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Learning Objectives:

After going through this lecture, you would be able to have an understanding of the following topics:

• Lease Financing:
• Types of Lease Financing:

Lease Financing:

• Leasing of Fixed Assets (Financing of Capital Expenditure)
• Leasing Company (Lessor) Buys / Owns the Asset and the Lessee (Borrower) Controls, Operates, and Uses it. Lessor receives a regular and fixed Lease Rental. Lifespan of lease is limited (few months to several years).
• It is just like a Collateralized Loan (where the leased asset is the collateral). Lease Contract is just as serious as a loan agreement. Failure to pay lease rental is just like failure to pay interest. Can bankrupt the Lessee (Borrower). Lessor (Lender or Leasing Company) can seize the leased asset and, if the claim is larger, also demand up to 1 year lease rental.
• The two parties of lease agreement are:
• Lessor (Leasing Company)
• Lessee
• Ownership vs. Control:
• Ownership of the asset is with leasing company
• Control is with lessee
• In most of the countries 10-30% of fixed assets owned by Companies are leased i.e. Warehouses, offices, equipment, machinery, computers, cars, furniture, airplanes!
• General Advantages of Leasing from Lessee’s (Borrower / user) Point of View It guides towards when lease financing should be used:
• Less risky than investing own large amount of money in expensive fixed assets in a new businesses that suffer from Cyclicality i.e. Airplanes
• More suitable for hi-tech assets that become Obsolete quickly.
• When product demand and hence equipment life is uncertain.
• Lender has to share portion of operational risk and maintenance costs

Types of Leasing Finance:

• 1- Financial Lease (or Capital Lease)

• Popular form of Leasing in Pakistan
• Financial Lease is Fully Amortized: Lessor recovers BOTH the full Value of Asset (Principal amount) AND the Profit (in form of interest or mark-up). BOTH are built into the Lease Rental amount collected by the Lessor over the lifespan of the Lease. Recall AMORTIZATION TABLE for Bank Loan where Principal and Interest are recovered in equal regular installments.

Fully Amortized Lease means the lessor recovers the principal amount plus interest amount:

• Financial Lease is NOT Cancelable: If Lessee MUST Cancel or Terminate the Lease Prematurely then pays heavy penalty to Lessor.
• Example of Financial Lease: You need to buy a Pentium IV computer hardware system complete with peripherals but you don’t have enough money. You go to computer hardware store and negotiate the price for the system at Rs.50000. You then contact a leasing company to buy the computer system and lease it to you in return for a monthly rental of say, Rs.5000 per month. After one year, if you have paid all the lease rentals on time, the Leasing Company will transfer the Ownership to you.
• Advantage of Financial Lease for Lessee:

• If factory needs to buy new machine urgently and does NOT have enough finances.

• Leased Assets (and lease liabilities) can sometimes be treated OFF THE BALANCE SHEET ITEMS. Accounting Standards (i.e. FASB USA) in some countries restrict this so generally speaking, Lease DOES affect DEBT RATIO & Capital Structure in similar way as Loan on Balance Sheet.
• If Company can NOT justify an increase in Assets on the Balance Sheet based on historical earnings. Capital expenditure in Leased Asset can be “Expensed” out gradually.
• Lease Rental is a TAX-DEDUCTIBLE EXPENSE just like interest payments.
• As long as IRR from leased equipment is higher than cost of lease financing.

• 2- Operating Lease (or Service Lease)

• Operating Lease offers Financing AND MAINTENANCE: often the Lessor is the Supplier / Vendor of the Asset i.e. IBM
• Operating Lease is NOT FULLY AMORTIZED AND IS CANCELLABLE • Example: Car rental company (Lessor) charges you Rs.1000 per day for renting out a new Honda Civic with driver. You can lease the car for 2 days. You will pay the Lessor Rs.2000. BUT, the value of the car might be Rs.1 million. Lessor does NOT expect you to pay that entire amount for using the car for just 2 days. The car rental company will service and maintain the car in good condition so it can rent it out to other people. This way, they can recover the value of the car from 1000 days of lease rent (= value / daily rental = 1,000,000 / 1000)!! This is the Payback Period (without taking their maintenance costs and profit margin). You can Cancel the lease and return the car after 1 day. Now you just have to pay Rs.1000.
• Other Examples of Operating Lease: IBM for Computer Hardware, Boeing for Airplanes

By not fully amortizing operating lease means the leasing company does not expect to recover the whole amount or value of asset from you.

