Question

30. Lease financing for business activities with focus on:

A.basic types of lease financing

B.advantages and disadvantages of particular types of lease financing

C. advantages and disadvantages of lease financing compared to financing through loan/credit

D. financing

E.tax implications of lease and loan/credit financing

Answer 1

30. Lease financing is one of the important 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 lessor and the user is called lessee.

The periodical payment made by the lessee to the lessor is known as lease rental. Under lease financing, 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.

A). Different Types of Lease:

Depending upon the transfer of risk and rewards to the lessee, the period of lease and the number of parties to the transaction, lease financing can be classified into two categories. Finance lease and operating lease.

Finance Lease:

It is the lease where the lessor transfers substantially all the risks and rewards of ownership of assets to the lessee for lease rentals. In other words, it puts the lessee in the same con­dition as he/she would have been if he/she had purchased the asset. Finance lease has two phases: The first one is called primary period. This is non-cancellable period and in this period, the lessor recovers his total investment through lease rental. The primary period may last for indefinite period of time. The lease rental for the secondary period is much smaller than that of primary period.

Features:

1. A finance lease is a device that gives the lessee a right to use an asset.

2. The lease rental charged by the lessor during the primary period of lease is sufficient to recover his/her investment.

3. The lease rental for the secondary period is much smaller. This is often known as peppercorn rental.

4. Lessee is responsible for the maintenance of asset.

5. No asset-based risk and rewards is taken by lessor.

6. Such type of lease is non-cancellable; the lessor’s investment is assured.

Operating Lease:

Lease other than finance lease is called operating lease. Here risks and rewards incidental to the ownership of asset are not transferred by the lessor to the lessee. The term of such lease is much less than the economic life of the asset and thus the total investment of the lessor is not recovered through lease rental during the primary period of lease. In case of operating lease, the lessor usually provides advice to the lessee for repair, maintenance and technical knowhow of the leased asset and that is why this type of lease is also known as service lease.

Features:

1. The lease term is much lower than the economic life of the asset.

2. The lessee has the right to terminate the lease by giving a short notice and no penalty is charged for that.

3. The lessor provides the technical knowhow of the leased asset to the lessee.

4. Risks and rewards incidental to the ownership of asset are borne by the lessor.

5. Lessor has to depend on leasing of an asset to different lessee for recovery of his/her investment.

B). Advantages of Financial Lease:

• Minimum capital expenditure.
• Accurate monthly budgeting.
• A fixed interest rate is available on some contracts.
• No damage recharge as you are responsible for disposal of the asset.
• Reduced administration.
• On-going advice and support.
• Optional maintenance package.
• Optional breakdown rescue cover.

Disadvantages:

• You will never own the asset as the asset must be sold to a third party as the end of the agreement.
• Operating risk associated with the asset.
• Interest rates can vary on some contracts.
• You must have fully comprehensive asset insurance.

Advantages of Operating Lease:

• Equipment will not be used long-term. It doesn’t make sense to make a large cash outlay for equipment that will only be used for a short period of time.
• Your equipment will become outdated quickly. If technological advances in your industry tend to make your equipment obsolete every few years, a short term lease can help you stay up to date.
• Cash flow is tight. With a lease, you avoid a hefty up-front charge, and you can make payments as you generate cash flow with your new equipment.
• You want to protect your balance sheet. An equipment purchase is recorded in your balance sheet, which increase your debt and reduces your available cash. In contrast, most leases are not recorded as debt, and are treated as an operating expense.

Disadvantages:

• You are tied into payments for the length of the lease. A lease is a commitment to making the payments for the length of the contract.
• You won’t build up equity. Buying something outright will give you equity. Just make sure that older equipment will still provide value for your business.
• With leasing, you may pay more over the long term. Lease payments include taxes, insurance and risk premiums, since the lessor is assuming the risk for the purchase.

C). LEASE FINANCE VS. TERM LOAN:

• While taking an asset on a lease, down payment is not required. Only a periodic lease rental payment is required which is lower as compared to the percentage of down-payment. Whereas in the case of a term loan, the borrower has to pay a small percentage in the form of down-payment (margin money) at the beginning of the transaction and an installment amount at the required time and the balance amount is financed by the loan.
• The lessee uses the asset up to the lease period and pays the rentals. He has the option of buying the asset at the end of the lease. Whereas in the case of loan financing, it is compulsory for the user to buy the asset as soon as he gets the loan.
• In the case of lease financing, the ownership of an asset is not attached to the user, so the risk of asset devaluation is transferred to the lessor. Whereas in the case of loan financing, the user of the asset has to bear all the risk of asset devaluation due to change in technology.

D). Tax Implications of Lease and Loan/credit financing:

• in the case where the asset is purchased on loan, the user can claim interest on loan payment (which decreases every year due to part payment of principal also) and the depreciation of the asset (which decrease every year due to written down value effect). Whereas in the case of lease financing, the user can claim only lease rentals which are uniform during the lease period.