FINANCIAL

MANAGEMENT
LEASING

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 LEASE OR BUY DECISIONS
 A lease contract is an agreement under which the
original owner of property permits someone else to
use it. The original owner is the ‘lessor’ and the user
of the property is the ‘lessee’. There are many kinds
of leases and subtleties to lease contracts, but the
major distinction to be aware of is the difference
between operating leases and capital leases.

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 OPERATING LEASES
 Operating leases sometimes called service leases,
provide for both financing and maintenance.

 The lease contract is normally written for a period

considerably less than the expected economic life of
the asset.

 Operating leases are used for shot-term leasing and

often for assets that are high-tech or in which the
technology changes often.
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 OPERATING LEASES
 The lessee uses the property but does not take on the
benefits or drawbacks of ownership, which are
retained by the ‘lessor’.

 The rental cost of an operating lease is considered

an operating expense.

 Operating leases are not fully amortized since the

payments required under the lease contract are not
sufficient to recover the full cost of the asset.
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 OPERATING LEASES
 The full cost is recover from either subsequent
renewal payments, or re-leasing the asset to other
lessees, or sale of the asset.
 Operating leases require the ‘lessor’ (owner) to
maintain and service the leased equipment at no cost
to the ‘lessee’, as the cost of the maintenance is built
into the lease payments.

 Operating leases often contain a cancellation clause,

which gives the lessee the right to cancel the lease
and to return the asset before the expiration of the
basic lease agreement. 5
 FINANCIAL LEASES
 Financial or Capital leases do not provide for
maintenance service as in the case of an operating
leases, nor can they be cancelled as with operating
leases.
 These leases are fully amortized by the lessor as the
received rental payments equal to the full price of the
leased equipment plus a return on investment.

 The lessee is generally given an option to renew the

lease at a reduced rate upon the expiration of the
basic lease. The lessee also pays property taxes and
insurance on the leased asset. 6
 FINANCIAL/CAPITAL LEASES
 Financial leases are used for long-term leases and
for items that will not become technologically
obsolete, such as many kinds of machinery.

 Financial leases give the lessee (the person who is

leasing) the benefits and drawbacks of ownership,
so they are considered as assets, and they may be
depreciated.

 These leases are considered as debts of the lessee.

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 FINANCIAL/CAPITAL LEASES
 In order to be considered a capital lease, the Financial
Accounting Standard Board (FASB) requires that at
least one of these conditions must be met:

 Title to the equipment passes automatically to the

lessee by the end of the Lease term.

 The lease contains an option to purchase the

equipment at the end of the lease for substantially
less than fair market value; sometimes this is a $1
purchase. 8
 FINANCIAL/CAPITAL LEASES
 The term of the lease is greater than 75% of the
useful life of the equipment.

 The present value of the lease payments is greater

than 90% of the fair market value of the equipment.

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 SALE-AND-LEASEBACK
ARRANGEMENT
In a sale and leaseback arrangement the firm that
owns the asset sells it to another firm and
simultaneously executes an agreement to lease the
asset back for a stated period under specific terms.

Sale and leaseback arrangements are almost the same

as financial leases, the major difference being that the
leased asset is used and the lessor buys it from the
lessee instead of from a manufacturer or a distributor.

This type of lease may be thought of as a special type

of financial lease. 10
 LEASE OR BUY DECISIONS
 Leasing is a common alternative to purchase. Of the
two kinds of leases each is used for different
purposes and results in differing treatment on the
accounting books of a business.

 Firms often choose to lease long-term assets rather

than buy them for a variety of reasons - the tax
benefits are greater to the lessor than the lessees,
leases offer more flexibility in terms of adjusting to
changes in technology and capacity needs.
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 LEASE OR BUY DECISIONS
 Lease payments create the same kind of obligation
that interest payments on debt create, and have to be
viewed in a similar light.

 If a firm is allowed to lease a significant portion of

its assets and keep it off its financial statements, a
perusal of the statements will give a very misleading
view of the company's financial strength.
 Consequently, accounting rules have been devised
to force firms to reveal the extent of their lease
obligations on their books. 12
 LEASE OR BUY DECISIONS
 There are two ways of accounting for leases. In an
operating lease, the lessor (or owner) transfers only
the right to use the property to the lessee. At the end
of the lease period, the lessee returns the property to
the lessor.

