Lease Financing

Leasing is defined as a contractual arrangement where a party owning an asset, known as the lessor, provides the asset for use to another party, the lessee, for a certain period of time. The consideration for this right to use the asset is typically in the form of periodic payments called lease rentals. Leasing can also involve an initial down payment. Essentially, leasing is a form of renting assets and provides a firm with the use and control over assets without the need to buy and own them. It serves as a source of finance and is considered an alternative to the purchase of an asset out of one’s own funds or borrowed funds. Lease finance can often be arranged much faster compared to term loans from financial institutions. Leasing is listed as a long-term source of finance, typically for requirements over 5 years, but is also mentioned as a medium-term source, for periods between 1 and 5 years.

Parties and Elements

The core parties to a lease financing contract are the lessor and the lessee.

• Lessor: The owner of the assets being leased. Lessors can include individuals, partnerships, joint stock companies, corporations, or financial institutions. Rights of the lessor include ownership of the asset, claiming depreciation, ensuring fair use of the asset within agreement limitations, collecting rentals, and the right to sue in case of agreement breach. Lessor in most cases are corporates only, including banks or bank-affiliated firms, captive leasing companies (subsidiaries of equipment manufacturers), independent leasing companies, and others like investment bankers and brokers who bring parties together.
• Lessee: The receiver of the service of the assets under the lease contract. Lessees are typically firms or companies. They make the periodic payments (lease rentals) for the right to use the asset.
• Lease Broker: An agent or intermediary who acts between the lessor and lessee to arrange lease deals. Examples include merchant banking divisions of foreign banks, subsidiaries of Indian banks, and private foreign banks.
• Lease Assets: The assets that can be leased are varied and may include plant, machinery, equipment, land, automobiles, factory buildings, and more.
• Lease Term: The period for which the lease agreement operates. This term can be fixed in the agreement or extend up to the expiry of the asset’s life. A lease term is a non-cancellable period for which the agreement remains in operation. However, cancellation might be possible during emergency situations with the lessor’s permission.

Types of Lease Contracts

Lease contracts can be broadly categorized in several ways according to the sources:

1. Based on Term/Nature:
   • Financial Lease (or Capital Lease): These leases cover the whole economic life or the major part of the useful life of an asset. They are long-term and non-cancellable contracts. The lessee cannot terminate the agreement subsequently or prior to its expiration date. Financial leases transfer substantially all the risks and rewards incidental to ownership of an asset. They are also known as full pay-out leases because the lessor is able to recover the total purchase cost of the asset through lease rentals. The present value of the total lease rentals payable often exceeds or is substantially equal to the fair value of the asset, implying the lessor recovers their investment and an acceptable return within the lease period. Ownership remains with the lessor, although title may or may not eventually be transferred. In a financial lease, the lessee is typically responsible for all risks and rewards associated with the asset, including bearing all costs of repairs, maintenance, insurance, and services, although in some cases, the lessor might maintain the asset in a ‘maintenance’ or ‘gross’ lease arrangement. Financial leases are common for assets like plant, machinery, land, buildings, ships, and aircraft. It can be regarded as any leasing arrangement that finances the use of equipment for the major part of its useful life and is sometimes described as a loan in disguise. Such leases usually provide the lessee with an option to renew for a further period at a normal rent.
   • Operating Lease (or Service Lease): This is a short-term lease. The lease period is less than the useful life of the asset. Operating leases are usually cancellable at short notice by the lessee. They do not amortize the original cost of the asset; the lessor must make further leases or sell the asset to recover their investment and expected return. Operating leases do not transfer substantially all the risks and rewards incidental to ownership and are considered merely a rental. The lessor usually bears insurance, maintenance, and repair costs. Examples include cars, computers, tractors, or air-conditioners, leased for periods like a month, six months, a year, or three years. Operating lessors often focus on large numbers of similar types of machines or equipment.
2. Based on Method:
   • Sale and Lease Back: Under this arrangement, the owner of an asset sells it to another party (the buyer/lessor), who then leases the same asset back to the original owner (now the lessee). The asset does not physically change hands; the transaction happens in records only. This method allows the lessee to free up operating capital and ensures the lessee is satisfied with the asset’s quality before converting the sale into a lease agreement.
   • Direct Lease: While not explicitly defined beyond being a type of lease, this generally implies a standard lease agreement where the lessor acquires the asset specifically to lease it to the lessee.
3. Based on Parties Involved:
   • Single Investor Lease: Implies a lease where only the lessor’s funds are used to acquire the asset.
   • Leveraged Lease: This lease involves three parties: the lessee, the lessor, and a lender/creditor (usually a financial institution or bank). The lessor finances the purchase of the asset by contributing some of their own funds (equity) and borrowing the rest from the lender. The lender typically receives a senior secured interest and an assignment of the lease and lease payments. The lessee pays lease rentals, which may go into an escrow account from which the lender deducts loan instalments (principal and interest) before the balance is transferred to the lessor. Leveraged leases are used for larger acquisitions.
4. Based on Area:
   • Domestic Lease: Lessor and lessee are in the same country.
   • International Lease (or Cross Border Leasing): Lessor and lessee are located in different countries.
5. Other Types:
   • Commodity Leases: Mentioned as a type of asset that can be leased.
   • Sales-aid Lease: The lessor enters an agreement with a manufacturer to market the manufacturer’s product through the lessor’s leasing operations. The manufacturer may provide credit or commission to the lessor.
   • Close-ended Lease: At the end of the lease term, the asset is transferred back to the lessor. The lessor retains the risk of obsolescence and residual value.
   • Open-ended Lease: The lessee has the option to purchase the asset at the end of the lease period.
   • Short Term Lease: Typically for assets with high depreciation eligibility, like computers, for periods of 2-3 years. Useful for corporates with high obsolescence risk or high taxable income in the near future.
   • Alternative Lease Rental Structures: Lease rents can be structured in different ways, such as Equated (fixed payments), Stepped (increasing payments over time), Ballooned (smaller initial payments, large lump sum at the end), or Deferred Payment (no rent in the initial period).

