Leasing

Introduction

A lease is a contract (written or implied or oral)

through which the owner of a specific asset grants the right to its
use (and often possession)
to a second party
The first party is called the lessor, and second party the lessee
For a prospective lessee, the most important decision is lease
versus buy
With implications for capital investment requirement, versus
Tax benefit
First we present a taxonomy of different types of leases in the
following
 Types of
Leases 1
(Agreements)

(1) (2) (2A) (2B) (3)

Operating Finance Sale & Leveraged Direct
Lease Lease Leaseback Lease Lease
 Types of Leases 2
Finance / Capital Lease
1. Such leases do not provide for maintenace or service by the
lessor (must be done by the lessee)
2. Such leases are fully amortized (lease payments recover the full
cost of assets to the lessor)
3. The lease agreement must incorporate / specify that the lessor
agrees to transfer the ownership right of the leased asset to the
lessee by the end of the lease term (Ownership criterion)
4. It must be a non-cancelable agreement in nature (in general,
excl. force majure type of conditions) (Non-Cancelability
criterion)
5. It contains an option given to the lessee to purchase the leased
asset at a favourable price (Bargain Price criterion)
6. It must be a long-term agreement [e.g., at least 75% (USA) or
100% (India) of the estimated economic life of the leased asset]
(Estimated Economic Life criterion)
 Types of Leases 3
6. The PV of lease payments (rentals and others, if any) less
payment due to execution cost (e.g., insurance, taxes, etc.)
should be at least 90% (USA as well as India) of the fair market
value of the asset at the time of entering into the lease
agreement (Fair Value criterion) fully amortized
The last two conditions are not applicable (USA, not India)
if the lease becomes effective at a time when
25% or less of the economic life of the asset is left
Above conditions, especially the second one, i.e., (2) [full
amotization], implies that finance lease is an alternative to the
purchase option
 Types of Leases 4
Operating Lease
Tenure of the lease is usually less than the economic life of the
asset
Such leases are not fully amortized PV of lease payments are
not enough to recover the full cost of the asset to the lessor
Lessor must expect to recover the cost of the asset by either
renewing the lease, or by selling the asset for its residual value
Maintenance of the asset is responsibility of the lessor
However, lessor may outsource this to the lessee or to any third
party, or may conduct itself
The lessee enjoys the right to cancel the lease before expiry of
the lease term
If cancel option is exercised, lessee must return the asset to the
lessor
 Types of Leases 5
Value of cancellation option (to the lessee) depends on whether
future technological / economic conditions are likely to make the
value of the asset (to the lessee) less than the PV of the
(remaining) future lease payments under the lease
Thus, in more senses than one, operating leases are exact
opposite to Finance Leases
While above description is the practice, accounting treatment
of operating lease slightly differs from the prevailing practice
Following is a tabular comparison of the two types of leases
Wherein accounting treatment of the two types of leases are also
dealt with
 Comparison: Finance & Operating Leases 1
Lease Finance/ Capital Lease Operating Lease
Criterion
Ownership Ownership of the asset might be Ownership is retained by
transferred to the lessee at the end the lessor during and after the
of the lease term. lease term.
Bargain The lease contains a bargain The lease cannot contain a
Purchase purchase option to the lessee to bargain purchase option to
Option buy the equipment at less than the lessee.
fair market value.
Term / Tenure The lease term equals or exceeds The lease term is less than
of Lease 75% (USA) / 100% (India) of the 75% (USA) / 100% (India) of
asset's estimated useful life the estimated economic life
of the equipment
PV of Lease The present value of the lease The PV of lease
Payments payments must equal or exceed payments may well be less
90% of the total original cost of than 90% of the equipment's
the equipment. fair market value
 Comparison: Finance & Operating Leases 2
Criterion Finance/ Capital Lease Operating Lease
Risks and Transferred to lessee. Lessee Lessee has right to use only. Risks
Benefits pays maintenance, insurance and benefits remain with lessor.
and taxes Lessor takes care of maintenance
costs, insurance, etc.
Accounting Lease is considered as asset Not reflected in liability/ asset of the
(Lessee (leased asset) and liability lessee, since risk of ownership is
perspective) (lease payments) by the absent. Payments are considered as
lessee. Payments are shown operating expenses (like interest
in Balance sheet (like loan expenses), and are shown in P&L
amortization) of lessee statement of lessee
Accounting Not reflected in liability/ Leased out equipment is shown as
(Lessor asset of the lessor, since risk asset (leased asset) of lessor, funded
perspective) of ownership is by its own sources (liabilities like
absent. Lease rental deposits of a bank or NBFC).
receipts are considered as Receipts are shown in P&L of lessor
operating incomes (like as operating income (like interest
interest incomes), and are income & loan amortization by a
shown in P&L statement of bank)
http://www.diffen.com/difference/Capital_Lease_vs_Operating_Lease
lessor
 Comparison: Finance & Operating Leases 3
Lease Finance/ Capital Lease Operating Lease
Criterion
Cancelability Usually not cancelable Usually cancelable.
Tax Lessee is considered to be Lessee is considered to be renting
(Lessee the owner of the equipment the equipment and therefore the
Perspective) and therefore claims lease payment is considered to be a
depreciation expense and rental expense (operating expense)
interest expense which is tax deductible
Tax Lessor shows lease rentals Lessor gets the tax benefit of
(Lessor as operating income which depreciation, and shows receipts of
Perspective) is taxable lease rentals as operating income
(which is taxable)

