Module 3 - Leasing Decisions: Pebsbafm 004 - Strategic Financial Management

PEBSBAFM 004– STRATEGIC FINANCIAL MANAGEMENT
MODULE 3– LEASING DECISIONS
Introduction
This module talks about how the company can exploit the economic value of equipment
by using it as if it owned it without paying for its capital cost. The fundamental characteristic of a
lease is that ownership never passes to the business customer. The leasing company claims the
capital allowances and gives the business customer some benefits, but a way of reduced rental
charges. For this module, we shall focus on these discussions.
Intended Learning Outcomes
At the end of the module, you can:
1. discuss the importance of leasing strategy in a business;

2. distinguish financial lease and operating lease;
3. justify the financial outcome of leasing as an expense instead of liability;
4. discuss the implication of leasing to the lessee;
5. support recommendation for a financing option;
6. explain the break-even lease rental from the perspective of the lessor and lessee; and
7. explain the benefit of cross-border leasing.
Topic Outline
1. Leasing
2. Types of Leasing
3. Advantages & Disadvantages of Leasing
4. Financial Evaluation
5. Break-Even Lease Rental (BELR)
6. Cross Border Leasing
Content
Preliminary Activity
Your parents gave you money amounting to P20,000 to buy a laptop for your online class.
You are already in your last year in college since you are now a graduating student. However,
one of your classmates offered his extra laptop but with a daily rent of 100 pesos. Considering
that you only have one month left to finish your studies, will you buy or just rent the laptop?
Discuss your reasons.
The module is for the exclusive use of the University of La Salette, Inc. Any form of reproduction, distribution, uploading, or
posting online in any form or by any means without the written permission of the University is strictly prohibited.
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Let’s start our Discussion!
LEASING
A lease can be defined as a right to use any Buying involves higher monthly costs,
equipment or capital goods on payment of a periodical but you own an asset
amount. This may broadly be equated to an installment Lease has lower monthly payments and
lets you drive a vehicle that may be more
credit being extended to the person using the asset by
expensive than you could afford to buy
the owner of capital goods with small variation.
IFRS 16 Appendix A Defined Lease is a contract or

part of a contract that conveys the right to use the underlying asset for a period of time in
exchange for consideration.
Parties to a Lease Agreement
There are two principal parties to any lease transaction as under:
1. Lessor - Who is the actual owner of equipment permitting use to the other party on
payment of the periodical amount.
2. Lessee - Who acquires the right to use the equipment on payment of the periodical
amount.
Assets
The assets, property, or equipment to be leased is the subject matter of a lease financing
contract. The asset may be an automobile, plant and machinery, equipment, land and building,
factory, a running business, an aircraft, and so on. The asset must, however, be of the lessee’s
choice, suitable for his business needs.
Ownership Separated from User
The essence of a lease financing contract is that during the lease tenure, ownership of the
asset vests with the lessor, and its use is allowed to the lessee. On the expiry of the lease tenure,
the asset reverts to the lessor.
Term of Lease
The term of the lease is the period for which the agreement of lease remains in operation.
Every lease should have a definite period, otherwise it will be legally inoperative. The lease
period may sometimes stretch over the entire economic life of the asset (Financial Lease) or a
period shorter than the useful life of the asset (operating lease). The lease may be perpetual, that
is, with an option at the end of lease period to renew the lease for further specific period.
Lease Rentals
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The consideration that the lessee pays to the lessor for the lease transaction is the lease
rental. Lease rentals are structured so as to compensate (in the form of depreciation) the lessor
for the investment made in the asset, and for the expenses like interest on the investment,
repairs and servicing charges borne by the lessor over the lease period.
Modes of Terminating the Lease
At the end of the lease period, the lease is terminated and various courses are possible,
namely
 The lease is renewed on a perpetual basis or for definite period,