 Since the lessee does not assume the risk of

ownership, the lease expense is treated as an
operating expense in the income statement and the
lease does not affect the balance sheet.
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 LEASE OR BUY DECISIONS
 In a capital lease, the lessee assumes some of the
risks of ownership and enjoys some of the benefits.
 Consequently, the lease, when signed, is recognized
both as an asset and as a liability (for the lease
payments) on the balance sheet.
 The firm gets to claim depreciation each year on the
asset and also deducts the interest expense
component of the lease payment each year.
 In general, capital leases recognize expenses sooner
than equivalent operating leases.
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 LEASE OR BUY DECISIONS
 Since firms prefer to keep leases off the books, and
sometimes prefer to defer expenses, there is a strong
incentive on the part of firms to report all leases as
operating leases.

 Consequently the Financial Accounting Standards

Board has ruled that a lease should be treated as a
capital lease if it meets any one of the following
four conditions as was earlier stated.

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 LEASE OR BUY DECISIONS
 The lessor uses the same criteria for determining
whether the lease is a capital or operating lease and
accounts for it accordingly.

 If it is a capital lease, the lessor records the present value

of future cash flows as revenue and recognizes expenses.

 The lease receivable is also shown as an asset on the

balance sheet, and the interest revenue is recognized
over the term of the lease, as paid.

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 LEASE OR BUY DECISIONS
 From a tax standpoint, the lessor can claim the tax
benefits of the leased asset only if it is an operating
lease, though the revenue code uses slightly different
criteria for determining whether the lease is an
operating lease.
 When a lease is classified as an operating lease, the
lease expenses are treated as operating expense and
the operating lease does not show up as part of the
capital of the firm. When a lease is classified as a
capital lease, the present value of the lease expenses
is treated as debt, and interest is imputed on this
amount and shown as part of the income statement. 17
 LEASE OR BUY DECISIONS
 In practical terms, however, reclassifying operating
leases as capital leases can increase the debt shown
on the balance sheet substantially especially for
firms in sectors which have significant operating
leases; airlines and retailing come to mind.

 An argument can be made that in an operating lease,

the lease payments are just as much a commitment
as lease expenses in a capital lease or interest
payments on debt.
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 LEASE OR BUY DECISIONS
 The fact that the lessee may not take ownership of
the asset at the end of the lease period, which seems
to be the crux on which the operating/capital lease
choice is made, should not be a significant factor in
whether the commitments are treated as the
equivalent of debt.

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 ADVANTAGES OF LEASING
 Risk of obsolescence.
 Fewer restrictions.
 Flexibility in duration.
 Provides working capital.
 Improvement in financial ratios.
 Full Financing.
 Lower price.

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 RISK OF OBSOLESENCE
 Obsolescence is a significant issue for many types
of equipment; leasing of computers is such a big
business that many large companies such as IBM
and Dell operate leasing subsidiaries. Therefore,
companies will often lease this type of equipment to
avoid the cost of repurchasing new equipment.
Under a lease arrangement it is sometimes much
easier to return your leased product for a new and
improved model, especially if you have been a
‘good’ lessee and you have paid all rents on time.
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 FEWER RESTRICTIONS
Many loan arrangements have included restrictive
covenants that have requirements for an organization to
meet or maintain certain liquidity levels or restrict
dividend payouts. In other words, covenants attached to
either bank loans or bond issues can significantly reduce
financial flexibility by restricting capital expenditures
and dividend payments; when leases, in general,
obligations are restricted to making payments on time
and ensuring the underlying asset is insured; with
certain types of assets, e.g., aircraft, additional payments
may be required to ensure that the asset is being
appropriately maintained but on balance there are likely
fewer restrictions on the lease option. 22
 FLEXIBILITY IN DURATION
 There are many instances where a company may
require an asset for only a relatively short period,
e.g., acquisition of an aircraft to meet a temporary
increase in passenger traffic. Leases are ideal for
these situations as they are easier to arrange than
purchasing an asset and reselling it at a later date

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PROVIDES WORKING CAPITAL
 If companies are in need of working capital they
will sometimes use ‘sale/leaseback’ arrangements.
This is an arrangement where an organization owns
an asset and sells it to a leasing company and then
leases that asset from the leasing company. These
arrangements are popular with land/buildings – tax
deductions are improved significantly since land
cannot be amortized under Canadian tax law but the
full lease payment can be expensed.

