A lease is a contract between a lessor (bank/finance house) and a lessee (person/company to whom the asset is leased) for the hire of a specific asset. The lessor retains ownership but gives the lessee the right to use the asset for an agreed period in return for the payment of specified rentals.
OPERATING AND FINANCE LEASES
The lessee hires the asset for a period which is normally substantially less than its useful economic life. The lessor retains most of the risks and rewards of ownership. Generally, there will be more than one lessee over the life of the asset. An operating lease is “Off Balance Sheet” finance.
This transfers substantially all the risks and rewards of ownership, other than legal title, to the lessee. It usually involves payment to the lessor over the lease term of the full cost of the asset plus a commercial return on the finance provided by the lessor.
Both the leased asset and the corresponding stream of rental liabilities must be shown on the lessee’s Balance Sheet. Other features include:
- The lessee is responsible for the upkeep, maintenance etc. of the asset.
- The lease has a primary period, covering the whole or most of the economic life of the asset. The asset will be almost worn out at the end of the primary period, so the lessor will ensure that the cost of the asset and a commercial return on the investment will be recouped within the primary period.
- At the end of the primary period the lessee has the option to continue to lease at a very small rent (“peppercorn rent”). Alternatively, he can sell the asset and retain about 95% of the proceeds. ADVANTAGES OF LEASING
- The lessee’s capital is not tied up in fixed assets, so a cash flow advantage accrues.
- Liquidity is improved as no down-payment is required.
- The lessor can obtain capital allowances and pass the benefit to the lessee in the form of lower lease rentals. This is especially important for a company with insufficient taxable profits.
- The whole of the rental payment is tax deductible.
- Security is usually the asset concerned. Other assets are free for other forms of borrowing.
- Traditional forms of borrowing often impose restrictive covenants.
- The cost of other forms of borrowing may exceed the cost of leasing.
SALE AND LEASEBACK
This is an arrangement whereby a firm sells an asset, usually land or a building, to a financial institution and simultaneously enters an agreement to lease the property back from the purchaser. The seller receives funds immediately and retains use of the asset but is committed to a series of rental payments over an agreed period. Thus, it is suited to capitalrationed companies who are eager to finance expansion programmes before the opportunity is lost.
The main disadvantages are the loss of participation in any capital appreciation and the loss of a valuable asset which could have been used as security for future borrowing.
HIRE PURCHASE (HP)
The user pays a periodic hire charge to a finance house which purchases the asset. The charge includes both interest and capital. Generally, the hirer must pay a deposit up-front. Ownership of the asset passes to the user at the end of the contract period, unless he defaults on repayments when the finance house will repossess the asset. The user may be able to claim capital allowances on the cost of the asset and the interest element of the periodic charge is tax deductible.
LEASE V BUY
Lease V Buy Decision
Traditional Method => Two stages – Acquisition & Financing Decisions
- Acquisition Decision – Is the asset worth acquiring? Operational cash flows are discounted by the cost of capital normally applied to project evaluations – after-tax cost of capital. If a positive NPV results, then proceed to Financing Decision
- Financing Decision – Cash flows of the financing decision (lease v buy) are discounted by the after-tax cost of borrowing.
PTO wishes to replace a piece of equipment, costing RWF120,000. This will produce operating savings of RWF50,000 per annum and will have a life of five years. PTO’s aftertax cost of capital is 15% and operating cash flows are taxed at 30%, one year in arrears.
PTO can borrow funds at 13% to purchase the machine or alternatively, it could acquire it by means of a finance lease costing RWF28,000 per annum for five years, the lease rentals payable in advance. The machine is expected to have zero scrap value at the end of the five years.
The machine qualifies for capital allowances on a reducing balance basis at the rate of 25% per annum. However, due to its tax position PTO is unable to utilise any capital allowances on the purchase until year one.
Should PTO replace the equipment and if so, should it buy or lease it?