3- Sale & Lease-Back

• Sale & Lease-Back is the Most Interesting Leasing Scheme – creative extension of Financial Lease where the Seller of the asset is the User-lessee. User sells his asset to Leasing Company in return for lump-sum cash and then repays the Leasing Company in form of Lease Rentals over a period of time to buy-back the asset. It is considered to be a creative way of mobilizing your asset to raise debt.
• Example of Sale & Lease-Back: You need Rs.300000 to start a business and all you own is a car. What can you do? Go to Leasing Company. Ask them to buy your car for Rs.300000 and then lease it back to you for 1 year!!! This way, the Leasing Company will take ownership of the car and give you Rs.300000 cash to start your business. Company has bought the car and you can start business from the cash you received. Suppose you expect to earn Rs.50000 per month from your business. Then you can easily pay Rs.30000 per month as lease rental and get your car back in 1 year. Remember company bought car from you for Rs.300000 but you will pay suppose Rs.360000 back to company at the end of period to have your car back. Rs.60000 is the profit or interest or mark-up Company is charging above the principal amount of Rs.300000.

Lease Analyses & Calculations:

• To Buy or To Lease? – That is the Question. Here we are doing some numerical calculations that can help us to decide whether it is better to lease?
• Assume that the Decision to Acquire the Asset has already been made independently at the Capital Budgeting Stage (which comes first).
• First value is NPV (Similar to Capital Budgeting) modified to NAL for Leasing Analysis

NAL = Net Advantage of Leasing = PV (Cost of Owning Asset) – PV (Cost of Leasing). If NAL >0 then Leasing is Better than Buying.

• Cost of Owning Asset: Cost of Owning includes following Cash Flows: Initial investment Io, yearly maintenance and service costs, yearly depreciation tax savings, replacement or the salvage value of the asset at the end of its life and Final net residual value (after any tax).
• Cost of Leasing includes following Cash Flows: Yearly Lease Rentals, Yearly Tax Savings associated with Lease Rentals
• Discount Rate “r”: Generate Cash Flow forecasts for life of asset. Cash Flows are quite FIXED AND CERTAIN so use a LOW DISCOUNT RATE = r = mark-up rate on bank loan OR use Risk Free Rate of Return = rRF = T-bill Interest rate. If Company is running in operation then use actual average cost of Debt.

• IRR (Similar to Capital Budgeting)

Set the NAL = 0 and solve for the Discount Rate “r” using Trial and Error or Iteration. This gives us the value of IRR.

• Most commonly used criterion – IRR % can simply be compared to mark-up % on bank loans and also to the market rate of interest and inflation rate.
• If IRR < interest rate on loan then leasing is better than buying

Lease Analysis (WACC):

• WACC (Capital Structuring Criterion)

• WACC = rDxD + rExE (where rD is AFTER-TAX Cost of Debt). Lease IRR % affects the “rD” After Tax Cost of Debt. WACC can be used as the Discount Rate “r” in NPV calculations in Capital Budgeting.
• Practically speaking, corporate financing and capital structure have feedback effect on capital budgeting decision. This means that capital budgeting ranking of projects may have to be revised taking into account the cost of debt (or leasing). The effect is minor because projects are selected based on strategic value and operational efficiency and not just minor differences in NPV. Of course, feedback effect goes entirely against mm theory which is for ideal, efficient markets.

• Leasing (and financing decisions in general) can (very rarely) have a FEEDBACK EFFECT on Capital Budgeting Decisions. Suppose that you had to choose one of 3 possible projects and you picked Project A based at the Capital Budgeting Stage (based on NPV). Many weeks later, you begin to decide where to raise the money and HOW TO FINANCE Project A. You need to take a bank loan at 15% pa interest. You realize now that another Project B (which had been rejected at the Capital Budgeting Stage) uses equipment that can be LEASED at a lower cost (say 13%). Now, you had done the Capital Budgeting exercise using your company’s WACC as the discount rate in the NPV calculation. That WACC used the company’s actual interest cost on bank loans as the after-tax cost of debt. But, since Project C can use the cheaper Lease Financing, you should RE-CALCULATE its NPV using the Cost of Lease (i.e. IRR) as the discount rate. This case is rare and the difference of a few percentage points in the cost of debt should not change a fundamental decision based on cash-flows, operational effectiveness, and overall strategic advantage of investing in a project which are considered at the Capital Budgeting Stage.