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 The decision to invest in an asset that has a long life is
a capital budgeting decision.
 The decision to acquire is a separate decision from the
decision on the method of financing the acquisition
 When these two decisions are combined, this is called
asset-based lending because the financing is tied
directly to a particular asset.
 Examples of asset-based lending include:
◦ Secured loans
◦ Leases

 Lease is a contract under which a lessor, the
owner of the assets, gives right to use the asset
to a lessee, the user of the assets, for an agreed
period of time for a consideration called the
lease rentals.
Hence A lease contract is an agreement
where the owner conveys to the user the
right to use an asset in return for a
number of specified payments over an
agreed period of time
Lessor is the owner of the asset
Lessee is the user of the asset

Operating Lease
 A lease where some of the benefits of ownership do not
transfer to the lessee and remain with the lessor.

Financial (Capital) Lease

A lease where essentially all the benefits of ownership
transfer to the lessee; also known as a capital or full payout

 Shot-term, cancelable lease agreements are
called operating lease.
 Tourist renting a car, lease contracts for
computers, office equipments and hotel
 The Lessor is generally responsible for
maintenance and insurance.
 Risk of obsolescence remains with the lessor.

 Long-term, non-cancelable lease
contracts are known as financial lease.
 Examples are plant, machinery, land,

building, ships and aircrafts.

 Amortize the cost of the asset over the

terms of the lease–Capital or Full pay-out


Table 16-1 Operating versus Financial Leases


Lessee Lessor Lessee Lessor

Asset Not on balance Report on B/S Report on B/S Not on B/S
sheet (B/S);
disclose in
Lease payments Expense the Claim as rental Decompose Claim the
full amount as income into interest interest portion
rental expense and principal of payments
repayment, and received as
expense the interest incom e
interest portion
Depreciation Cannot claim Claim Claim Cannot claim
(associated with
leased asset)

 Sometimes, a user may sell an (existing) asset
owned by him to the lessor (leasing company)
and lease it back from him. Such sale and lease
back arrangements may provide substantial tax
 In April 1989, Shipping Credit and Investment
Corporation of India purchased Great Eastern
Shipping Company bulk carrier, Jag Lata, for Rs
12.5 Cr and then leased it back to GESC on a 5
years lease, the rentals being Rs 28.13 Lakh per
month. The ships WDV was Rs 2.5 Cr.

The lessee is deemed to own the asset and
will claim depreciation on the firm’s income
statement and record the value as an asset
and liability on the balance sheet.
Such leases usually:
Require the lessee to carry out maintenance
and insure the asset
 Provides the lessee with a fixed purchase option
The lease agreement covers 75% of the economic
life of the asset
Is structured so that the present value of lease
payments exceeds 90 % of the cost
Involves fixed rental payments.

• If a lease is NOT a capital lease, then it is an
operating lease
• Operating leases do not transfer to the lessee
the benefits of ownership

• A three-way agreement among the lessee, the
lessor, and a third party lender in which the lessor
buys the asset with only a small down payment
and the lender supplies the financing

 Financial leases are included on the balance
sheet of the lessee

 Operating leases are off-balance-sheet financing

for the lessee (included only in the notes to the
financial statements)

 Leasing is an alternative means of obtaining the use of an
asset. There are four main differences in the cash flows for
a company that leases an asset instead of buying it:
1. It does not have to pay for the asset up front
2. It does not get to sell the asset when it is finished with it,
if it is an operating lease, or if title is not transferred
through a financial lease
3. It makes regular lease payments. If the lease is an
operating lease, then the full amount of the lease
payments is tax deductible; only the interest portion is
deductible for capital leases
4. Operating leases are not depreciated.

IRR of Leasing Analysis
 Estimate incremental cash flows that result from
◦ Solve for the discount rate (IRR) that equates the
incremental cash flows with the initial value of the
asset. (This is the after-tax IRR or cost of leasing)
 If IRR of leasing > after-tax cost of borrowing
(borrow and buy the asset)
If IRR of leasing < after-tax cost of borrowing (lease
the asset)

NPV of Leasing Analysis
◦ Estimate incremental cash flows that result from
◦ Calculate NPV using after-tax cost of borrowing as
the discount rate.
If NPV of leasing is – (borrow and buy the asset)
If NPV of leasing + after-tax cost of borrowing (lease
the asset)

 The direct cash flow consequences are:
1. The purchase price of the asset is avoided.
2. The depreciation tax shield Is lost.
3. The after tax lease rentals are paid.
 The net present value of these cash
flows at after tax cost of debt should be
calculated. If it is positive lease is

1. Cheaper financing
2. Reduce the risks of asset ownership
3. Implicit interest rates
4. Maintenance
5. Convenience
6. Flexibility
7. Capital budgeting restrictions
8. Financial statement effects

In this chapter you have learned:
◦ That firms can gain the use of assets through
leasing rather than outright ownership
◦ The general differences between operating
and financial leases
◦ How to evaluate a potential lease decision
using discounted cash flow analysis
◦ The various reasons firms might have for
entering into lease arrangements