Lease Finance

Leasing
Leasing is an alternative method of financing, available to a business of financing the
acquisition of property. Under a lease agreement, a leasing company or a financial
institution (Lessor) legally owns property that it in turn lease to another business firm
(Lessee).
Basic Advantages of Leasing are:
1. Facilitating the acquisition of needed equipment
2. Making available funds that would otherwise be tied up in ownership of fixed
assets.
3. Possible tax advantages
4. Possible improvement of the statement of financial position (balance sheet)
Leasing credit requirement:

The standards for granting credit to a lessee in a lease finance agreement or to a

borrower in a lending agreement are similar.
Less strict than bank lenders when it comes to documentation and to financial strength
of the lessee.
Primary consideration is intrinsic value or marketability of leased asset and cash flow
of the lessee.
After completion of Lease Term
1. Start new lease with a new property
2. Purchase property for residual amount
3. Renew lease with less rent
Lease Rates
Lease rates varies with risk involved (More specialized asset or longer the term, more
risk, higher rate)
Often add-on interest method is applied to determining lease rent:
Add-on- interest X no of years

Rabby, DU Finance

Lease Finance
Types of Lease
Sale-Leaseback
-

Under sale and leaseback agreement, a firm owning a property sells the asset to
Lessor and simultaneously executes an agreement to lease the property back for a
specific period and specific term.

Seller-Lessee gets purchase price from the buyer-lessee immediately on sale and
retains the right to use of property.

Alternative to mortgage

Considered special type of finance lease

Bargain Purchase Option

Tax Benefit is higher

Service Lease/ Operating Lease

-

Service lease includes both financing and maintenance arrangements.

Not fully amortize, Lessor expects to recover all cost from subsequent renewal
payment or through residual values on disposal of leasing equipment
It is cancellable
Lessor bears the risks of obsolesce
Used for mostly standard equipment or asset

Finance Lease/ Net Lease

-

Finance lease does not provide maintenance services

It is not cancellable
Fully amortized
Lessee bears the risks of obsolesce
Generally Lessee pays property tax, insurance
Used for both standardized and customized products

Rabby, DU Finance

Lease Finance
Conditional Sales Contract
-

Portions of the periodic payments are specifically applicable to an equity to be

acquired by the lessee
Title will be acquired upon payment
The total payments required for a relatively short period of use constitute an
excessively large portion of the total amount required to be paid to secure the
transfer of the title of equipment
The agreed rental payments materially exceed the current fair market rental value
for the same equipment, payment includes element other than compensation to
use the equipment
The property may be acquired under a purchase option at a price that is less than
normal in relation to the value of the property at the time the option may be
exercised as determined at the time of entering contract or that is relatively small
when compared to the lessee is required to make
Price under purchase option < value of property at the end of the lease

Some portion of the periodic payments is specifically designated as interest or is

otherwise readily recognizable as equivalent of interest
Title will be acquired on payment of an aggregate amount that approximate the
initial sales price, plus interest and carrying charges at which lessee could have
purchased the equipment when he entered into agreement
Aggregate Amount ~ Initial sales + Interest + Carrying charges
True Lease
Conditional Purchase
-Interest Expense, depreciation Interest Expense
Expense
-Show as Asset in Balance Sheet
Lease Rent
-Interest
Expense,
depreciation Expense
-Show as Asset in Balance
Sheet

Lessor

Lessee

Leveraged Leases
Three Parties:






-

Lessor
Lessee
Lender (to lessor)

This is generally a financial lease.

Lease terms covers a large portion of the useful life of the leased property
Lessee payments to the lessor are sufficient to discharge the lessor pay

Rabby, DU Finance

Lease Finance
Conditions of Leveraged Leases:
-

Minimum at risk Investment by lessor for the period

No Bargain purchase option
No investment or lending to Lessor by Lessee
Must have a profit motive by Lessor

Bona Fide Leased transaction:

-

The term should be less than 30 years

The rent should be represent a reasonable return to lessor
Renewal option should be bona fide
No bargain purchase option

Leasing vs. Ownership

Three alternatives-

Lease Agreement
Installment Sales
Term loan secured by mortgage

Total benefits derived from these alternatives:

-

Interest Expense
Depreciation Expense
Tax benefit
Discount rate
Capital gain from salvage

Assumed Cost of Leasing relative to Ownership

Cost of Leasing vs Ownership
Condition
Firm uses accelerated depreciation
Implicit interest rates are higher for leasing than borrowing
Equipment has large residual values
Equipment experiences rapid obsolescence

Lower

Higher
X
X

Rabby, DU Finance

Lease Finance
Accounting Implication of Leasing
Operating Lease:
General Journal

Date
Transaction
Debit
Credit
________________________________________________________________________
01/01/2013

Lease Expense
Cash

1,600
1,600

Capital Lease:
General Journal

Date
Transaction
Debit
Credit
________________________________________________________________________
01/01/2013

Lease Asset
Lease Obligation
Cash

10,000
8,000
2,000

Balance Sheet Implication:

Before Equipment
Purchase

Asset
Total
Debt
Equity
Total
Debt to Equity

After Equipment Purchase/

Lease

Firm X
200
200

Firm Y
200
200

Firm X- P
300
300

Firm Y- L
200
200

100
100
200

100
100
200

200
100
300

100
100
200

100%

100%

200%

100%

Rabby, DU Finance

Lease Finance
TAX aspects of Leasing
To determine the type and characteristics of tax deductions a lessee must determine
whether the lease agreement is a true lease or conditional sales contract.
-

If the agreement is a true lease, the lessee may deduct rental payment for tax
purpose
If the agreement is a conditional sales contact, payment under contract will be
payment for purchase of the property and will be allowed for depreciation and
possible interest expense.

