Question

What are the risks vs. possible returns in a leasing cash flow?

Answer 1

Leasing :

A lease can be defined as an arrangement between the lessor (owner of the asset) and the lessee (user of the asset/ who takes the asset on lease) where the lessor purchases an asset and allows the lessee to use it in exchange for periodical payments called lease rentals or lease payments. Leasing is beneficial to both the parties for getting tax benefits. At the end of the lease period, the asset goes back to the lessor (the owner) unless there is a contract between them saying that, the lessee shall be the owner after the end of the lease period.

Advantages of Leasing :

• Tax benefits:

Lessor, being the owner of the asset, can claim depreciation as an expense in his books and therefore get the tax benefit. On the other hand, the lessee can claim the lease payments or lease rentals as an expense to get tax benefit in a similar way.

• Balanced cash outflows:

​​​​​​​The main advantage of leasing is that cash outflow or lease payments are paid over several years, hence there is no need for one-time significant cash payment. This helps a business to maintain a steady cash-flow profile.

• Better usage of capital:

​​​​​​​If the company chooses to lease instead of purchasing an asset, it releases capital for the business to fund its other capital needs or to save money for a better capital investment decision.

• Low capital expenditure:

​​​​​​​Leasing is a better option for a newly set-up business because this can lower the initial cost and can lower the Capital expenditure requirements.

• No Risk of Obsolescence:

​​​​​​​For businesses operating in the sector, where there is a high risk of technology becoming obsolete, leasing yields great returns and saves the business from the risk of investing in a technology that might soon become out-dated. For example, it is ideal for the technology business.

Disadvantages of leasing:

• Limited financial benefits:

If paying lease payments towards a land, the business cannot benefit from any appreciation in the value of the land. The long-term lease agreement also remains a burden on the business, in case when the use of asset does not serve the requirement after some years, lease payments become a burden

• Reduced Return for Equity Holders:

​​​​​​​Since lease expenses reduce the net income without any appreciation in value, it means reduced returns for an equity shareholder. Which is bad for the company.

• Limited Access to Other Loans:

​​​​​​​Although lease doesn’t appear on the balance sheet of a company, investors still consider the long-term lease as a debt. This makes it difficult for a business to tap capital markets and raise further loans or other forms of debt from the market.

• Processing and Documentation

Overall, to enter into a lease agreement is a complex process and requires thorough documentation and proper examination of an asset being leased. Which takes time and money.

• No Ownership

At the end of the leasing period, the lessee doesn’t end up becoming the owner of the asset though quite a good sum of payment is being done over the years towards the asset.

• Maintenance of the Asset

The lessee remains responsible for the maintenance and proper operation of the asset being leased.