• Companies have usually several options when acquiring capital equipment.
• There are at least three possibilities:
– lease
– buy and finance through a loan – buy with cash on hand
• Cash flows of these three options are driven by several components including
• interest and discount rates, effective tax rate, number of depreciable years for tax purposes, how long the equipment will be used, and the salvage value at the end of its use
• Simply comparing different cash flows in different time periods may not be practical in order to arrive at a capital investment decision.
• Hence there is a need for a metric that can accurately summarize these cash flows for each investment option.
• Net present value (NPV) is such a metric. NPV is calculated as the sum of present values of current and future cash flows.
• The focus on NPV forces companies to identify all cash flows from these three lease-or-buy options, which ensures that not only the month-to-month payments are considered.
• Hence, from a purely financial point of view, companies should acquire capital equipment based on the option with the lowest NPV.
58
• By leasing, the company can use its cash for investment in its core business rather than in the infrastructure required to run it.
• Equipment that is often leased includes computers and peripherals, office furniture, manufacturing and construction equipment, and commercial vehicles.
• Between leasing and financing, leasing usually offers the lowest month-to-month payments.
• But there are also other costs associated with a lease, especially the residual value of the equipment and the buyout price agreed with the leasing company upfront.
• Some lessees make the mistake of focusing on the low monthly payments and don't consider also the choices that they will need to make at the end of the lease.
• Lessees should keep in mind for example that they may need to continue using the equipment, which may require extending the lease or buying out the equipment.
• Both choices may generate additional costs
• Financing the purchase through a loan may make more sense if the company needs to use the equipment longer than just few years.
• Cash purchase could be the preferred option, on the other hand, if the equipment is needed for longer period of time and the interest rate of the lease or loan significantly exceeds company's cost of capital.
59
History
• Leasing techniques have been used for financing purposes for several decades in the United States.
• The practice developed as a method of financing aircraft.
• Several airlines in the early 1970s were notoriously unprofitable and very capital intensive. A very prominent bank would purchase aircraft and lease them to the airlines.
• These airlines had no need for the depreciation deductions generated by their aircraft and were significantly more interested in reducing their operating expenses.
• Because the bank was able to claim depreciation deductions for the aircraft,
• the bank was able to offer lease rates significantly lower than the interest payments that airlines would otherwise pay on an aircraft purchase loan (and most commercial aircraft flying today are operated under a lease).
• In the United States, this spread into leasing the assets of U.S. cities and governmental entities and eventually evolved into cross-border leasing.
• In a globalizing environment, cross-border leasing has not picked up the way it might have been expected.
• Cross-border lease transactions are generally restricted to aircraft leasing, where this is the most popular means of financing, marine equipment and railroad rolling stock to some extent.
60
SUMMARY
A lease is an agreement for the use of the asset for a specified rental. The owner of the asset is called the lessor and the user the lessee. Two important categories of leases are: operating leases and financial leases. Operating leases are short team, cancellable leases where the risk of obsolescence is borne by the lessor. Financial leases are longterm, non-cancellable leases where any risk in the use of the asset is borne by the lessee and he enjoys the returns too. The other sub-parts of finance lease are: sale and lease back and leveraged financing. Under sale and lease back lease the owner of an asset sells the asset to a party, who in turn leases back the same asset to the owner in consideration of lease rentals. Under leveraged leasing a third party (i.e. financier or lender) is involved beside lessor and lessee. Direct lease another type of leases, which is popularly used. Under this, a firm acquires the right to use an asset from the manufacturer directly. Leasing plays an important role in the economic development of a country by providing money incentives to lessee. Lease financing has several advantages. In India, the First Leasing Company Ltd. was set up in Madras in 1973. As per the industrial investment, lease finance in India just like a newborn baby. Hire purchase and factoring are the other forms of financial services. Hire purchase is a type of instalment credit under which the hire purchaser agrees to take the goods onhire at a stated rental. The system of the hire purchase is regulated by the Hire Purchase Act 1972. Small scale firms suffer from the problem of dearth of funds. In this case hire purchase system plays an important role by providing equipment; vehicles etc. on hire purchase without making full payments. NSIC also provides machinery and equipment to Small Scale units on hire purchase basis and on lease basis. Factoring the other financial service under which a financial institution undertakes the task of collecting the book debts of it client
61
GLOSSARY
Capital lease: It is a lease obligation that has to be capitalized on the balance sheet. It is characterized by: it is non-cancelable; the life of lease is less than the life of the asset(s) being leased; and, the lessor does not pay for the upkeep, maintenance, or servicing costs of the asset(s) during the lease period. Sub-lease: A transaction in which leased property is released by the original lessee to a third party, and the lease agreement between the two original parties remains in effect. Wet lease: A wet lease is any leasing arrangement whereby a company agrees to provide an aircraft and at least one pilot to another company. ‗Dry lease‘ on the other hand, refers to leasing only the aircraft.
62
REFRENCE
1. Lease Financing in India by M. Sree Lakshmi 2. Evaluation of Lease Financing by E. Chandraiah
3. Lease Financing & Hire Purchase (Concept, Law & Procedures) With Consumer Credit by S. Venugopalan