sorts of ownership risk relating to the asset concerned.
Balance Sheet Advantages: Lease financing is thought to be advantages by many firms
because of the fact that the lease obligation does not appear in the balance sheet as
liability.
The advantages from the viewpoint of lessor:
Full Security: The lessor is fully secured since he is the owner of the leased asset and can
be repossession of the asset if the lessee defaults.
Tax Benefit: the lessor benefits from investment tax credits and depreciation. A lease
payment is deductible as an expense for corporate tax purpose.
High profitability: The leasing business is highly profitable since the rate of return is
more than what the lessor pays on his borrowing.
Profitable Investment: Under sale and lease base back arrangement the firm sells the
asset and receives the cash which it can use in more profitable investment. At the same
time it can use the asset by leasing it back.
High growth potential: The lease financing enables to acquire equipment and
machinery even during a period of depreciation, thus leasing maintains economic
growth even during a recessionary period.
Differences between Operating Lease & Financial Lease
Topics Operating Lease Financial Lease
1. Definition Operating lease is short term lease Financial lease is the lease used in
used to finance asset and is not fully connection with long term asset and
amortized over the life of the asset. amortizes the entire cost of the asset
over the life of lease.
2. Duration Short term leasing. Long term leasing.
3. Cost Lessor pays the maintenance cost. Lessee Pays the maintenance cost.
4. Objective For operation & service. For financing & capital.
[Link] Cancelable lease Non-cancelable lease
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[Link] It is changeable lease contract It is not changeable lease contract
[Link] Lessor bears the risk of asset Lessee bears the risk of asset
[Link] At the end of the contract the asset At the end of the contract the asset is
is not purchasable purchasable
[Link] It is renewable contract It is not renewable contract
[Link] called Service lease, short term lease, Capital lease, long term lease, Non-
cancelable lease cancelable lease.
Differences between lease and Purchase
The differences between lease and purchase are as follows:
Topics lease Purchase
1. Definition Lease is a contract that enables lessee To achieve the ownership of the goods
to secure the use of tangible property or take the service, the payment is made
for specified period by making by cash or account is called Purchase.
payments to the owner (lessor).
2. Ownership Lessor holds ownership and lessee Ownership right goes to
can use it. purchaser
3. Use Without ownership the asset is Without ownership the asset is not
useable useable
4. Period Asset is useable by lease contract for Asset is useable by purchase for the life
specific period. time of asset.
5. Tax The lease rent is tax deductible The depreciation is not tax
expense deductible expenses
6. Residual Lessor takes possession to residual Purchaser enjoys the residual
Value value of the assets. value
7. Sale On the lease asset cannot be sold. Purchased assets always can be sold.
8. Parties Often more than two parties are Only two parties are involved
involved with lease with purchase
9. Loan Use Lease may use as a loan. It uses for change the ownership of asset
10. Renew There is the option to renew or to There is no other option to renew it.
purchase the asset for leasing.
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Differences between Lease and Loan/ credit/ Borrowing
The differences between lease and loan/ credit/ borrowing are given below
Topics Lease loan/ credit/ borrowing
1. Definition Lease is a contract that enables Loan is arrangement between bank and
lessee to secure the use of their customers that allows for
tangible property for specified borrowing under certain conditions.
period by making payments to the Interest and fee to be paid for using
owner (lessor). bank fund.
2. Objective Without having ownership the To meet up working capital and long
use of asset term asset.
3. Ownership Lessee would not get Borrower gets the ownership of the
ownership amount and asset
4. Risk Lessor bears the risk. Borrower bears the risk.
5. Liability No liability is created. Liability is created byloan'
6. Security No asset is taken as security. Others assets are taken as security.
7. Residual Lessor takes Possession to Borrower-takes possession to residual
Value Residual value of the asset. value of the asset which is purchased by
the loan
8. Reword Rent is paid for lease. Interest is paid for loan.
9. Parties Often more than two Parties are Only two parties are involved within
involved within lease. lease.
10. Medium Asset is the only medium of the Money is the medium of the loan
lease contract. contract often use asset as a medium.
