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Lease Financing: Dr. Md. Anwar Ullah, FCMA Southeast University

The document discusses lease financing, including the basics of leasing agreements and the main types of leases. It covers the accounting treatment of operating leases and financial leases, with financial leases requiring capitalization on the balance sheet. Criteria for classifying a lease as a capital lease are outlined. An example leasing decision is presented and analyzed using net present value calculations to compare leasing versus buying an asset. Reasons for and against leasing are briefly discussed.

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102 views13 pages

Lease Financing: Dr. Md. Anwar Ullah, FCMA Southeast University

The document discusses lease financing, including the basics of leasing agreements and the main types of leases. It covers the accounting treatment of operating leases and financial leases, with financial leases requiring capitalization on the balance sheet. Criteria for classifying a lease as a capital lease are outlined. An example leasing decision is presented and analyzed using net present value calculations to compare leasing versus buying an asset. Reasons for and against leasing are briefly discussed.

Uploaded by

asif rahan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Presented by

Lecture 12 Dr. Md. Anwar Ullah, FCMA


Southeast University

Lease
Financing

1
Lease Basics

– A lease is a contractual agreement


between a lessee and lessor.

– The lessor owns the asset and for a fee


allows the lessee to use the asset.
Types of Leases
1. Operating Leases
2. Financial Leases

Operating Leases
• Usually not fully amortized.
• Usually require the lessor to maintain and
insure the asset.
• Lessee enjoys a cancellation option.
Financial Leases
1. Do not provide for maintenance or service by
the lessor.
2. Financial leases are fully amortized.
3. The lessee usually has a right to renew the
lease at expiry.
4. Generally, financial leases cannot be cancelled.
Lease Accounting

• Financial leases are essentially treated as debt


financing

– Present value of lease payments must be included on


the balance sheet as a liability

– Same amount shown on the asset as the “capitalized


value of leased assets”

• Operating leases are still “off-balance-sheet”


and do not have any impact on the balance
sheet itself
Criteria for a Capital Lease
• If one of the following criteria is met, then the
lease is considered a capital lease and must
be shown on the balance sheet
– Lease transfers ownership by the end of the lease
term
– Lessee can purchase asset at below market price
– Lease term is for 75 percent or more of the life of
the asset
– Present value of lease payments is at least 90
percent of the fair market value at the start of the
lease
Capital Lease
• A lease must be capitalized if any one of the
following is met:
– The present value of the lease payments is at least 90
percent of the fair market value of the asset at the start of
the lease.

– The lease transfers ownership of the property to the lessee


by the end of the term of the lease.

– The lease term is 75 percent or more of the estimated


economic life of the asset.

– The lessee can buy the asset at a bargain price at expiry.


Leasing Decision
Consider a firm that wishes to acquire a Covered Van. The Van is
expected to reduce costs by Tk.4,500 per year.

The Van costs Tk.25,000 and has a useful life of 5 years. If the
firm buys the Van, they will depreciate it straight-line to zero.

They can lease it for 5 years from Tiger Leasing with an annual
lease payment of Tk.6,250.

Assume tax rate is 34% and required rate is 5%. You are
required to give decision based on NPV analysis.
The Cash Flows of Leasing
• Cash Flows: Buy
Year 0 Years 1-5
Cost of Van –Tk.25,000
After-tax savings 4,500×(1-.34) = Tk.2,970
Depreciation Tax Shield 5,000×(.34) = Tk.1,700
–Tk.25,000 Tk.4,670

• Cash Flows: Lease


Year 0 Years 1-5
Lease Payments –6,250×(1-.34) = – Tk.4,125
After-tax savings 4,500×(1-.34) = Tk.2,970
–Tk.1,155
The Cash Flows of Leasing

• Cash Flows: Leasing Instead of Buying


Year 0 Years 1-5
Tk.25,000 –Tk.1,155 – Tk.4,670 = –Tk.5,825

• Cash Flows: Buying Instead of Leasing


Year 0 Years 1-5
–Tk.25,000 Tk.4,670 +Tk.1,155 = Tk.5,825

• However we wish to conceptualize this, we need to have an


interest rate at which to discount the future cash flows.
• That rate is the after-tax rate on the firm’s secured debt.
NPV Analysis
of
The Lease-vs.-Buy Decision
• A lease payment is like the debt service on a
secured bond issued by the lessee.

• In the real world, many companies discount


both the depreciation tax shields and the
lease payments at the after-tax interest rate
on secured debt issued by the lessee.
NPV Analysis of the Lease-vs.-Buy Decision
• There is a simple method for evaluating leases: discount all cash
flows at the after-tax interest rate on secured debt issued by the
lessee.
NPV Leasing Instead of Buying
Year 0 Years 1-5
Tk.25,000 –Tk.1,155 – Tk.4,670 = -Tk.5,825

5
Tk.5,825
NPV  Tk.25,000   t
 Tk.219.20
t 1 (1.05)
NPV Buying Instead of Leasing
Year 0 Years 1-5
-Tk.25,000 Tk.4,670 – Tk.1,155 = Tk.3,515
5
Tk .5,825
NPV  Tk .25,000   t
 Tk .219.20
t 1 (1.05)
Reasons for Leasing
• Good Reasons
– Taxes may be reduced by leasing.

– The lease contract may reduce certain types of


uncertainty.

– Transactions costs can be higher for buying an


asset and financing it with debt or equity than for
leasing the asset.

• Bad Reasons
– Accounting

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