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 IMPROVEMENT IN FINANCIAL RATIOS
Operating leases have the effect of improving financial
ratios for an organization as there is no visible increase in
liabilities on the balance sheet and the total assets do not
include leased assets. Therefore, leverage ratios and
profitability ratios will be higher than if debt was
incurred to purchase an asset. It is important to note that
analysts and bankers do take into account the impact of
both operating and capital leases when completing an
analysis of an organization, hence it is unlikely the
enterprise would get any real value from the fact the
operating lease is not disclosed in the same manner as
capital leases. From the analysts’ point of view both
leases involved financial commitments and risk. 25
 FULL FINANCING & LOWER PRICE
 Leasing allows you to finance an asset 100% where
traditional borrowing often limits the percentage of
the asset’s value you can borrow. Therefore, often
you can only borrow up to 90% of the value of asset
you purchase.
 Often major lease companies are able to acquire
equipment and vehicles at lower prices due to bulk
purchases than most organizations can negotiate. The
effect of this better pricing can allow an organization
to pay less for an asset under a lease due to the fact
that part of the lower price may be passed through to
the lessee as a better lease rate. 26
DISADVANTAGES OF LEASING
 The rate unknown.
 Value of ownership.
 Approval for adjustment to assets
 Obsolescence

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 THE RATE UNKNOWN
 The rate implicit in a lease is often not stated in
commercial leases – therefore the cost can be quite
high versus traditional borrowing costs, and the
financial officer needs to do some careful analysis.

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 VALUE OF OWNERSHIP
 In the case of a lease, the ownership rights are
limited to the value of the leasehold interest and this
is generally less than the outright ownership value.
The relative value of the leasehold interest and
outright ownership will depend upon the lease
payments and the value of the asset returned to the
lessor at the end of the lease term. There is no
ownership position in the asset. Therefore at the end
of the lease term the asset is returned to the lessor. If
there is any value left the lessor reaps the rewards of
this through the sale of the asset.
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 APPROVAL FOR ADJUSTMENT
 Most lease agreements have a provision that
improvements or changes to the leased property
cannot be made without the permission of the lessor.
If the equipment were owned by the organization,
they would not need to seek approval of an outside
party to make such improvements. Of course if the
improvement is seen to add value to the asset then
the lessor is not likely to withhold this approval.

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 OBSOLESCENCE
 If an asset leased becomes obsolete during the lease
term, the lessee must continue to make lease
payments to the end of the lease term regardless of
whether the asset is being used. However if the asset
is purchased using debt and becomes obsolete, the
owner is faced with a potentially similar problem of
owing money on the debt when the asset is obsolete.

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 LEASE OR BUY DECISION
 The lease vs. buy decision is often not a
straightforward number crunching exercise. There
are many qualitative factors that must be considered
in your analysis.

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 ASSET REPLACEMENT
 In replacement analysis, the defender is an existing
asset; the challenger is the best available
replacement candidate.
 The current market value is the value to use in
preparing a defender’s economic analysis. Sunk
costs—past costs that cannot be changed by any
future investment decision— should not be
considered in an economic analysis.
 Two basic approaches to analyzing replacement
problems are the cash-flow approach and the
opportunity-cost approach.
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 ASSET REPLACEMENT
 The cash flow approach explicitly considers the
actual cash-flow consequences for each replacement
alternative as it occurs. Typically, the net proceeds
from the sale of the defender are subtracted from the
purchase price of the challenger.
 The opportunity-cost approach views the net
proceeds from the sale of the defender as an
opportunity cost of keeping the defender. That is,
instead of deducting the salvage value from the
purchase cost of the challenger, we consider the
salvage value an investment required in order to keep
the asset. 34
 ASSET REPLACEMENT
 Economic service life is the remaining useful life of
a defender (or a challenger) that results in the
minimum equivalent annual cost or maximum
annual equivalent revenue. We should use the
respective economic service lives of the defender
and the challenger when conducting a replacement
analysis.

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 ASSET REPLACEMENT
 The role of technological change in asset
improvement should be weighed in making long-
term replacement plans: If a particular item is
undergoing rapid, substantial technological
improvements, it may be prudent to shorten or delay
replacement (to the extent where the loss in
production does not exceed any savings from
improvements in future challengers) until a desired
future model is available.

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 ASSET REPLACEMENT
 Ultimately, in replacement analysis, the question is
not whether to replace the defender, but when to do
so. The AE (annual equivalence) method provides a
marginal basis on which to make the year-by-year
decision about the best time to replace the defender.
As a general decision criterion, the PW (present
worth) method provides a more direct solution to a
variety of replacement problems with either an
infinite or a finite planning horizon or a
technological change in a future challenger.
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 CAPITAL RATIONING
 Shareholder wealth is maximised if a company
undertakes all possible positive NPV projects. Capital
rationing is where there are insufficient funds to do so.
This implies that where investment capital is rationed,
shareholder wealth is not being maximised.
 There are two types of capital rationing: Hard capital
rationing - An absolute limit on the amount of finance
available is imposed by the lending institutions. Soft
capital rationing - A company may impose its own
rationing on capital. This is contrary to the rational view
of shareholder wealth maximisation.
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