Benefits of Lease Financing

Leasing offers several potential advantages:

• Source of Financing: Provides a way to acquire the use of an asset without a large upfront purchase cost, freeing up capital for other purposes.
• Financing of Fixed Assets.
• Assets-Based Finance.
• Convenience, Simplicity, and Low Transaction Cost.
• Potentially Lower Cost: Mentioned as having a low rate of interest, although another source lists being costlier than buying on credit as a disadvantage.
• Reduced Risk: Can help reduce certain risks. For example, in an operating lease, the lessor typically bears the risk of obsolescence and residual value.
• No Dilution of Ownership or Control: Unlike issuing equity or taking on traditional debt, leasing does not dilute the promoters’ ownership or control of the company. Lenders in institutional financing may impose restrictive conditions (like board representation or debt-to-equity conversion), which are not present in lease financing, enhancing the firm’s operational independence.
• Access to Assets: Allows immediate use of an asset without immediate purchase payment.
• Tax Shield: Lease payments are generally deductible for tax purposes, acting as a tax shield. Source suggests the tax shield from lease rentals (full deduction) can be more beneficial than the tax shield from loan payments (only interest and depreciation deductions).
• Improved Borrowing Capacity: Lease obligations may not appear as debt on the balance sheet, potentially improving the firm’s capacity to borrow funds through other means.
• Faster Arrangement: Lease finance can be arranged more quickly than term loans from financial institutions.

Limitations of Lease Financing

Despite the advantages, leasing also has limitations:

• Restrictions on Use: The lessor may impose limitations on how the leased asset can be used, and the lessee may not be allowed to make alterations to suit their specific needs.
• High Payout Obligation: A financial lease, being non-cancellable, may result in a high payment obligation for the lessee even if the equipment proves not useful later, especially if they opt for premature termination.
• No Ownership: In most cases, the lessee does not become the owner of the asset and is thus deprived of the asset’s residual value. There is also a deprivation of potential profits from asset appreciation.
• Cost: One source lists it as potentially costlier than buying on credit.
• Long-Term Obligation: Lease financing creates long-term legal obligations, requiring the firm to pay rent even if its operations cease.

