Business Finance Leasing PDF

MODULE BUSINESS FINANCE CHAPTER 7 LEASING Learning Objectives: 1. Explain the meaning of lease 2. Enum...

MODULE BUSINESS FINANCE CHAPTER 7 LEASING Learning Objectives: 1. Explain the meaning of lease 2. Enumerate the types of leases 3. Analyze basic lease provisions 4. Understand the advantages & disadvantages of leasing Lease is a process of obtaining economic use of an asset for a specified period of time without obtaining ownership of the said asset. In a lease contract, the property owner (lessor) agrees to permit the use of his property to a lessee for a period of time. In return the lessee agrees to make a series of periodic payments to the lessor. "Financial leasing companies engage in financing the purchase of concrete assets. Though leasing company is the legal owner of the goods, the ownership and possession is effectively conveyed to the lessee, who earns all benefits, costs, and risks linked to ownership of the assets.” Types of Leases 1. Operating leases, also known as service or maintenance lease. It is an agreement that provides the lessee with the use of an asset on a period-by-period basis. Normally, the payments under an operating lease contract are insufficient to recover the full cost of the asset for the lessor. As a result, the contract period tends to be less than the useful economic life of an asset, and the lessor expects to recover the costs, and have a return, from renewal rental payments, sale of an asset at the end of the contract. 2. Financial or capital leases is a non-cancellable contract in which the lessee is required to make payments throughout the lease period, whether or not the asset is needed. One type is known as leveraged lease, under which the lessee selects the leased asset needed for business and makes the periodical lease payments. The lessor provides the equity funds needed to purchase the asset which typically amounts to 20 to 40 percent of the cost. The lenders provide the balance of funds needed to purchase the asset, which may amount to 60-80 percent of the cost. Leveraged leases provide financing for assets that require large capital outlays. 3. Sale and Lease Back. It is an arrangement wherein the owner of the asset may sell it to the leasing company and lease it back. Such an arrangement is adopted when the firm faces shortage of funds. The firm can overcome liquidity problem and at the same time retain use of the asset. 4. Leveraged Lease. Under this arrangement, the lessor borrows funds from the lender and provides a part of the money to acquire the asset. The lessor services the debt out of lease rentals. Thus, there is third party (lender) in addition to the lessor and the lessee. The lender is usually a financial institution or a commercial bank. Leverage lease is used in case of very large assets such as a ship or an aero plane. Page 1  MODULE BUSINESS FINANCE Basic Lease Provisions Standard lease provisions that set forth landlord and tenant rights and obligations include the following important clauses:  The names of the parties - While this may sound obvious, you want to make sure that everyone who is a party to the lease (such as sublessors) is accounted for in case a problem arises.  A description of the rental property - Does the rental property include a parking space? What about the locked storage unit attached to the building?  The term, or length, of the lease - When does the lease end? Is there a lease renewal provision? Without this, the term often reverts to month-by-month, with no obligation to stay for a fixed term.  The amount of rent - This is best set in writing, so as to clear up any possible confusion.  The due date of the rent - Again, all parties should be clear on rent amount, when the monthly rent is due, how much (if any) time may pass before a late fee or another adverse action is taken, etc.  The amount of the security deposit - This sometimes comes as a surprise to tenants; make sure it's clarified up-front.  Whether the tenant is subject to late fees - If it's not in the contract, the landlord can't charge a late fee.  Maintenance responsibilities - Often, property managers will make it clear what they will and what they won't fix, and the procedure for getting something fixed.  Options to renew - Make sure this is cleared up ahead of time, so you know what to expect at the end of your lease.  Termination notice requirements - If either party has to terminate the lease, you'll want to have a procedure in place ahead of time.  When the landlord may enter the rental property - Landlords must respect your privacy, but also have a right to enter the property under certain conditions. Get this in writing to prevent any surprises.  Rules concerning pets - Apartments that allow pets often certain rules for noise, the types of animals allowed, where they may urinate, etc. Page 2  MODULE BUSINESS FINANCE The Advantages of Leasing Leasing brings six major advantages, and all directly involve the company’s cash flow. Essentially, the advantage to leasing over buying is that there’s usually no large outlay of cash at the beginning of the lease as there is with an outright purchase.  100 percent financing: Many business leases come with 100 percent financing terms, which means no money changes hands at the inception of the lease. Can you imagine what a boon to cash flow this can be? Well, it’s not totally cash-free, because the lessee has to make the lease payments each month. But many times the assumption is that the company will be making the payments from future cash flows — in other words, from enhanced revenues that the company earns because of the lease.  Obsolescence: Another advantage to leasing is working around obsolescence, which means the company anticipates frequently replacing the fixed asset. For example, many larger clients lease rather than purchase their computer equipment so they can stay current with new and faster computer processing technology.  Flexibility: Asset flexibility is another leasing advantage. Based on the relationship between the lessor and the lessee, the lease may be for either just a few months or the entire expected life of the asset. Or let’s say an employee for whom the company leases a vehicle leaves the company. Predicated on the terms of the lease, the company doesn’t have to worry about advertising the car for sale and trying to find a buyer, as it would with an owned vehicle — the company just turns the car back in to the leasing company.  Lower-cost financing: Based on many different variables, a company may be able to utilize tax benefits associated with leasing. This topic is a more complicated tax issue that is more appropriate for your taxation classes.  Tax advantages: Separate from any tax benefit a company may gain, lease payments can reduce taxable income in a more appropriate manner than depreciation expense. Remember that you treat operating leases like rentals by expensing the entire lease payment when the business makes it.  Off-balance-sheet financing: Finally, operating leases provide off-the- books (or balance sheet) financing. In other words, the company’s obligation to pay the lease, which is a liability, doesn’t reflect on the balance sheet. This can affect a financial statement user’s evaluation of how solvent the company is because he will be unaware of the debt—hence the importance of footnotes to financial statements. Page 3  MODULE BUSINESS FINANCE Other Advantages of Leases:  Liquidity. The lessee can use the asset to earn without investing money in the asset. He can employ his funds for working capital needs.  Convenience. Leasing is the easiest method of financing fixed assets. No mortgage or hypothecation is required. Restrictions involved in long-term borrowing from financial institutions are avoided. Formalities involved in leasing are much less than in case of borrowing from financial institutions.  Hidden Liability. Lease obligations are not reported as a liability in the company’s balance sheet. On the other hand, loans raised to buy assets are reported as liability. Thus, leasing helps the lessee to report a better debt-equity ratio.  Time Saving. The asset is available for use immediately without loss of time in applying for the loan, wanting for approval and sanction, etc. Lease rentals can be matched with cash flows of the lessee.  Cost Saving. Lease rentals are deductible from taxable income. The lessee has lower obligation in bankruptcy than under debt financing.  Flexibility. Leasing arrangement is more flexible. The rental schedule can be adjusted to accommodate genuine needs and problems of the lessee.  Disadvantages:  The lessee gets only the right to use the asset. In case the leasing company is wound up the asset may be taken back from the lessee thereby disrupting his operations.  The lessee cannot make alterations or improvements in the asset without the prior approval of the lessor. The lessor may also put some restrictions on the lessee.  The lessee has to pay lease rentals on a regular basis to the lessor. For further discussion, please refer to the link provided: Leasing https://www.youtube.com/watch?v=oQHEVMAjB6Q For further discussion, please refer to the link provided: Types of leases https://www.youtube.com/watch?v=AjJ5qFPMPEs REFERENCES: Basic Business Finance: Management Approach, 2nd Ed., BY: Ruby F. Alminar-Mutya Page 4