Leasing

Meaning of Lease and Leasing

Aleaseisacontractualarrangementcallingfor
thelessee(user)topaythelessor(owner)foruseof
anasset
Leasingisaprocessbywhichafirmcanobtainthe
useofacertainfixedassetsforwhichitmustpaya
seriesofcontractual,periodic,taxdeductible
payments.

Important Terms:
Lesseeisthereceiveroftheservicesortheassets
undertheleasecontract.
Lessoristheowneroftheassets.
Tenancyistherelationshipbetweenthetenantand
thelandlord.
Termisthefixedoranindefiniteperiodoftime
involvedintheleasecontract.
Rentistheconsiderationforthelease.

Types of Lease:
Operating lease: Shortterm,cancellablelease
agreements.Thelessorisresponsibleforthemaintaince
andinsuranceoftheasset.Example:Touristrentinga
car,Hotelrooms,etc.
Financial Lease: Longtermnoncancellablelease
contract.Example:Plant,Machinery,Building,Ships
andaircraft.
Sale and Lease-back: Specialfinancialagreementin
whichtheusermaysellanassetownedbyhimtothe
lessorandleaseitbackfromhim.Example:shipping
Industry.

Financial evaluation of
leasing

Two ways of
evaluating
1. Lessees point
of view

2. Lessors point
of view

Lessees point of view:

Lease or borrow decisions:
Steps:
Calculate present value of netcash flow of the buying optionNPV(B)
Calculate present value of net
cash flow of the leasing optionNPV(L)
Decide whether to buy or lease
the asset or reject the proposal .

How to decide.
If NPV(B) is positive and
greater than NPV(L) then

 If NPV(L) is positive and greater

than the NPV(B)
then lease the asset.

 If NPV(B) as well as NPV(L)

are both negative,
reject the proposal

From the lessors point

of view

Present value
Internal
rate method of return
method

A. Present value method

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 favour 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

B. Internal rate of return

method
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.

Advantages of Leasing:
Leasing is lesscapital-intensive than purchasing,
so it is more suitable for a business
which has constraints on its capital.

Leasing shifts risk to the lessor in cases

where Capital assets tend to fluctuate in value.

Advantages of Leasing:
Lease payments are considered expenses
rather than assets, which can be set off
against revenue when calculating taxable
profit at the end of the relevant tax
accounting period.
Leasing provides more flexibility to a
business which expects to grow in the
relatively short term because a lessee is not
usually obliged to renew a lease at the end
of its term.

Disadvantages of Leasing:
Usuallyleasetermsarerigidand
difficulttonavigateincircumstances
wherethebusinesshasto
changeitsoperationssubstantially.

Tactical legal considerations usually make it expedient

for lessees to default on their leases

Disadvantages of Leasing:
If the business is successful, lessors
may demand higher rental payments
when leases come up for renewal.

Anet leasemay shift some or all of

the maintenance costs onto the
tenant.

Leasing - advantages
:

The lessee does not commit their (or

anyone else's) financial resources to the
procurement of necessary assets
(equipment, facilities, real estate,
consumer durables, etc.).
The rental, which sometimes exceeds
the purchase price of the asset, can be
paid from revenue generated by its use,
directly impacting the lessee's liquidity.

Leasing advantages

Lease instalments are exclusively

material costs. Using the purchase
option, the lessee can acquire the
leased asset at a lower price, as they
pay the residual or non-depreciated
value of the asset. For the national
economy, this way of financing
allows access to state-of-the-art
technology otherwise unavailable,
due to high prices, and often

Disadvantages of leasing
Leasing can be an expensive way of
financing. In renting, the lessors want
a return on their capital, while
protecting themselves from any risk
arising in collection of receivables.
Even given the high perceived price
of leasing, however, there are
benefits like those above that make
it attractive.

Disadvantages of leasing
In undeveloped legal systems (like Bosnia
and Herzegovina), lease arrangements
can result in inequality between the
parties due to the lessor's economic
dominance, which may lead to the lessee
signing an unfavourable contract.
Leasing can be undesirable because of
taxation or for other fiscal reasons,
depending on the taxation policy and
restrictive legislation of the country, etc.

Calculation of NPV (Leasing)

Cost of Asset :
Less : PV of Lease Rentals (LR) (Discounted at Kd)
Add : PV of tax shield on LR (Discounted at Ke)
Less : PV of interest on debt tax shield (Discounted at
Ke)
Less : PV of tax shield on depreciation (Discounted at
Ke)
Less : PV of salvage value (Discounted at Ke)
If NPV (L) is Positive the leasing alternative to be used,
otherwise borrowing alternative would be preferable.

Lease Rentals

Illustration

Lease Example

Calculate the present value of Lease

rental payable every year

Lease Illustration