Introduction One of the major challenges which corporate finance manager’s face today is financing assets involving large amount of funds. For this purpose they look towards funding by way of long term debt or equity which are traditional in nature, related to the liability side of the balance sheet and have their own drawbacks. A high rate of inflation results into expensive long term debt as interest rates rise. On the other hand equity also becomes an expensive method of financing if corporate earnings depress. Thus corporate finance managers are developing alternatives related to the asset side of the balance sheet without disturbing the liability side. Leasing today has become a very important tool to acquire an asset involving large funds for a long / short period, derive benefits out of it, but without disturbing the liability side of the balance sheet and also without owning the asset. Leasing as a financial service is not a new concept. It has been into existence since Sumerian and Greek civilization where leasing of land, animals, utensils, ships, etc use to take place. However with due course of time the nature of lease transaction(s) have changed considerably with the changes in the requirements. Lease transactions done today are totally different from those done in past. The whole gamete of lease has changed in due course of time.
This chapter aims to provide an insight into the theoretical and practical / regulatory aspect of leasing. The theoretical aspect covers concept, types, and evaluation of lease with other options, advantages and limitations. Leasing in India is governed by a number of legislations as there is no one specific act or regulation for leasing hence it becomes more important to look into various regulatory aspects that govern leasing in our country. Lease Definition A lease is a financial agreement between two parties; lessor and the lessee. The main subject matter in the agreement is an asset. The lessor is the owner of the asset and the lessee is the user of the asset. Under the agreement the owner i.e. the lessor gives the right to use the asset to the user i.e. is lessee for a predetermined period of time for a consideration known as lease rental.
1
Elements in a Lease Agreement
1. Participants: -- As discussed above a simple lease agreement will involve only two parties lessor
and the lessee, whereby the lessor is the owner of the asset and the lessee is the user of the asset. However there are lease agreements which involve more than the two parties mentioned above. Discussion on them has been done in the later part of this chapter. A lessee can be a firm or an individual similarly a lessor can be a leasing company (a company engaged in the business of leasing equipment), an equipment manufacturing firm or an individual also.
2.
Asset / Equipment: -- This is the main subject matter of the agreement and is of high value. Asset is legally owned by the lessor and he leases it to the lessee. During the lease period the lessee uses the asset but the ownership remains with the lessor only. Some common examples of assets which are widely leased are aircrafts, buildings, ships, etc.
3. Period: -- The duration of the lease is called the lease period. It is the predetermined time period
during which the lease agreement remains in force i.e. the lessee uses the asset and the lessor receives the lease rentals during that period. At the end of the period the lessee returns back the asset to the lessor and stops paying the lease rentals. In a long term lease at the end of the period the lessee is given an option to buy the asset or renew the lease agreement.
4. Lease Rentals: -- The amount paid by the lessee to the lessor in consideration for the use of the
asset is known as lease rental. In a simple lease agreement the lessee pays rentals to the lessor as regular fixed payments over a period of time at the beginning or at the end of a month, quarter, half year or year. However rental payments can be structured according to the cash flows or profits of the lessee. When more rent is charged in the initial years and less at the end of the agreement it is termed as up-fronted lease. When low rent is charged in the initial years and high at the end of the agreement it is termed as back ended lease. For the purpose of rentals sometimes the lease agreement can divided into two parts called primary lease and secondary. During the primary lease period (initial period of the lease) which is normally of four to five years more
2
rentals are taken so as to recover the cost of the asset and profit. In the later part of the lease agreement know as secondary lease less rentals are charged. However various other combinations of rental payments are possible depending upon factors like cost of the asset, life of the asset, cash inflows of the lessee etc. Lease Classification Lease agreements are tailor made agreements and can be structured into various forms depending upon the requirements of the parties involved. However broadly lease transactions can be classified into following categories:
(a) Operating lease:-- The features of an operating lease are as follows • •
• • For a short period of time Can be cancelled at a short notice by the lessee at any time before the end of the period. The lessee can ask the lessor to renew the lease at the end of the period. The asset is not fully amortized during the non cancelable period of the lease and the lessor does not rely on the lease rentals for profit.