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Valuation of Lease Financing under Lessee & Lessor Viewpoint
A. Value Calculation of Lease using Present Value Ordinary Annuity:
Example-01
The Padma Company is planning to acquire a plant costing TK. 2 million. The company has got
offer of taking lease from a leasing company for 10 years at 12% interest rate in equal
installments to be paid at the end of each year. How much should be paid to leasing company in
each installment?
Given that,
PV= Present Value = 20,00,000
r= Rate of Interest =0.12
n= Number of Year =10
m=1
PMT = Amount of Installment =?
We have,
r nm
1 1
PVA PMT
m
r
m
0.12 10 1
1 (1 )
20,00,000 PMT 1
0 .12
1
20,00,000 PMT (5.6502)
20,00,000
PMT 353968.3283
5.6202
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B. Value Calculation of Lease using Present Value Annuity Due:
Example-02
The Meghna Company is planning to acquire a plant costing TK. 2 million. The company has got
offer of taking lease from a leasing company for 10 years at 12% interest rate in equal
installments to be paid at the beginning of each year. How much should be paid to leasing
company in each installment?
Solution
Where, PV= Present Value = 20,00,000
r= Rate of Interest =.12
n= Number of Year =10
m=1
PMT = Amount of Installment =?
We have,
r
nm
1 1
PVAD PMT m 1 r
r m
m
0.12 101
1 (1 1 ) 0.12
20,00,000 PMT 1 6.3282PMT
0.12
1
1
20,00,000
PMT 316043.1503
6.3282
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C. Value Calculation of Purchase/Loan using Present Value Ordinary Annuity:
Example
You have the right to receive rents from equipment in future as an installment of TK. 40,000 at
the end of every year for next 8 years. A bank is willing to buy your right to receive these rents,
at 9% discount rate. How much would the bank be willing to pay you at now?
Solution
PMT = Amount of Installment=40,000
r=Discount Rate=9%=.09
n= Number of Years=8
PVA= Present Value of Installments=?
r
nm
1 1
PVA PMT m
r
m
0.09 8
1 (1 )
PVA 40000 1
0.09 221392.7646
1
D. Value Calculation of Purchase/Loan using Present Value Mixed Streams:
Example
You have the right to receive rents as follows:
December 31, 2012 TK.40, 000
December 31, 2013 50, 000
December 31, 2014 55, 000
December 31, 2015 60, 000
December 31, 2016 70, 000
A bank is willing to buy your right to receive these rents, at a discount of 8% yearly. How
much would the bank pay you on January 1, 2012?
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Solution
CF= Amount of Receipts
CF1=40,000
CF2=50,000
CF3=55,000
CF4=60,000
CF5=70,000
r= Discount Rate=.08
PV= Present Value=?
CF1 CF2 CF3 CF4 CF5
PV ( n4 ) m
( n 3 ) m
( n2) m
( n 1) m
( n 0 ) m
r r r r r
1 1 1 1 1
m m m m m
40000 50000 55000 60000 70000
PV
(1 0.08) (1 0.08) (1 0.08) (1 0.08) (1 0.08) 5
1 2 3 4
PV 215307.3663
E. Value Calculation of Lease versus Loan/Borrowing:
Example
Shahara Food Ltd. has two options to finance its midterm capital requirement for food
processing equipment; (i) to take lease from united leasing company for 5 years with an annual
lease payment of TK. 150, 000 to be paid at the end of each year. (ii) to taka loan from a bank at
15% interest. The equal installment of TK. 135, 000 has to be paid at the end of each of 6 years.
Which offer should the company accept?
Solution
Present Value of the Lease:
Where,
PMT = Amount of Installment=150,000
r= Rate of Interest =.15
n= Number of Year =5
PV= Present Value of Installment=?
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r
nm
1 1
PVA PMT m
r
m
0.15 5
1 (1 )
PVA 150000 1
0.15 502823.26
1
Present Value of the Loan:
r
nm
1 1
PVA PMT m
r
m
0.15 6
1 (1 1 )
PVA 135000 510905.16
0.15
1
Answer: The present value of cash outflows under:
(i) Lease Financing = 502823 TK.
(ii) Loan Financing = 510905 TK.
Decision: Since the present value of lease financing is less than loan financing. So, the
company should accept lease financing.
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