LEASE FINANCING AND TYPES OF LEASE FINANCING:Sale & Lease-Back, Lease Analyses & Calculations

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Financial Management MGT201

Lesson 42

LEASE FINANCING AND TYPES OF LEASE FINANCING

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.

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Financial Management MGT201

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.

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Financial Management MGT201

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.

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