http://www.diffen.com/difference/Capital_Lease_vs_Operating_Lease
 Types of Leases 6
The following two types are considered as variants of Finance
/ Capital Lease
Sale & Leaseback
Leveraged Lease
Sale & Leaseback (2A)
Occurs when a firm sells an assets (it owned) to another firm
and immediately takes the asset on lease (for use) from the
firm to which it sold the asset
The following things happen in this case
After the transactions are done, the first firm becomes the lessee,
and the second firm becomes the lessor
The lessee receives the cash flow from sale of the asset
The lessee enters into (non-cancelable) contractual agreement to
make periodic lease payments to the lessor
The lessee retains the right to own the asset at favourable terms
immediately before or at the end of contract period
 Types of Leases 7
Leveraged Lease (2B-Another Variant of Finance Lease)
It is a three-sided arrangement between the lessee, the lessor,
and the lender
The lessee uses the asset and makes periodic lease payments (to
the lessor)
The lessor purchases the asset on credit from the lender with a
part (usually 50% or 40% or less) contributed by itself, and rest
taken on loan from the lender
The lessor delivers the asset to the lessee, and begins to collect
the lease payments from the lessee
The lessor pays out a part of the lease payment received from the
lessee towards payment of interest and amortization to the lender
The lender in a leveraged lease (either a banker or a
manufacturer) typically use a non-recourse loan
 Types of Leases 8
This means that the lessor is not obligated to the lender in case
of default by the lessee
Lender has two safeguards in non-recourse lease
It has the first charge on the asset
In case of loan default by the lessor, lessee makes lease payment
directly to the lender
The above is the traditional structure of Leveraged Lease
Mostly applied in airlines service industries across the world
(what about mobile towers to mobile services firms in India?)
Post-2010, due to rising risks of non-recourse finance and
changes in tax laws, USA has witnessed the emergence of
orphan equity
For further study, begin with
https://www.wilmingtontrust.com/repositories/wtc_sitecontent/
PDF/Leveraged_Leasing_Thought_Leadership.pdf
 Types of Leases 9
However, recourse-based lease (leveraged) is also possible
In this case, the lessor is obliged to honour the loan commitment
in case of a default by the lessee
Such leases are usually short and medium term (e.g. up to 3
years), and not long term
 Indian Accounting Treatment (Summary)
ICAI issued AS19 on leasing (applicable to hire purchase as
well), effective from April 2001
Though there are several criteria to judge whether a lease is a
finance lease or operating lease,
In India, the most important one is the fair value criterion,
usually called present value test or full payout test
This requires that PV of (minimum) lease payments by the
lessee (i.e., from lessees point of view) must constitute at least
90% of the fair value of the asset
For further details, see www.icaijaipur.org/as_19.ppt
Self study: 21.2 & 21.3 of text (RWJK, Eighth Edition)
 Lease versus Buy 1
See Example 1 to identify the cash flows (under lease vs. buy)
Note the method of evaluation
Operational efficiency from use of new machine remains
irrespective of buy or lease
Hence not considered for a financial evaluation of the alternatives
In case of lease, XYZ Ltd saves on the cost of machine considered
as a cash inflow
In case of lease, XYZ Ltd must give up the depreciation tax benefit
considered as cash outflow
In case of lease, a lease rental is to be paid considered as cash
outflow
Since lease rental is tax deductible expense, it gives rise to tax
benefit considered as cash inflow
This is lease relative to purchase
 Lease versus Buy 2
In case of purchase relative to lease, the net cash flows will be
(- 1) * CF of lease relative to purchase
Once these cash flows are noted, evaluation is still problematic
Which discount rate to use?
We cant use WACC, since it captures the risks of operating
cash flows, while lease payments are like debt service cash
flows
Hence, the appropriate rate should be less than WACC
The answer comes from the concept of debt displacement
See Example 2
Under purchase, the firm finances with a SECURED LOAN
Enough equity is also raised to maintain the DE ratio
Under leasing, the firm reduces the debt (as well as equity)
To maintain the DER
 Lease versus Buy 3
Consequently, the firm is unable to use tax benefit of debt
Assuming that the firm was already at its optimal debt capacity
before introducing the new machine
Since leasing leads to replacement of debt
Consequently, the appropriate discount rate for evaluating
lease versus buy choice must be the rate that the lessee firm
should pay on a secured loan
On after-tax basis
Because leasing leads to reduction in (displacement of) debt,
with consequent reduction in tax benefit
Consider the purchase relative to lease option in Example 1
The CFs are: -10,000, 2330, 2330, 2330, 2330, 2330 (years 0
to 5)
 Lease versus Buy 4
Purchase leads to a outflow of 10,000 and then additional
inflows of 2,330 for each of 5 years relative to leasing
Implies that the firm confronts guaranteed cash inflow of
2,330 per year
This is risk-less cash inflow, since the debt used is secured by
charge on the asset
Finally, the appropriate discount rate for evaluating lease
versus buy choice must be the after-tax rate that the lessee
firm should pay on a secured loan
Self-study: Work-out the calculations in Table-21.6, pp. 727
 Who Benefits from Leasing 1
The lessor, or the lessee?
If the NPV of purchase relative to lease is 87.68, the firm
(XYZ Ltd) would be better off by purchasing
Even if it is leased, its loss would be 87.68, and consequent
gain to the lessor would be the same
Under the assumptions:
Both firms facing same tax rates
Both firms facing same interest rates
No transaction costs (of buying or leasing)
So net gain from a lease deal would be zero
Of course, in an actual deal, the lease payment would be
decided at a level for which NPV of lease versus buy would be
zero
 Who Benefits from Leasing 2
Thus, in theory, the firm (XYZ Ltd) would be indifferent
between lease and buy
But still leases do take place
WHY DO LEASES TAKE PLACE
Lease may lead to differential tax benefits for lessor and lessee
Especially if the lessor is in a lower tax bracket than the lessee
Then the lessee will enjoy greater tax benefit of depreciation and
interest payment than the lessor
Lease is a major solution to the problem of capital scarcity
(mostly the reason in India) small firms
If the lessor has a higher credit rating (& lower interest cost)
than the lessee
If purchase involves significant transaction cost
 Who Benefits from Leasing 3
If the use of the equipment is for a far less period than its
economic life (Operating lease)
Use of MHC crane in construction of metro rail project
Asset characteristics also play a role
Assets whose values are more sensitive to use and maintenance
decisions are more likely to be purchased than leased
Majority of aircrafts are leased (and not owned by airline
companies)
Due to huge capital cost, AND
Since maintenance specifications are legally determined
Implying that the lessee has very little room to change the level
(and hence costs of maintenance)
Even though the value of an aircraft is highly sensitive to
maintenance
 Further References from the Web 1