 The asset reverts to the lessor,
 The asset reverts to the lessor and the lessor sells it to a third party and;
 The lessor sells the asset to the lessee.
The parties may mutually agree to and choose any of the aforesaid alternatives at the beginning
of a lease term.
Lease Vis-à-vis Hire Purchase
Hire-purchase transaction is also almost similar to a lease transaction with the basic
difference that the person using the asset on hire-purchase basis is the owner of the asset and
full title is transferred to him after he has paid the agreed installments. The asset will be shown
in his balance sheet and he can claim depreciation and other allowances on the asset for
computation of tax during the currency of hire-purchase agreement and thereafter.
In a lease transaction, however, the ownership of the equipment always vests with the
lessor and lessee only gets the right to use the asset. Depreciation and other allowances on the
asset will be claimed by the lessor and the asset will also be shown in the balance sheet of the
lessor. The lease money paid by the lessee can be charged to his Profit and Loss Account.
However, the asset as such will not appear in the balance sheet of the lessee. Such asset for the
lessee is, therefore, called off the balance sheet asset.
TYPES OF LEASING
A lease transaction has many variants OPERATING LEASE – the owner will
relating to the type and nature of leased equipment, still be the Lessor, it is a rent transaction,
amortization period, residual value of equipment, we can’t transfer the right of the asset
period of leasing, option for termination of lease etc.
Various types of leasing transactions are, therefore,
operating in the market on the basis of these
variants. The different leasing options may however, be grouped in two broad categories as
under:
1. Operating Lease
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In this type of lease transaction, the primary lease period is short and the lessor would not
be able to realize the full cost of the equipment and other incidental charges thereon during the
initial lease period. Besides the cost of machinery, the lessor also bears insurance, maintenance
and repair costs etc. The lessee acquires the right to use the asset for a short duration.
Agreements of operating Lease generally provide for an option to the lessee/lessor to terminate
the lease after due notice. These agreements may generally be preferred by the lessee in the
following circumstances:
 When the long-term suitability of asset is uncertain.

 When the asset is subject to rapid obsolescence.
 When the asset is required for immediate use to tide over a temporary problem.
2. Financial Lease
As against the temporary nature of an

operating lease agreement, financial lease FINANCIAL LEASE – lessee is the owner of
agreement is a long-term arrangement, which is the asset.
irrevocable during the primary lease period which
is generally the full economic life of the leased .
asset. Under this arrangement lessor is assured to
realize the cost of purchasing the leased asset, cost
of financing it and other administrative expenses
as well as his profit by way of lease rent during the initial (primary) period of leasing itself.
Financial lease involves transferring almost all the risks incidental to ownership and benefits
arising therefrom except the legal title to the lessee against his irrevocable undertaking to make
unconditional payments to the lessor as per agreed schedule. This is a closed-end arrangement
with no option to lessee to terminate the lease agreement subsequently. In such lease, the lessee
has to bear insurance, maintenance and other related costs. The choice of asset and its supplier
is generally left to the lessee in such transactions. The variants under financial lease are as
under:
 Lease with purchase option-where the lessee has the right to purchase the leased assets
after the expiry of initial lease period at an agreed price. z
 Lease with lessee having residual benefits-where the lessee has the right to share the sale
proceeds of the asset after expiry of initial lease period and/or to renew the lease
agreement at a lower rental.
In a few cases of financial lease, the lessor may not be a single individual but a group of equity
participants and the group borrows a large amount from financial institutions to purchase the
leased asset. Such transaction is called ‘Leveraged lease’.
LEVERAGED LEASE – A leveraged lease is a lease agreement that is financed through

