Question

RJ Transport Pty Ltd has a long-term contract with PKR Small Goods Pty Ltd to deliver PKR’s products to supermarkets and wholesalers across Australia. In light of PKR’s expansion plans, the board at SRJ are looking to increase the number of delivery trucks and refrigerated trailers making up their fleet. One of the ideas put forward by the finance manager at SRJ is for the firm to look at leasing the trucks and trailers rather than purchasing them. Having never previously leased vehicles, the board at SRJ has requested that you write a brief report outlining the benefits to SRJ of leasing the trucks and trailers, as opposed to buying the trucks and trailers by taking out a loan with their principal banking partner – Rural Bank. (300 words)

Answer 1

A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.

An operating lease is a rental arrangement under which the lessor provides an asset to a lessee, but does not transfer the risks and rewards of ownership of the asset. Therefore, it does not affect the balance sheet. Only the lease rent expense would be reported on the income statement.

A finance lease on the other hand, transfers substantially all the risks and rewards of ownership of the asset. A finance lease is in essence a financing arrangement which allows the lessor to recover its investment in the asset, and also a return on the funds invested. The asset comes on to the balance sheet of the lessee, with a corresponding lease liability, and both depreciation expense and interest expense for the period are recognized and reported on the income statement. Financial leverage and resultant financial risk increases for the firm in a finance lease.

If it is an operating lease that is being considered, buying would be a better option, because of the following reasons:

a. Rural bank is expected to have a favorable rate of interest. Therefore, the monthly payments are going to be less than the monthly lease rental.

b. The EMIs are going to end after a period, but the lease payments would carry on until the trucks are turned in.

c. SRJ is going to be the owner of the fleet of trucks and trailers, which would lead to balance sheet growth.

d. Purchasing new trucks would mean lower costs in repairs and maintenance.

e. SRJ would be able to enjoy the tax shield of depreciation expense and interest expense, Therefore, the cash outflow on account of taxes is going to be lower.

The major points in support of leasing would be:

a. The repairs and maintenance costs are normally borne by the lessor, if SRJ is covered by a manufacturer's warranty during the lease term.

b. A good negotiation can lead to lower monthly lease payments.

c. No loan approval required.

d. No costs of ownership and negligible costs of maintanance.

e. The lessor would replace the trucks if they are not functioning as they should.

f. At the end of the lease term, SRJ, can opt for a fleet with more up-to-date technology.

Summing it up, if the incremental borrowing rate of the lessor exceeds the interest rate of Rural Bank, it is better to opt for outright purchase or operating lease. If however, the borrowing rate of the lessor is significantly lower than the lending rate of Rural Bank, then a finance lease can be a suitable option.