Sale & Leaseback

www.conway.com/geofacts/pdf/50910.pdf
http://www.srr.com/article/sale%E2%80%93leaseback-
transactions-financing-alternative-middle-market-companies
http://www.investopedia.com/exam-guide/cfa-level-
1/liabilities/sale-leaseback.asp
Sale and leaseback how it could benefit your business
Spring 2012 - http://www.colliers.com.au/Find-
Research/~/media/Files/Corporate/Research/Speciality%20Re
ports%20and%20Property%20White%20Papers/Sale%20and
%20Leaseback%20White%20Paper%20-
%20Spring%202012.ashx
 Further References from the Web 2

Sale & Leaseback - Continued

http://www.mesirowfinancial.com/saleleaseback/
http://www.wilmingtontrust.com/wtcom/index.jsp?fileid=3000
125
Leveraged Lease
http://en.wikipedia.org/wiki/Leveraged_lease
http://www.investopedia.com/terms/l/leveragedlease.asp
http://www.businessdictionary.com/definition/leveraged-
lease.html
 Further References from the Web 3

Leveraged Lease - Continued

www.investopedia.com/terms/l/leveragedlease.asp
en.wikipedia.org/wiki/Leveraged_lease
http://www.elfaonline.org/cvweb_elfa/Product_Downloads/E0
6MAYBRADY.PDF
Economic of Leveraged Leasing: http://interet.com/article-
econlevlease.htm
http://connect.mcgraw-
hill.com/sites/0077328787/student_view0/ebook/chapter15/ch
body1/leveraged_leases.htm
 Further References from the Web 4

Direct Lease
http://www.wisegeek.com/what-is-a-direct-lease.htm
http://www.answers.com/topic/direct-financing-lease