Tax effect on Sale and Lease Back

Because funds are tied up in ownership of assets, a firm may sell and lease the same
property back. Conditional Sale and lease back may have
-

Investment tax credit

Depreciation tax benefit
Interest tax benefit

Criteria of Tax Benefit

Sale leaseback or gift and lease back may provide some tax advantage
-

Lack of equity interest: the tax payer cannot hold title

Business Purpose: must be present
Independent Trustee

Legal Aspects of Leasing

Four Categories:

Sale and leaseback of real property (land)

Chattel leases intended as security agreements
True leases of property
Lease of natural resources

Rabby, DU Finance

Lease Finance
Lease of Real Property
Right of ownership in real property is call called ESTATE. There are two categories:
-

Free hold estate (identify time)

Leasehold estate (pre-determined time)

In real property lease is a contract by which the owner of the property (Lessor) grants to
other (Tenant/ Lessee).
-Lessee must pay rent
- Implied obligation to pay reasonable rent
Provision is included to effect
-

Lessor can end lease

Lessor can regain property

Under Common Law

-

Can recover the rent

Can not evict

Assignments (right/obligation transfer)

-

Rent obligation ceases when leasehold is transferred by assignment

Obligation to pay rent passes to assignee

Is lease is assignable ?
If no restriction is mentioned in contract free to assign
Assignment vs Sub Lease

Transfer less than all rights of lease

All rights are not transferred to sub lease
If sub lease defaults, original lessee is liable
Sub lessee is not liable to original lessor

Rabby, DU Finance

Lease Finance
Destruction of Property
-

Lessee is liable to pay rent

Lessee can not terminate contract
If lessor wants to destroy and reconstruct the property, contact is void
As for government acquisition, lessee is released from obligation (if partial,
partial rent )

Abandonment of Lease
If lessee do not pay rent and abandon the property, lessor have right to recover rent from
lessee till he take over the property
Repair/ Restore
Lessee has no obligation to repair otherwise mentioned
Indemnification Clauses
By which Lessee /Lessor limits their obligation. Indemnification represents a promise by
one party to other party that they rescue from loss or damage from claims made by third
person (Sale and lease back tax indemnification)
Expiration of Lease
-

Virtue of own limitation (time expiration)

Periodic tendency of definite term (from year to year)
Provision (any party can terminate)

Sale and Lease back of Real Estate

Should be obtained to
-

Protect ability of lessee to use and enjoy the property

Protecting the principal amount of sums advanced to lessee
Protecting the interest payment
Tax provision of the lessor

Rabby, DU Finance

Lease Finance
Economics of Lease Financing
A firm tries to create financial capital. It is theoretically:
Incentive to go for leasing
1. The business does not have to pay tax
2. Useful life of asset is so short that the tax benefit for ownership are irrelevant
and residual value immaterial.
3. Ownership is not possible
Lease has arisen in response to an economic need to:
1. Transfer tax benefit to those who can use the most appropriately (offer reduced
rental)
2. Provide use rather than ownership of assets that have relatively short life
3. Provide access to assets when ownership is not possible (eg. Public Utility)
-

In addition lease is preferred in industries where there is rapid technological

obsolescence.
Lessor assumes the risk of obsolescence and spread among a number of lessee
over a multiple assets.
Also equipment leasing can provide flexibility that may not be available through
other method of financing. For example, it does not restrict further borrowing,
leasing tends to smooth out imperfection in capital market
Although leasing is said to improve financial position through off balance sheet
financing, it can nor escape the eyes of financial analysts.

Evaluation of Cost of Leasing

Cost of leasing involve discounting stream of after tax cashflow.
-

Investment decisions are different from financing decision

What is appropriate interest rate for discount

Two major approaches are: NPV and IRR

Lease have both financial and investment decisions. To resolve Vancil proposed Basic
Interest Rate Method:
PV of lease rental Cash purchase price) = Amount available for risk premium, admin
and financial expense
All these cost would be Bourne by the lessee.

Rabby, DU Finance

Lease Finance
Lease Problem: 1

You have taken a lease of an asset of Tk 500,000 that has an useful life of 5 year
where lease period is also 5 years. Rent is Tk. 135,000 annually. Loan can be
taken at 12% annual interest rate with annual payment of equal installment. NBR
allows 5% investment credit. Tax rate is 30%. Depreciation is straight line.

Rabby, DU Finance