Leasing

Question 1

What is a lease?

Answer 1

A contract that provides a right to use of assets, legally owned by the lessor, in exchange for a specified rental paid by the lessee.

Question 2

Leasing is considered as a source of finance, true or false?

Answer 2

True

Question 3

When is the lease rental normally paid?

Answer 3

Normally paid at the beginning of each month in the period covered by the lease.

Question 4

Lease payment is included in the gross taxable income of the lessor, true or false?

Answer 4

True

Question 5

Is the lessee allowed to deduct the lease payment in calculating his taxable income?

Answer 5

Yes, therefore it is one of the benefit of leasing, the tax saving.

Question 6

What is a finance lease?

Answer 6

A lease that transfer substantially all the risks and rewards associated with the ownership of the asset from lessor to the lessee. Lessee has the option to buy the asset at the end of the lease and is responsible for the maintenance and insurance of the asset. Common source of finance.

Question 7

What is an operating lease?

Answer 7

A lease that does not transfer the risks and rewards of ownership.
Usually short term in nature in relation to the useful life if the asset being leased. The lessor normally assume responsibility for the maintenance and insurance of the asset. This is not considered as a source of finance.

Question 8

List the three most important types of lease.

Answer 8

1. Direct leases
2. Sale and lease back transactions
3. Leveraged leases

Question 9

What is a direct lease?

Answer 9

The lessor acquired the asset in order to lease it to the lessee.

Question 10

What is a sale and lease back transaction?

Answer 10

A firm sells an asset under an agreement to lease it back.

Question 11

What is a leveraged lease?

Answer 11

The lessor does not provide all the funds required to purchase the asset that is to be leased, the balance of the fund would be obtained from other financial institutions and the lease payments made by the lessee are then used to service the loans.

Question 12

What are the effects of leasing on financial statements?

Answer 12

Leasing was often perceived as providing off balance sheet financing. (Major advantage of leasing) as the firm do not own the asset, the leased assets and the liability reflected in the lease contract may not be reflected in the balance sheet. Buying usually resulted in increase in financial leverage (higher financial risk) therefore leasing does not affect the company’s financial leverage ratio.

Question 13

What are the requirements of the IAS 17 financial lease?

Answer 13

A lease should be classified as a finance lease are as followed:

1. A lease transfers ownership of the asset to the lessee by the end of the lease term
2. Lessee has the option to purchase the asset at a price lower than the fair value
3. The lease term is for the major part of the economic life of the asset
4. The inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset
5. Leased assets are of such a specialized nature that only the lessee can use them

Question 14

What are the advantages of leasing?

Answer 14

1. Changing technology
2. Tax advantage
3. Obtaining 100% debt financing
4. Operating flexibility
5. Reduction in operating leverage
6. Coping with uncertain demands
7. Specialization effect on maintenance, residual value and purchase costs
8. Standardization of contracts
9. Fewer restrictions
10. Off balance sheet financing
11. Avoidance of capital expenditure controls and budgetary constraints

Question 15

Is leasing considered as a financing decision or an investing decision?

Answer 15

Financing decision, as the assumption is that the investment proposal has already been accepted

Question 16

What is the appropriate discount rate for calculating the net present cost of a lease?

Answer 16

After tax cost of debt

Question 17

What is the difference in the appropriate discount rate for financing and investing decisions?

Answer 17

For investment decision, the weighted averaged cost of capital (WACC) should be used.
For finance decision, the after tax cost of debt should be used.

Question 18

How do you evaluate a lease?

Answer 18

Lease can be evaluated by cash flow analysis. We started with the assumption that the asset, as a result of a positive net present value, will be acquired, and that the acquisition will be financed either by debt or lease. Next we develop the annual net cash outflows associated with each financing option. Finally we discount the two sets of outflows at the company’s after tax cost of debt and choose the alternative with the lowest net present cost. The difference between the net present cost of leasing and borrowing to purchase is called the net advantage of leasing.

Question 19

Why is the after tax cost of debt used for leasing decisions?

Answer 19

To ensure comparability to the alternative financing option