5016 - Investment and Financial Analysis - Leasing p313 - 343 Flashcards
What is leasing
Rather than purchasing an asset you may choose to finance it by equity and debt through leasing assets
According to the Finance and Leasing Association, how much of fixed investments are leased
30% of all fixed investment, 50% for smaller firms
Leveraged Lease
Leasing Company borrows the funds to purchase the asset
Operating Lease Definition
An asset is leased to many users over the life of the asset
Finance Lease Definition
An asset is leased to one user over its life
Who maintains legal ownership of an asset in a lease agreement?
The lessor, or leasing company
Operating Lease Characteristics
- 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
Financial Lease Characteristics
- 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
Direct Finance Lease
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
Reasons for leasing
- 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- Reduces risk of obsolescence (becoming outdated)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
WDA on depreciating assets
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.
Lease Payments in relation to tax
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.
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.
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
Leasing example using WDA:
Lease cost of 23k a year, tax rate 20%
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
Is buying or leasing better?
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
Annuity meaning
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
Smith and Wakeman (JOF 1985) findings on factors behind likelihood of leasing
- Sensitivity of the asset to use and maintain
- Degree of which asset is specialised to firm
- Expected period of use relative to the lifespan of the asset
- Degree of market power held by lessor
- Degree to which lessor holds an advantage in asset disposal
Fawthrop and Terry (JBFA 1975) findings on leasing
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
Sykes (IBM 1976) reasons for leasing
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
Hill and Hubbard (Cranfield 1979) reasons for leasing
Conserved cash flow (54%)
Cheaper than purchase (45%)
Additional source of finance (27%)
Sale and Leaseback
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
Which party is the Lessee
The person leasing the equipment off a lessor
Which party is the Lessor
The person leasing the equipment to a lessee
