Construct a simple numerical example that explains why a lease would expose a firm to financial...

Construct a simple numerical example that explains why a lease would expose a firm to financial risk.

Expert Solution

Lease agreement is an agreement between lessor and lessee. In a lease agreement, the owner of the asset (lessor) lets out the possession of an asset to the lessee for a particular period of time for a consideration in the form of lease rentals. The title of the goods remain with the lessor. The lessor can, on the violation of the terms of agreement terminate the lease agreement.

Financial risk of leasing can be explained in two perspectives.

i) From the view of lease financing company

ii) From the view of the lessee company

i) From the view of lease financing company

Residual value risk is the major financial risk faced by the lease financing companies. Residual value means the value of the asset at the end of its lifetime. It is the estimated value at which an asset can be re- leased or sold. Lease agreements are based on the residual value of an asset. In a lease agreement, the re sale or re lease value of the asset will be lower than the estimated residual value of the asset. This is known as the residual value risk. In closed ended lease, the lessor or the owner of the asset has to bear the residual value risk.

For Example,

A plant which worth $100,000 is leased for a rent of $9500 per month for 2 years. The residual value of the asset is $10000. The estimated life of the asset is 10 years.

The depreciation of the asset =(100,000 - 10,000)/10 = 9000

On the end of lease period or on the termination of the lease agreement, the lessor regains the possession of the plant. If the lessor has to re lease the asset, the residual value of the asset will be $9000 only.

The residual value risk = 10,000 - 9,000 = 1,000

This loss has to be borne by the lessor in a closed ended lease agreement. It also put the firm at a greater financial risk.

ii) From the view of the lessee company

Capitalised leases affect the balance sheet of the company. It increases the value of assets of the firm. It also affects the ratios used for managerial decision making of the company. They will affect the ratios for analysing the profitability and efficiency of the firm. It will affect the return on capital. Due to these reasons the firm will be exposed to the financial risk.

For example,

A plant worth $100,000 was leased. The lease is shown in the balance sheet as liability. It affects the liability side of the balance sheet. The EBIT of a firm reduces with leasing. Reduction in EBIT denotes reduction in Earnigns per share to the shareholders

jeff jeffy answered 1 year ago

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