•
• • • •
The lease period is normally less than the useful life of the asset. The lessor is responsible for the maintenance and insurance of the asset Lessor bears the risk of obsolescence Lease rentals are normally higher Examples; lease contracts for computers, office equipments, tourist cars, hotel rooms etc.
(b) Financial Lease :-- The features of an financial lease are as follows
• • For a long period of time Cannot be cancelled at a short notice by the lessee at any time before the end of the period.
3
•
The asset is fully amortized during the non cancelable period of the lease and the lessor gets some profit also from the lease rentals.
• • • • •
The lease period is normally equal to or more than the useful life of the asset. The lessee is responsible for the maintenance and insurance of the asset The lessee can ask the lessor to renew the lease at the end of the period. Lessee bears the risk of obsolescence Lease rentals are equally distributed over the period of time Also known as Capital or Full payout lease.
•
(c) Direct Lease: -- Under this type of lease agreement the lessee identifies the asset the lessor
purchases it from the manufacturer, passes it to the lessee and signs a lease contract with him.
(d) Sale-and-Lease-back:--In such type of lease transaction the owner of the asset sells the asset to
the lessor first and then takes it back from him as leased equipment under a lease agreement.
(e) Master lease: -- The period of the lease is more than the economic life of the asset and the lessor
is responsible for proper maintenance of the equipment during the lease period.
(f) Closed and Open ended lease:-- In a closed ended lease at the end of the contract period the
asset returns back to the lessor whereas in an open ended lease the lessee has the option to buy the asset at the end of the contract period.
(g) Percentage lease :-- Here the lessee not only pays lease rent but also pays some percentage of
previous year’s gross revenue to the lessor. This protects the lessor from inflation.
(h) Wet and Dry lease: -- Generally wet lease take place in aircraft industry when the lease involves
financing as well as maintenance and fuel. Dry lease involves only providing asset for use but no maintenance and fuel.
(i) Net lease:-- As per US Controller of Currency a net lease is one in which the lessor will not
provide directly or indirectly or be obliged to provide any of the following • The servicing repair or maintenance of the lease property during the lease term
4
• •
The purchasing of parts and accessories for the lease property The loan of a replacement or substitute while the lease property is being serviced The purchasing of insurance for the lessee, except where the lessee has failed in its contractual obligation to purchase or maintain the required insurance.
•
•
The renewal of any license or registration for the property unless such action is clearly necessary to protect the interest of the lessor.
(j) Net net net lease: -- When the lessee is responsible for all the three costs that are insurance,
maintenance and taxes it is called a net net net lease.
(k) Cross border lease / International lease: -- Under this type of lease agreement the parties to the
agreement are situated in two different countries. Involves accounting, taxation and other issues of both the countries and hence turns to be complicated .When a lease transaction takes place between three parties manufacturer, lessor, lessee and all the three are situated in different countries it is termed as foreign-to-foreign lease.
(l) Leveraged lease: -- It is a popular method of financing expensive assets and involves a financer
also along with the lessee and lessor. In this type of lease the lessor who happens to be one financer involves one more financer who may hold a charge over the leased asset or on a part of the lease rentals.
Lessor Loan Participant
Trustee
Leases the Equipment
Lessee
The transaction is routed through a trustee who looks after the interests of the lender and lessor. On receiving the rentals from the lessee the trustee remits the debt service component of the rental to the loan participant and the balance to the lessor. Lease rental component Pays lease rentals
Lessor
Trustee
Lessee
5
Loan Participant
Debt service component
(m) Update lease:-- Under such type of lease the lessor agrees to replace the obsolete asset with a
new asset at a specified rent. This protect the lessee from the risk of obsolescence.
Balloon lease: -- When the residual value of the asset at the end of the lease period is zero it is
termed as balloon lease. In this kind of lease the lease rentals are low at the beginning , high during the mid period and again low again at the end of the period
(o) Wrap lease:-- When the lessee further leases the asset which he had taken on lease , to another
user it is termed as a wrap lease. Here the first lessee retains a fees and a share of the residual value. The term of first lease is more than the second lease.
Leasing some Myths
1. Leasing gives full financing for the asset:-- It is opined that leasing results into full financing. If
an asset is acquired by way of a loan the borrower commits itself to fixed payment of principal and interest (loan installment). Similarly if an asset is acquired through lease the lessee commits himself to fixed payment of lease rentals. Thus leasing also like borrowing results into inclusion of a liability by way of fixed periodical payments.
2. Leasing removes evaluating capital expenditure decision activity: -- Leasing does not involve
capital investment hence no capital expenditure screening is required. This is a common misconception. Like any other buying decision leasing also needs to be evaluated very religiously in terms of cash flows. In the absence of a proper evaluation process leasing could expose the firm to risk(s) in adverse business conditions.
3. Leasing is an off-balance-sheet activity:-- Lease liability need not to be disclosed on the
balance sheet , hence leasing does not increase the debt-equity ratio of the firm but borrowing
6
does. Thus the myth arises that leasing is an off-balance-sheet financing activity keeping the firm’s debt taking capacity intact. However this argument is not correct as the debt taking capacity of the firm is not dependent on debt equity ratio but it is dependent on the debt servicing capacity of the firm. Any type of contractual agreement whether it is to pay loan installment or lease rental reduces the debt servicing ability and increases the financial risk. Lenders look at the lessee’s cash flow burden arising from lease payment. Leasing can help companies which have enough debt servicing ability but cannot borrow from banks or financial institutions on account of institutional norms on debt-equity or regulations. Under no circumstances lease can enhance a firm’s debt taking capacity.
4. Improvement in performance: -- It is argued that leasing improves ROI. Lease dose not appear
as an investment in the books or balance sheet and hence it is possible to enhance the ROI with less asset base. These type of ratios are a result of accounting treatments and many a times may be misleading. The value of a firm can be increased by a lease transaction only when the benefits from it are more than its cost. Benefits of Leasing
• •
•
Lessee can acquire the equipment that is needed now, not when the cost meets budgeting
requirements. Leasing helps avoidance of capital investment hence capital saved from buying the asset Early settlement and upgrade of equipment is available during the lease period. Leasing provides flexibility by structuring the lease payments to match lessee’s cash Leasing does not disturb normal other lines of credit of the lessee. Leasing avoids performing complex investment decision exercise. A good mode for acquiring assets for firms (like hospitals, NGO’s etc) which have The lessee is free from the hassles of searching for a buyer at the end of the economic life
can be employed into other profitable areas.
•
• • • •
flow. Such tailored payment schedules are helpful to a lessee who has fluctuating cash flows.
budget constraints. of the asset as the asset reverts back to the lessor on expiry of the lease contact.
7
•
If the requirement of the asset is for small period, buying an asset and then looking for a
resell after use may be difficult and one may not get the right price in that case leasing is a better alternative. • Financial institutions which provide loan for asset purchase may put restrictions on the borrower with respect to repayment, use of asset etc. However leasing is subject to fewer restrictions.
•
Small and new firms which do not have long track record, but have good potential may
not get funds from banks or financial institutions to purchase assets for such type of firms leasing is a good option.
• •
A full service lease provides the lessee with the advantages of maintenance and
specialized services. The extent of benefits that would be derived by owning an asset, by way of depreciation
tax shield is less than the benefit to the lessee by way of lease rentals. This is because depreciation tax shield is less than lease rentals. Moreover, lease rentals are fully tax-deductible. Further this will help amortize the cost of the asset in the books of the lessee in a much shorter period. This also enables the lessee to write off more amounts in the initial years, which eventually makes it possible to postpone taxes to the latter years. Similarly the lease on land permits the lessee to write off land values against taxable income, which is not otherwise permissible under income tax rules.
•
Sale and lease back type of lease provide double benefit to the lessee as it helps a crash
crunch lessee firm to overcome its liquidity problem simultaneously provides the use of the asset also. It helps overcome working capital requirements.
• •
Even during depression period the lessee can acquire the asset thus contributing towards
a continuous and stable manufacturing business for the lessor also. Less and easy documentation is required.
Limitations of Leasing
•
In a financial lease the non cancelable feature is a serious disadvantage where the equipment leased has uncertain technological and / or product – market lives.
8
•
Firms with high debt equity ratio and with high business risk need to be very careful when considering leasing because case of depressed business activity leasing reduces the debt capacity of such firms and also increases financial risk.
•
In a perfectly competitive financial market the cost of leasing tends to be equal to the costs of other forms of borrowing. Therefore in this market a borrower (lessee) can afford to be indifferent between the options of leasing and borrowing. But in an imperfect financial market where the tax shields associated with leasing and owning are different, where some long term interest rates are regulated, etc. the costs of leasing and borrowing can be significantly different. More often than not leasing turns out to be costlier than most forms of borrowing. So the lessee has to necessarily evaluate the costs of leasing and borrowing before choosing between lease or buy.
•
If depreciation rate are high and a firm goes for lease then the firm looses depreciation tax shield. Sales tax rates vary from state to state thus there are possibilities that the lease rental revenues may attract sales tax twice, once at the time of the purchase of the asset by the lessor and second at the time when the asset is leased out.
•
•
The lessee has to return the asset back to the lessor at the end of the lease period and thus there is a loss of residual value of the asset for the lessee.
• •
Leasing exposes the lessee to a fixed commitment of lease payment. Leasing does not give the lessee the right of ownership and hence he cannot use the benefits of ownership.
•
If the asset provided by the lessor to the lessee has been acquired by why of hypothecation from some financial institution and the lessor fails to pay the installments the asset may be taken up by the financial institution and this may hamper the activities of the lessee.
• •
Funds of lessor are blocked up for a long term and he is exposed to a number of risks. Leasing does not provide access to working capital finance.
9
•
Selecting an appropriate discount rate to evaluate lease transaction is also a hurdle.
10
doc_113170753.doc
This chapter aims to provide an insight into the theoretical and practical / regulatory aspect of leasing. The theoretical aspect covers concept, types, and evaluation of lease with other options, advantages and limitations. Leasing in India is governed by a number of legislations as there is no one specific act or regulation for leasing hence it becomes more important to look into various regulatory aspects that govern leasing in our country. Lease Definition A lease is a financial agreement between two parties; lessor and the lessee. The main subject matter in the agreement is an asset. The lessor is the owner of the asset and the lessee is the user of the asset. Under the agreement the owner i.e. the lessor gives the right to use the asset to the user i.e. is lessee for a predetermined period of time for a consideration known as lease rental.
1
Elements in a Lease Agreement
1. Participants: -- As discussed above a simple lease agreement will involve only two parties lessor
and the lessee, whereby the lessor is the owner of the asset and the lessee is the user of the asset. However there are lease agreements which involve more than the two parties mentioned above. Discussion on them has been done in the later part of this chapter. A lessee can be a firm or an individual similarly a lessor can be a leasing company (a company engaged in the business of leasing equipment), an equipment manufacturing firm or an individual also.
2.
Asset / Equipment: -- This is the main subject matter of the agreement and is of high value. Asset is legally owned by the lessor and he leases it to the lessee. During the lease period the lessee uses the asset but the ownership remains with the lessor only. Some common examples of assets which are widely leased are aircrafts, buildings, ships, etc.
3. Period: -- The duration of the lease is called the lease period. It is the predetermined time period
during which the lease agreement remains in force i.e. the lessee uses the asset and the lessor receives the lease rentals during that period. At the end of the period the lessee returns back the asset to the lessor and stops paying the lease rentals. In a long term lease at the end of the period the lessee is given an option to buy the asset or renew the lease agreement.
4. Lease Rentals: -- The amount paid by the lessee to the lessor in consideration for the use of the
asset is known as lease rental. In a simple lease agreement the lessee pays rentals to the lessor as regular fixed payments over a period of time at the beginning or at the end of a month, quarter, half year or year. However rental payments can be structured according to the cash flows or profits of the lessee. When more rent is charged in the initial years and less at the end of the agreement it is termed as up-fronted lease. When low rent is charged in the initial years and high at the end of the agreement it is termed as back ended lease. For the purpose of rentals sometimes the lease agreement can divided into two parts called primary lease and secondary. During the primary lease period (initial period of the lease) which is normally of four to five years more
2
rentals are taken so as to recover the cost of the asset and profit. In the later part of the lease agreement know as secondary lease less rentals are charged. However various other combinations of rental payments are possible depending upon factors like cost of the asset, life of the asset, cash inflows of the lessee etc. Lease Classification Lease agreements are tailor made agreements and can be structured into various forms depending upon the requirements of the parties involved. However broadly lease transactions can be classified into following categories:
(a) Operating lease:-- The features of an operating lease are as follows • •
• • For a short period of time Can be cancelled at a short notice by the lessee at any time before the end of the period. The lessee can ask the lessor to renew the lease at the end of the period. The asset is not fully amortized during the non cancelable period of the lease and the lessor does not rely on the lease rentals for profit.
•
• • • •
The lease period is normally less than the useful life of the asset. The lessor is responsible for the maintenance and insurance of the asset Lessor bears the risk of obsolescence Lease rentals are normally higher Examples; lease contracts for computers, office equipments, tourist cars, hotel rooms etc.
(b) Financial Lease :-- The features of an financial lease are as follows
• • For a long period of time Cannot be cancelled at a short notice by the lessee at any time before the end of the period.
3
•
The asset is fully amortized during the non cancelable period of the lease and the lessor gets some profit also from the lease rentals.
• • • • •
The lease period is normally equal to or more than the useful life of the asset. The lessee is responsible for the maintenance and insurance of the asset The lessee can ask the lessor to renew the lease at the end of the period. Lessee bears the risk of obsolescence Lease rentals are equally distributed over the period of time Also known as Capital or Full payout lease.
•
(c) Direct Lease: -- Under this type of lease agreement the lessee identifies the asset the lessor
purchases it from the manufacturer, passes it to the lessee and signs a lease contract with him.
(d) Sale-and-Lease-back:--In such type of lease transaction the owner of the asset sells the asset to
the lessor first and then takes it back from him as leased equipment under a lease agreement.
(e) Master lease: -- The period of the lease is more than the economic life of the asset and the lessor
is responsible for proper maintenance of the equipment during the lease period.
(f) Closed and Open ended lease:-- In a closed ended lease at the end of the contract period the
asset returns back to the lessor whereas in an open ended lease the lessee has the option to buy the asset at the end of the contract period.
(g) Percentage lease :-- Here the lessee not only pays lease rent but also pays some percentage of
previous year’s gross revenue to the lessor. This protects the lessor from inflation.
(h) Wet and Dry lease: -- Generally wet lease take place in aircraft industry when the lease involves
financing as well as maintenance and fuel. Dry lease involves only providing asset for use but no maintenance and fuel.
(i) Net lease:-- As per US Controller of Currency a net lease is one in which the lessor will not
provide directly or indirectly or be obliged to provide any of the following • The servicing repair or maintenance of the lease property during the lease term
4
• •
The purchasing of parts and accessories for the lease property The loan of a replacement or substitute while the lease property is being serviced The purchasing of insurance for the lessee, except where the lessee has failed in its contractual obligation to purchase or maintain the required insurance.
•
•
The renewal of any license or registration for the property unless such action is clearly necessary to protect the interest of the lessor.
(j) Net net net lease: -- When the lessee is responsible for all the three costs that are insurance,
maintenance and taxes it is called a net net net lease.
(k) Cross border lease / International lease: -- Under this type of lease agreement the parties to the
agreement are situated in two different countries. Involves accounting, taxation and other issues of both the countries and hence turns to be complicated .When a lease transaction takes place between three parties manufacturer, lessor, lessee and all the three are situated in different countries it is termed as foreign-to-foreign lease.
(l) Leveraged lease: -- It is a popular method of financing expensive assets and involves a financer
also along with the lessee and lessor. In this type of lease the lessor who happens to be one financer involves one more financer who may hold a charge over the leased asset or on a part of the lease rentals.
Lessor Loan Participant
Trustee
Leases the Equipment
Lessee
The transaction is routed through a trustee who looks after the interests of the lender and lessor. On receiving the rentals from the lessee the trustee remits the debt service component of the rental to the loan participant and the balance to the lessor. Lease rental component Pays lease rentals
Lessor
Trustee
Lessee
5
Loan Participant
Debt service component
(m) Update lease:-- Under such type of lease the lessor agrees to replace the obsolete asset with a
new asset at a specified rent. This protect the lessee from the risk of obsolescence.
Balloon lease: -- When the residual value of the asset at the end of the lease period is zero it istermed as balloon lease. In this kind of lease the lease rentals are low at the beginning , high during the mid period and again low again at the end of the period
(o) Wrap lease:-- When the lessee further leases the asset which he had taken on lease , to another
user it is termed as a wrap lease. Here the first lessee retains a fees and a share of the residual value. The term of first lease is more than the second lease.
Leasing some Myths
1. Leasing gives full financing for the asset:-- It is opined that leasing results into full financing. If
an asset is acquired by way of a loan the borrower commits itself to fixed payment of principal and interest (loan installment). Similarly if an asset is acquired through lease the lessee commits himself to fixed payment of lease rentals. Thus leasing also like borrowing results into inclusion of a liability by way of fixed periodical payments.
2. Leasing removes evaluating capital expenditure decision activity: -- Leasing does not involve
capital investment hence no capital expenditure screening is required. This is a common misconception. Like any other buying decision leasing also needs to be evaluated very religiously in terms of cash flows. In the absence of a proper evaluation process leasing could expose the firm to risk(s) in adverse business conditions.
3. Leasing is an off-balance-sheet activity:-- Lease liability need not to be disclosed on the
balance sheet , hence leasing does not increase the debt-equity ratio of the firm but borrowing
6
does. Thus the myth arises that leasing is an off-balance-sheet financing activity keeping the firm’s debt taking capacity intact. However this argument is not correct as the debt taking capacity of the firm is not dependent on debt equity ratio but it is dependent on the debt servicing capacity of the firm. Any type of contractual agreement whether it is to pay loan installment or lease rental reduces the debt servicing ability and increases the financial risk. Lenders look at the lessee’s cash flow burden arising from lease payment. Leasing can help companies which have enough debt servicing ability but cannot borrow from banks or financial institutions on account of institutional norms on debt-equity or regulations. Under no circumstances lease can enhance a firm’s debt taking capacity.
4. Improvement in performance: -- It is argued that leasing improves ROI. Lease dose not appear
as an investment in the books or balance sheet and hence it is possible to enhance the ROI with less asset base. These type of ratios are a result of accounting treatments and many a times may be misleading. The value of a firm can be increased by a lease transaction only when the benefits from it are more than its cost. Benefits of Leasing
• •
•
Lessee can acquire the equipment that is needed now, not when the cost meets budgeting
requirements. Leasing helps avoidance of capital investment hence capital saved from buying the asset Early settlement and upgrade of equipment is available during the lease period. Leasing provides flexibility by structuring the lease payments to match lessee’s cash Leasing does not disturb normal other lines of credit of the lessee. Leasing avoids performing complex investment decision exercise. A good mode for acquiring assets for firms (like hospitals, NGO’s etc) which have The lessee is free from the hassles of searching for a buyer at the end of the economic life
can be employed into other profitable areas.
•
• • • •
flow. Such tailored payment schedules are helpful to a lessee who has fluctuating cash flows.
budget constraints. of the asset as the asset reverts back to the lessor on expiry of the lease contact.
7
•
If the requirement of the asset is for small period, buying an asset and then looking for a
resell after use may be difficult and one may not get the right price in that case leasing is a better alternative. • Financial institutions which provide loan for asset purchase may put restrictions on the borrower with respect to repayment, use of asset etc. However leasing is subject to fewer restrictions.
•
Small and new firms which do not have long track record, but have good potential may
not get funds from banks or financial institutions to purchase assets for such type of firms leasing is a good option.
• •
A full service lease provides the lessee with the advantages of maintenance and
specialized services. The extent of benefits that would be derived by owning an asset, by way of depreciation
tax shield is less than the benefit to the lessee by way of lease rentals. This is because depreciation tax shield is less than lease rentals. Moreover, lease rentals are fully tax-deductible. Further this will help amortize the cost of the asset in the books of the lessee in a much shorter period. This also enables the lessee to write off more amounts in the initial years, which eventually makes it possible to postpone taxes to the latter years. Similarly the lease on land permits the lessee to write off land values against taxable income, which is not otherwise permissible under income tax rules.
•
Sale and lease back type of lease provide double benefit to the lessee as it helps a crash
crunch lessee firm to overcome its liquidity problem simultaneously provides the use of the asset also. It helps overcome working capital requirements.
• •
Even during depression period the lessee can acquire the asset thus contributing towards
a continuous and stable manufacturing business for the lessor also. Less and easy documentation is required.
Limitations of Leasing
•
In a financial lease the non cancelable feature is a serious disadvantage where the equipment leased has uncertain technological and / or product – market lives.
8
•
Firms with high debt equity ratio and with high business risk need to be very careful when considering leasing because case of depressed business activity leasing reduces the debt capacity of such firms and also increases financial risk.
•
In a perfectly competitive financial market the cost of leasing tends to be equal to the costs of other forms of borrowing. Therefore in this market a borrower (lessee) can afford to be indifferent between the options of leasing and borrowing. But in an imperfect financial market where the tax shields associated with leasing and owning are different, where some long term interest rates are regulated, etc. the costs of leasing and borrowing can be significantly different. More often than not leasing turns out to be costlier than most forms of borrowing. So the lessee has to necessarily evaluate the costs of leasing and borrowing before choosing between lease or buy.
•
If depreciation rate are high and a firm goes for lease then the firm looses depreciation tax shield. Sales tax rates vary from state to state thus there are possibilities that the lease rental revenues may attract sales tax twice, once at the time of the purchase of the asset by the lessor and second at the time when the asset is leased out.
•
•
The lessee has to return the asset back to the lessor at the end of the lease period and thus there is a loss of residual value of the asset for the lessee.
• •
Leasing exposes the lessee to a fixed commitment of lease payment. Leasing does not give the lessee the right of ownership and hence he cannot use the benefits of ownership.
•
If the asset provided by the lessor to the lessee has been acquired by why of hypothecation from some financial institution and the lessor fails to pay the installments the asset may be taken up by the financial institution and this may hamper the activities of the lessee.
• •
Funds of lessor are blocked up for a long term and he is exposed to a number of risks. Leasing does not provide access to working capital finance.
9
•
Selecting an appropriate discount rate to evaluate lease transaction is also a hurdle.
10
doc_113170753.doc