the lessor with help from a third-party financial institution. In a leveraged lease, an asset is
rented with borrowed funds. involves the participation of the Lenders, Lessor and the Lessee.
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Sales and Lease Back Leasing
Under this arrangement an asset which already exists and is used by the lessee is first
sold to the lessor for consideration in cash. The same asset is then acquired for use under
financial lease agreement from the lessor. This is a method of raising funds immediately
required by lessee for working capital or other purposes. The lessee continues to make economic
use of assets against payment of lease rentals while ownership vests with the lessor.
Sales-Aid-Lease
When the leasing company (lessor) enters into an arrangement with the seller, usually
manufacturer of equipment, to market the latter’s product through its own leasing operations, it
is called a ‘sales-aid-lease’. The leasing company usually gets a commission on such sales from
the manufacturers and increases its profit.
Apart from term loan and other facilities available from financial institutions including banks to
a promoter to acquire equipment and other capital goods, the promoter now has an alternative
option to acquire economic use of capital assets through leasing. The ultimate decision to either
approach a financial institution or a leasing company will, however, depend on the nature of
each such transaction.
ADVANTAGES OF LEASING
 The first and foremost advantage of a lease agreement is its flexibility. The leasing
company in most of the cases would be prepared to modify the arrangement to suit the
specific requirements of the lessee. The ownership of the leased equipment gives them
added confidence to enable them to be more accommodative than the banks and other
financial institutions.
 The leasing company may finance 100% cost of the equipment without insisting for any
initial disbursement by the lessee, whereas 100% finance is generally never allowed by
banks/financial institutions.
 Banks/financial institutions may involve lengthy appraisal and impose stringent terms
and conditions to the sanctioned loan. The process is time-consuming. In contrast leasing
companies may arrange for immediate purchase of equipment on mutually agreeable
terms.
 Lengthy and time-consuming documentation procedure is involved for term loans by
banks/institutions. The lease agreement is very simple in comparison. In short-term lease
(operating lease) the lessee is safeguarded against the risk of obsolescence. It is also an
ideal method to acquire use of an asset required for a temporary period.
 The use of leased assets does not affect the borrowing capacity of the lessee as lease
payment may not require normal lines of credit and are payable from income during the
operating period. This neither affects the debt equity ratio or the current ratio of the
lessee.
 Leased equipment is an ‘off the balance sheet’ asset being economically used by the lessee
and does not affect the debt position of lessee.
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 By employing ‘sale and lease back’ arrangement, the lessee may overcome a financial
crisis by immediately arranging cash resources for some emergent application or for
working capital.
 Piecemeal financing of small equipment is conveniently possible through lease
arrangement only as debt financing for such items is impracticable.
 Tax benefits may also sometimes accrue to the lessee depending upon his tax status.
DISADVANTAGES OF LEASING
 the lease rentals become payable soon after the acquisition of assets and no moratorium
period is permissible as in case of term loans from financial institutions. The lease
arrangement may, therefore, not be suitable for setting up of the new projects as it would
entail cash outflows even before the project comes into operation.
 The leased assets are purchased by the lessor who is the owner of equipment. The seller’s
warranties for satisfactory operation of the leased assets may sometimes not be available
to lessee
 Lessor generally obtain credit facilities from banks etc. to purchase the leased equipment
which are subject to hypothecation charge in favor of the bank. Default in payment by the
lessor may sometimes result in seizure of assets by banks causing loss to the lessee.
 Lease financing has a very high cost of interest as compared to interest charged on term
loans by financial institutions/banks.
Activity 1
1. After understanding What leasing is? What do you think is a more important strategy for a
business? Is it leasing or buying? Explain.
2. Explain your interpretation briefly on the difference between Financial Lease and Operating
Lease.
3. For operating lease, do you agree that one of the advantages of leasing is that the company will
create an expense instead of a liability? Explain.
4. The major disadvantage of leasing is that the lessor will transfer all the rights to the lessee for a
specific period, creating a moral hazard issue because the exercise of the asset is no longer on
your part; it’s in the possession now of the lessee. What are your thoughts on this?
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FINANCIAL EVALUATION
Steps in financial evaluation of a financial lease:
 evaluation of client in terms of financial strength and credit worthiness.

