Leasing & Off Balance Sheet Financing

Question 1

Explain leasing

Answer 1

-> where one party (lessee- company we represent) obtains use of an asset for a period of time, whereas the legal ownership of the asset remains with the other party (lessor)

Question 2

Reasons for leasing

Answer 2

1. Lack of alternative sources of funds (at the right price at the right time)
2. Considerable tax advantages as has expenses that act as a tax shield
3. Firms may prefer to lease rather than buy which occurs when certain assets have higher levels of risk attached
4. The lease contract may reduce certain types of uncertainty by ensuring that production or service takes place immediately
5. Transaction costs can be higher for buying an asset and financing it (legal costs) with debt or equity than for leasing the asset

Question 3

Sale and leaseback characteristics

Answer 3

1. a firm that owns land sells to another firm
2. simultaneously agree to lease property back for a stated period under specific terms (20 yrs) (what can land be used for? Restrictions?)
3. the seller receives cash immediately and has created a regular cash flow liability for itself
4. efficiency boost because managers are made more aware of the value of land used in business

Question 4

Sale and leaseback disadvantages

Answer 4

1. land is no longer owned by the firm and therefore any capital appreciation is lost (land only asset that appreciates once sold that it lost)
2. rental payments can increase at regular intervals after the initial sale + lease back contract of 20 years
3. eliminates the flexibility to move to cheaper premises (increase cash flow directly)
4. complex documentation and large legal fees because leasing period is over 20 years and therefore there is need to protect property of the lessee
5. the property is no longer available to be offered as security for loans which prevents more raising of debt in any form

Question 5

Operating lease vs Financial lease

Answer 5

OL
- more expensive because risk is bore by the lessor
- for a specific task over a short time period
- disclosed in footnotes and therefore off balance sheet financing
- can be easily terminated

FL
- less expensive as risk is bore by lessee
- purpose is more general
- capitalised in balance sheet
- harder to terminate as long term lease

Question 6

Operating lease characteristics

Answer 6

1. Referred to as part payout leases
2. Short term in nature
3. Multiple lessees over the assets life
4. Lessee does not bear risk of ownership
5. The lessor maintains and insures the leased assets
6. Lessee has the right to cancel the lease contract before the expiration date

Question 7

Financial lease characteristics

Answer 7

1. Referred to as capital leases or full payout leases
2. Very similar to borrowing and buying
3. The lessee faces all the risks of ownership
4. Do not provide for maintenance or service by the lessor
5. Lessee has the right to renew the lease on expiration
6. Leases cannot be cancelled