Lease vs. Buy Evaluation

Firms often face the decision of whether to purchase an asset or acquire it on lease. Evaluating this involves comparing the relevant cash flows and tax savings associated with each option. This comparison often involves calculating the present value of the cash outflows for both the ‘buy’ option (including purchase cost, loan payments if applicable, maintenance, and considering depreciation tax shields) and the ‘lease’ option (including lease rentals and the tax shield on lease payments).

A related concept is the Break-Even Lease Rental (BELR). This is the lease rental amount at which the buying and leasing options are equally preferable. In a leveraged lease, the BELR is the minimum lease rental the lessor must quote to recover their equity investment by the net cash flow (lease rental less loan instalment payments) at their required rate of return.

Types of lease agreements

Leasing is fundamentally a contractual arrangement where the owner of an asset, the lessor, grants another party, the lessee, the right to use that asset for a specified period. The lessee provides consideration, typically in the form of periodic payments called lease rentals. The lease term is the period for which the agreement is in effect, which can be fixed or extend up to the asset’s life. Leasing provides a firm with the use and control over assets without requiring them to purchase and own the assets.

Lease contracts can be broadly classified in several ways based on different criteria:

1. Lease Based on Term/Nature:

This is a primary classification and includes Financial Lease and Operating Lease.

• Financial Lease (or Capital Lease):
  • These leases are long-term contracts that are generally non-cancellable by either party. The lessee cannot terminate the agreement before its expiration date. However, cancellation might be possible during emergencies with the lessor’s permission.
  • A financial lease typically covers the entire economic life or a major portion of the useful life of the asset.
  • A defining characteristic is that a financial lease transfers substantially all the risks and rewards incidental to ownership of an asset.
  • They are also known as full pay-out leases because the lessor is able to recover the total purchase cost of the asset through the lease rentals over the lease period. The present value of the total lease rentals payable usually equals or exceeds the fair value of the leased asset, meaning the lessor recovers their investment and an acceptable return within the lease term.
  • Ownership of the asset typically remains with the lessor, although title may or may not eventually be transferred.
  • In a financial lease, the lessee is generally responsible for all risks and rewards associated with the asset. The lessee also typically bears all costs for repairs, maintenance, insurance, and services. However, sometimes the lease agreement may require the lessor to maintain the asset; this is called a “maintenance or gross lease”.
  • Financial leases are commonly used for assets like plant, machinery, land, buildings, ships, and aircraft. The leased asset is often of a specialized nature used by the lessee without major modifications.
  • A financial lease can be viewed as any leasing arrangement that finances the use of equipment for the major part of its useful life. It is sometimes described as a loan in disguise.
  • Financial leases usually provide the lessee with an option to renew for a further period at a normal rent.
  • One source states that compared to an operating lease, a financial lease is for a shorter period of time. However, multiple other sources state that a financial lease is for a longer period and covers the major part or whole economic/useful life of the asset, in contrast to the short-term nature of an operating lease.
• Operating Lease (or Service Lease):
  • This is a short-term lease. The lease period is less than the useful life of the asset.
  • Operating leases are usually cancellable at short notice by the lessee.
  • The lease payments under an operating lease are generally not enough to cover the full cost of the equipment. The lessor must lease the asset to other parties or sell it at the end of the term to recover their initial investment and expected return, as the lease does not necessarily amortize the original cost.
  • Operating leases do not transfer substantially all the risks and rewards incidental to ownership.
  • The asset reverts back to the lessor at the end of the lease term.
  • There is conflicting information regarding who bears maintenance costs in an operating lease. Some sources state the lessor usually bears costs like insurance, maintenance, and repairs. Another source indicates that in an operating lease, the lessee usually pays for maintenance and service costs, and this is known as a “net lease,” unless it’s a gross lease. Some lessors who limit activities to similar equipment offer attractive terms due to savings in maintenance costs.
  • The lessee is not entitled to the entire risks and rewards associated with the leased equipment.
  • Operating lessors often focus on large numbers of similar machines or equipment.
  • Examples of assets typically leased under operating leases include cars, computers, tractors, or air-conditioners, for periods like a month, six months, a year, or three years.
  • Operating lease rentals may be higher compared to other leases due to the short basic lease period.
  • An operating lease is considered merely a rental.

Comparison Summary (based on differences highlighted in sources):

• Term: Financial is longer, covering major useful life vs. Operating is shorter, less than useful life. (Note: one source contradicts this).
• Cancellability: Financial is non-cancellable vs. Operating is usually cancellable.
• Risk/Rewards Transfer: Financial transfers substantially all risks/rewards vs. Operating does not. Lessee in Financial bears entire risks/rewards vs. Lessee in Operating is not entitled to entire risks/rewards.
• Cost Recovery: Financial is full pay-out, amortizing total cost vs. Operating lease payment not enough to cover full cost.
• Maintenance/Costs: Financial lessee usually bears costs (unless gross lease) vs. Operating lessor usually bears costs (unless net lease).

2. Lease Based on Method:

• Sale and Lease Back: Under this arrangement, the owner of an asset sells it to another party (the buyer, who becomes the lessor), and then leases the same asset back from the buyer (the original owner now becomes the lessee). The asset does not physically change hands; the transaction is recorded only. This method allows the lessee to free up operating capital. It also allows the lessee to be satisfied with the asset’s quality before converting the sale into a lease. The seller receives the agreed selling price, and the buyer receives the lease rentals.
• Direct Lease: This is a simple lease where the lessor either already owns the asset or acquires it specifically to lease to the lessee. If the lessor and equipment supplier are the same, it’s a bipartite lease. If the equipment supplier, lessor, and lessee are three different parties, it’s a tripartite lease.

3. Lease Based on Parties Involved:

• Single Investor Lease: This lease involves only two parties: the lessor and the lessee. There is only one investor, who is the owner (lessor). This category can include operating, financial, sale & lease back, and direct leases.
• Leveraged Lease: This type of lease involves three parties: the lessee, the lessor, and a lender or creditor (typically a financial institution or bank). The lessor finances the purchase of the asset by contributing a portion of the funds (equity) and borrowing the majority from the lender. The asset purchased is often held as security against the loan. The lender usually receives a senior secured interest and an assignment of the lease and lease payments. The lessee makes payments to the lessor, or sometimes directly into an escrow account maintained by the lessor with the financial institution. The lender then deducts loan instalments (principal and interest) from these payments before the remaining balance is transferred to the lessor. Leveraged leases are typically used for larger acquisitions, such as airplanes. The lessor is entitled to claim depreciation allowance.

4. Lease Based on Area:

• Domestic Lease: In this type of lease transaction, both the lessor and the lessee are located in the same country.
• International Lease (or Cross Border Leasing): This involves lease transactions where the lessor and lessee are located in different countries.

5. Other Types of Leases:

Several other specific types or classifications are mentioned in the sources:

• Sales-aid Lease: This occurs when a lessor collaborates with a manufacturer to market the manufacturer’s products through the lessor’s leasing activities. The manufacturer might provide credit or a commission to the lessor for aiding sales.
• Close-ended Lease: At the end of the lease term, the leased asset is transferred back to the lessor. The lessor retains the risks associated with obsolescence and the asset’s residual value.
• Open-ended Lease: In this arrangement, the lessee has the option to purchase the asset when the lease period ends.
• Short Term Lease (based on asset type/purpose): These are typically for assets eligible for high depreciation, such as computers or windmills, and are often for periods of 2-3 years. They can be beneficial for companies facing high obsolescence risks or having high taxable income in the near future.
• Long Term Lease (based on asset type/purpose): These leases are for assets with lower depreciation eligibility and a long economic life, like plant and machinery, cars, or furniture. Corporations aiming to leverage their balance sheet and having higher operational profits might prefer this type.
• Commodity Leases: Assets listed as “commodity leases” can also be leased. (Note: The term “commodity leases” is listed as a type of lease based on the term of lease in source, but the term itself sounds more like a type of asset. Source lists “commodity” as an asset that can be leased. Given the structure in, it might refer to a specific lease structure for commodities, but details are not provided).

6. Alternative Lease Rental Structures:

While not distinct lease types themselves, the structure of the periodic lease payments can vary:

• Equated Periodic Plan: Lease rent is divided into equal amounts over the period using an annuity factor based on a predetermined interest/discount rate.
• Stepped-up Plan: The periodic lease rent increases over time, often at a specified rate.
• