Leasing Lease Notes By Jim Mahar
Lessee: party who uses the property (Tenant) Lessor: Person who owns the property
Types of leases: Operating Lease (also called Service Lease)
- Generally for a shorter lease term than the asset’s useful life
- Maintenance is generally the responsibility of the lessor.
- Commonly have a cancellation clause which shifts risk back to lessor
Financial Lease (or Capital Lease) is generally non-cancellable and for a longer duration than an operating lease.
- Payments are set to fully amortize the lessor’s costs. –
- generally all maintenance must be provided by the Lessee. Example airlines lease their planes, but the airlines must maintain the planes.
- lease is generally approaching the useful life of the asset
Types of Financial Leases
Sale and lease back-Special type of Financial lease, assets owned by A are sold to lessor and then leased back to A. This is similar to a direct lease except here A does not originally own the asset, but agreed in advance to lease the asset if lessor could purchase it elsewhere.
Leveraged lease: The lessor finances the asset predominantly with debt. The lendor gets first lien on the asset and in the event of a default, the lender takes the lease payments directly.
Leases and Taxes Taxes play an important and frequently changing role in leases IRS currently recognizes two types of leases. Well ok, actually one 😉 If the IRS classifies the lease as a True lease, the lessee is allowed to deduct lease payments and the lessor is allowed to take depreciation. Over the years the types of leases that qualify as a True Lease have become more restricted.
For instance back in 1995 the IRS ruled that 5 requirements must be met to be a “true” lease:
The estimated market value at the end of the lease must be 20% or more of the original cost (in real terms)–in English the lease must not use up all of the assets’ value. The asset must have at least 20% of its useful live remaining. The lessee must not be able to purchase the asset below fair market value at the end of lease. The lessor must have a minimum “at risk” investment equal to 20% or more of the cost. The lessor must make a fair return (similar to loans)
This section is from Financial Management by Ramesh Rao. I recommend this book quite highly!
Accounting for leases In earlier times many managers tried to get around bond covenants and or other balance sheet issues by using leasing. For example if a lease gave the firm the use of an asset but the asset was not classified as an asset ROA would be higher, or on the other side of the balance sheet the firm could finance the asset without incurring debt.
To attempt to end this “Off Balance-Sheet Financing” FASB #13 (1976) requires firms to capitalize financial leases if any of the following: if ownership is effectively transferred if lessee can purchase the property or renew lease at less than market value if lease is for 75% or more of the asset’s useful live the PV of lease payments is 90% or more of asset’s value at inception If any of these are met, then the firm must classify the asset and the PV of lease payments as a liability. Operating leases still can get around this provision but they must be commented in a footnote to the lessee’s financial statements. Net Advantage to Lease (NAL)
Reservation Price of Lessee: (this is the most that the lessee should ever pay) NPV of lease = cost – Lmax(PVAF, r, n) solve for Lmax = cost/Pvaf(r,n) Reservation Payment of Lessor: this is the minimum that the lessor would accept NPV of lease=0= – cost + Lmin(1-tax rate)*PVAF(r,n) + PV of depreciation tax shield solve for Lmin
Other (fairly miscellaneous) comments on leasing
- The more sensitive the asset value is to maintenance, the more likely it is purchased since ownership gives better incentives to keep the asset “up”
- Leasing can also be a way around laws etc. (suppose foreigners were not allowed to own land in a country)
- Third party lessors have certain advantage over manufacturers in that the basis for manufacturers is their cost of production. For 3rd party lessors, it is the purchase price. That said the manufacturer’s gain can often be deferred if they lease rather than sell.
NB: The lease vs. Buy decision is largely (but not exclusively) a decision on how to finance the asset.
Thus, the decision should be made after you have already decided to acquire the use of the asset. In consumer markets in particular, leasing has become popular as it allows customers to acquire the use of a more expensive item than they would be willing to pay for (of course the classic example of this is in auto leasing–monthly lease payments tend to be lower so many customers lease the car.) Hints: always run NPV analysis. Use after-tax cost of debt as the discount rate because the cash flows are low risk and seen as an alternative to borrowing.
Things to consider: if you will use the asset more than the terms allow. If so what are the “penalties”? What is the residual value (expected value of the asset at the end of the lease)? Would you be willing to buy it then? Would you be able to sell it for more than that?