5016 - Investment and Financial Analysis - Leasing p313 - 343

Question 1

What is leasing

Answer 1

Rather than purchasing an asset you may choose to finance it by equity and debt through leasing assets

Question 2

According to the Finance and Leasing Association, how much of fixed investments are leased

Answer 2

30% of all fixed investment, 50% for smaller firms

Question 3

Leveraged Lease

Answer 3

Leasing Company borrows the funds to purchase the asset

Question 4

Operating Lease Definition

Answer 4

An asset is leased to many users over the life of the asset

Question 5

Finance Lease Definition

Answer 5

An asset is leased to one user over its life

Question 6

Who maintains legal ownership of an asset in a lease agreement?

Answer 6

The lessor, or leasing company

Question 7

Operating Lease Characteristics

Answer 7

• Generally short term in nature
• Number of lessees over assets life
• The lessee holds no risk of ownership (depreciation, becoming obsolete etc)
• Maintenance and insurance may be included in lease cost - called a Full Service Lease

Question 8

Financial Lease Characteristics

Answer 8

• Lessor sets lease payments to recover the purchase price plus a return
• One lessee (User)
• Contract cannot normally be cancelled by either party
• Lessee faces all risks of ownership

Question 9

Direct Finance Lease

Answer 9

The lessor buys the asset knowing they are going to lease it to someone - they are in a sense buying it to rent to someone

Question 10

Reasons for leasing

Answer 10

• Lack of funds for purchase
• Tax advantages
• Reduces risk of obsolescence (becoming outdated)
• Many leases also provide maintenance
• Can be ‘off balance sheet’
• Low transaction cost
• May avoid capital rationing constraints as lease payments can fall under operating costs

Question 11

WDA on depreciating assets

Answer 11

Depending on the type of asset and when it was purchased, the company may be able to claim an allowance for depreciation anywhere from 10% to 100% of the purchase price.

Question 12

Lease Payments in relation to tax

Answer 12

Lease payments are tax deductible, so if you leased something for 10,000 and your corporation tax rate is 20% you would save 2,000 making it effectively cost 8000 instead.

Question 13

Buying Example using WDA:

£100,000 Asset buying vs leasing. WDA of 40% 1st year followed by 25% for depreciation with 10,000 residual value after 6 years.

Answer 13

Buying:

100,000 cost year 1

Year 1 depreciation of 40% meaning book value of 60k, 40k depreciation discounted at 20% tax rate = 8,000 savings

Year 2 depreciation of 25% meaning book value of 45k, 15k depreciation discounted at 20% tax rate = 3,000 savings

Year 3 depreciation of 25% meaning book value of 33.75k, 11.25k depreciation discounted at 20% tax rate = 2250 savings

Year 4: 8.44k depreciation, discounted at 20% tax rate, saving 1690

Year 5: 6.33k depreciation, discounted at 20% tax rate. saving 1270

Year 6: 4.75k depreciation, discounted at 20% tax rate, saving 950

Book value at end of year 6: 14.24, 10k value at the end meaning a book loss of 4.24 (because your selling a 14.24k asset for 10k), again discounted at 20%, so 0.84, giving 18,000 saving overall through WDA total cost = 82,000

Question 14

Leasing example using WDA:

Lease cost of 23k a year, tax rate 20%

Answer 14

Yr 1: 23,000 x 0.20 = 4.6
Yr 2: 4.6
Yr 3: 4.6…. so on

4.6 x 6 = 27.6k savings, total cost 110,400 compared to buying costing 82,000 so buying much better if you can afford it

Question 15

Is buying or leasing better?

Answer 15

Generally buying is better because how else would the person lessor make a profit, an example of when it may be cheaper to lease is if the leasing company pays a higher corporation tax rate

Question 16

Annuity meaning

Answer 16

Refers to an insurance contract issued and distributed by financial institutions with the intention of paying out invested funds in a fixed income stream in the future

Question 17

Smith and Wakeman (JOF 1985) findings on factors behind likelihood of leasing

Answer 17

1. Sensitivity of the asset to use and maintain
2. Degree of which asset is specialised to firm
3. Expected period of use relative to the lifespan of the asset
4. Degree of market power held by lessor
5. Degree to which lessor holds an advantage in asset disposal

Question 18

Fawthrop and Terry (JBFA 1975) findings on leasing

Answer 18

60% of surveyed companies leased pant and machinery

73% of companies did not treat leasing as debt when calculating gearing

66% said tax benefits of leasing were irrelevant

Question 19

Sykes (IBM 1976) reasons for leasing

Answer 19

Main reason for leasing (76%)was to maintain working capital, 29% cited off balance sheet financing as the reason, 25% for tax reasons, 28% said it was a less restrictive source of financing

Question 20

Hill and Hubbard (Cranfield 1979) reasons for leasing

Answer 20

Conserved cash flow (54%)
Cheaper than purchase (45%)
Additional source of finance (27%)

Question 21

Sale and Leaseback

Answer 21

This is where the lessee sells its asset (Usually property) to a lessor when then leases it back to the lessee, providing them with a capital sum whilst allowing them to retain use of the asset. The buyer (lessor) gains ownership and any gain in value from that ownership

Question 22

Which party is the Lessee

Answer 22

The person leasing the equipment off a lessor

Question 23

Which party is the Lessor

Answer 23

The person leasing the equipment to a lessee