Loans versus lease
Leasing is an important source of equipment financing. A lease contract embraces an interest-rate cost to the party using the asset and interest-rate return to the party providing the asset. Therefore, effectively, it is a capital market instrument. Though certain features differentiate it from other fixed-income financing, the principles of evaluation are similar.
A Contract is termed as lease contract when:
the owner of the asset known as the lessor grants
another party known as the lessee, the exclusive right to use the asset
the consideration for the contract being rent.
Under a maintenance lease, the lessor pays for the maintenance, repairs, taxes, and insurance. Under a net lease, the lessee bears these costs.
Operating Versus Financial Lease
The lease contract may be cancellable or noncancellable. Normally, a cancellable lease may have a penalty for terminating the contract prior to the contracted period.
An operating lease is a short-term contract and can be terminated with proper notice.
A financial lease is a long-term contract and cannot be terminated prior to the expiry of the lease period.
A lease contract also provides an option to the lessee at the expiration:
To either renew the lease for another lease period, and/or.
To purchase the asset on expiration.
The assumption of the residual/salvage value is an important factor that influences the cost of leasing.
Types of Lease Contracts
1) Sale and Leaseback: Under this type of a lease, a firm sells an asset to another party and leases it back.
2) Direct Leasing: This type of leasing occurs when a company takes an investment decision to acquire the economic use of a new asset.
3) Leveraged Leasing: This form of leasing is used to finance projects involving a huge capital outlay and involves three parties.
The lessee
The lessor or equity participant
The lender
There is no change in the role and status of the lessee under leveraged leasing. However, the role and functions of lessor undergoes a change. The lessor:
Pools in a percent of the cost of the asset by an equity investment (hence the name equity participant), and
Sources the remaining part through a secured long-term loan. The lease payments are assigned in favor the lender as additional security.
Accounting and Tax Treatment of Leases
The value of the asset along with the corresponding lease liability must reflect on the balance sheet when the lessee acquires a majority of the economic benefits and risks of the leased property. Leases that conform to this definition are called Capital Leases. Leases that meet any of the following criteria are regarded as capital leases:
The lease transfers the title to the asset to the lessee by the end of the lease period.
The lease term is > 75% of the estimated economic life of the asset.
The present value of the lease payments is > 90% of the fair value of the leased property at the time of commencement of the lease.
The lessee's balance sheet must reflect as an asset:
The present value of the capital lease payments or
The fair value of the leased property, whichever is lower.
The discount rate employed is the lower of:
The lessees incremental borrowing rate or
The lessors implicit interest rate.
In the balance sheet, the lease obligation is reflected in the liabilities column. The present value of the payments due:
With in one year are reflected as current liabilities, and
The present values of payments due after one year are reflected as noncurrent liabilities.
Amortization
The capital lease payments must be written off over the lease period. The lessees normal method of depreciation for assets owned can be used for amortization. The asset is amortized over the period of lease. The interest method should be used to reduce the capital lease obligation over the lease period. Under this method, each lease payment is separated into two components:
The payment of principal and
The payment of interest
The obligation is reduced by the amount of the principal payment.
For income-reporting purposes the amortization of the leased property and the annual interest embodied in the lease payments are treated as an expense. This expense is then deducted (along with other expenses) to obtain net income.
Tax Treatment
Capital leases are accounted differently for:
Tax purposes, and
Recording income.
A company does not deduct the amortization of the asset and the interest as the expense of capital lease. It deducts the annual lease payment.
Return to the Lessor
The return depends on three factors:
The length of the lease
The periodic lease payments (and whether paid at the beginning or the end of the period, and
The residual value assumption.
The implied interest return is the rate that equates:
The cost of acquiring the asset with
The aggregate of the present values the periodic lease payments and the residual value at the end of the lease term.
After-Tax Analyses of Lease Versus Loan
Where the before-tax cost of lease financing is not dominated by the before-tax cost of borrowing, it is appropriate to bring in tax effects and analyze according to discounted cash flows.
To arrive at the favored option, the patterns of cash flow under each alternative and the opportunity cost of funds have to be compared.
Internal Rate of Return analysis
The cost of leasing is the rate that equates:
The cost of the asset with the
Sum of the present values of lease payments adjusted for tax benefits and the expected residual value after taxes.
The rate thus arrived is the after-tax cost of leasing. This rate is compared to the after-tax cost of borrowing (discussed above). The lower of the two is the desirable option.
Sources of Value in Leasing
If a lessee or borrower liquidates, the lessors position is comparatively superior to that of a supplier of capital. The lessor is the owner of the asset and can retrieve it when the lessee defaults. The lender finds it more difficult and costly to gain possession when the borrower defaults, even though the loan was secured with the asset.
The primary factor in favor of leasing is that companies, financial institutions, and individuals derive different tax benefits from owning assets. The greater the divergence in these benefits, the greater the attraction of lease financing overall, all other things remaining the same. Therefore, it is the prospective lessees ability to realize tax benefits in a given situation (and not the existence of taxes per se) that gives rise to leasing being a valuable option.
How much realization of tax benefits the lessee is able to achieve depends on the supply and demand relationship in the market for lease financing. The exact sharing of tax benefits is negotiable, but will depend on equilibrium conditions in the capital market.
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