 evaluation of security / collateral security offered
 financial evaluation of the proposal
The most important part in lease financing is its financial evaluation both from the point of view
of lessor and lessee.
Lessee Perspective
Finance lease can be evaluated from the point of view of both the lessee and the lessor.
From the perspective of the lessee, leasing should be evaluated as a financing alternative to
borrow and buy. The decision-criterion requires comparison of the present value(PV) of cash
outflows after taxes under the leasing option and borrowing-buy alternative. The alternative
with the lower PV should be selected.
The Net Advantage of Leasing (NAL) approach is the alternate approach to evaluate
finance lease. The benefits from leasing are compared with the cost of leasing.
The benefits from leasing are:
 Investment cost of asset (saved)

 Plus, PV of tax shield on lease payment, discounted by Kc and
 Plus, PV of tax shield on management fee, discounted by Kc.
The costs of leasing are:
 Present value of lease rentals, discounted by Kd

 Plus, management fee
 Plus, PV of depreciation shield foregone, discounted by Kc
 Plus, PV of salvage value of asset, discounted by Kc and
 Plus, PV of interest shield, discounted by Kc.
In case Net Advantage of Leasing (NAL) is positive (Benefits> costs), leasing alternative is
preferred.
Equation: NPV(L)/NAL
=Investment cost
Less: Present value of lease payments (discounted by Kd)
Plus: Present Value of tax shield on lease payments (discounted by Kc)
Less: Management fee
Plus: Present Value of tax shield on management fee (discounted by Kc)
Less: Present Value of tax shield on interest (discounted by Kc)
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Less: Present value of residual/salvage value (discounted by Kc)
Where Kc= Post –tax marginal cost of capital

Kd= Pre-tax cost of long-term debt
If the NPV(L)/NAL is positive, the leasing alternative should be used, otherwise the
borrowing alternative would be preferable.
Lessor Perspective
For the lessor, The Leasing is viable when the PV of cash inflows after taxes (CFAT)
accruing to him exceeds the cost of asset. The CFAT are discounted at the weighted average cost
of capital.
The NAL approach can also be used by the lessor to assess the financial viability of the
lease decision. The NAL to a lessor= Present Value of Lease payment plus Present value of
management fee, Present value of depreciation tax shield, Present value of net salvage value,
Present Value of Tax shield on initial direct costs, minus Initial Investment, Present Value of tax
on lease payments, Present Value of tax on management fee and Present value of initial direct
cost.
Right to obtain the use of an Asset:

 Obtain substantially all the economic benefits from the use of the identified asset.
 Direct the use of the Identified asset.
Point of View of Lessor as FINANCE LEASE
 Transfer of ownership
 Option to purchase the asset
 Material Lease Term
 Substantial present value of Lease payments
Point of View of Lessor as OPERATING LEASE
 Lease Payments
 The owner will still the lessor and recognize depreciation expense
Note: Those items that were mentioned on the Point of view of the Lessor under Finance Lease
if does not meet meaning we identified it as an OPERATING LEASE.
Two types of Finance lease on the Point of view of the LESSOR:
 Direct Finance Lease - the lessor engaged in the Financing business (Bank or Financial
Institutions)
 Sales Type Lease - the lessor is a Manufacturer or Dealer of properties (Toyota or other
Car establishment)
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Evaluation of Lease Methods
There are three methods of evaluating a leasing proposal viz. Present Value analysis,
Internal Rate of Return analysis, and the Bower Herringer Williamson method. These are
explained below.
Present Value Analysis
The Net Present Value technique is a discounted cash flow method that considers time value of
money in Evaluating capital investments.
It is a method of calculating the present value of cash flows (inflows and outflows) of an
investment proposal using the cost of capital as an appropriate discounting rated.
Present Value Method was identified with the following criteria:
 Determine cash outflows by deducting tax advantage of owing an asset.

 Determine cash inflows after tax.
 Determine the present value of cash outflows and after tax cash inflows by discounting at
weighted average cost of capital of the lessor
 Decide in favor of leasing out an asset if p.v of cash inflows exceeds the p.v of cash
outflows i.e. if the NPV is positive.
Internal Rate of Return Analysis
The IRR represents the discount rate at which the NPV of an investment is zero
It is a discounted cash flow technique which takes into account the time value of money.
Under this method there is no need to assume any rate of discount. To this extent, this is
different from the former method where the after-tax cost of borrowed capital was used as the
rate of discount. The result of this analysis is the after tax cost of capital explicit in the lease
which can be compared with that of the other available sources of finance such as a fresh issue of
equity capital, retained earnings or debt. Simply stated, this method seeks to establish the rate at
which the lease rentals, net of tax shield on depreciation are equal to the cost of leasing.
Internal Rate of return was identified with the following criteria:
 Rate of discount at which the present value of cash inflows is equal to the present value of
cash outflows.
 Can be determined with the help of mathematical formula.
 Can also be determined with the help of present value tables.
Bower-Herringer-Williamson Method
This method segregates the financial and tax aspects of lease financing. If the operating
advantage of a lease is more than its financial disadvantage or vice-versa lease will be preferred.
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The procedure of evaluation is briefly as follows:
 Compare the present value of debt with the discounted value of lease payments (gross),
the rate of discount being the gross cost of debt capital. The net present value is the
financial advantage (or disadvantage).
 Work out the comparative tax benefit during the period and discount it at an appropriate
cost of capital. The present value is the operating advantage (or disadvantage) of leasing.
 If the net result is an advantage, select leasing.
Illustration 1.
Solution:
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Activity 2
1. Squid Game company requires equipment costing P1,000,000; the same will be utilized over 5 years.
It has two financing options in this regard:
A. Arrangement of a loan of 1,000,000 at an interest rate of 13%, the loan being repayable
in 5 equal year-end installments. The equipment can be sold at the end of the fifth year
for P100,000.
B. Leasing the equipment for 5 Years at an early rental of P330,000 payables at the year-
end.
Note: The depreciation rate is 15% on a reducing balance basis. The income tax rate is 35% & the
discount rate is 12 %; advise which of the following options should Squid Game company exercise and
why?
Required:
Show your solution on the Debt repayment schedule and Cash Outflows Debt Alternative for Option A
and Solution for option B.
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PEBSBAFM 004– STRATEGIC FINANCIAL MANAGEMENT

MODULE 3– LEASING DECISIONS

Intended Learning Outcomes

At the end of the module, you can:

1. discuss the importance of leasing strategy in a business;

Let’s start our Discussion!

IFRS 16 Appendix A Defined Lease is a contract or

Parties to a Lease Agreement

There are two principal parties to any lease transaction as under:

Ownership Separated from User

Modes of Terminating the Lease

 The lease is renewed on a perpetual basis or for definite period,

Lease Vis-à-vis Hire Purchase

 When the long-term suitability of asset is uncertain.

As against the temporary nature of an

LEVERAGED LEASE – A leveraged lease is a lease agreement that is financed through

Sales and Lease Back Leasing

Steps in financial evaluation of a financial lease:

 evaluation of client in terms of financial strength and credit worthiness.

The benefits from leasing are:

 Investment cost of asset (saved)

The costs of leasing are:

 Present value of lease rentals, discounted by Kd

Less: Present value of residual/salvage value (discounted by Kc)

Where Kc= Post –tax marginal cost of capital

Right to obtain the use of an Asset:

Point of View of Lessor as FINANCE LEASE

Point of View of Lessor as OPERATING LEASE

Two types of Finance lease on the Point of view of the LESSOR:

Evaluation of Lease Methods

Present Value Analysis

Present Value Method was identified with the following criteria:

 Determine cash outflows by deducting tax advantage of owing an asset.

Internal Rate of Return Analysis

Internal Rate of return was identified with the following criteria:

The procedure of evaluation is briefly as follows:

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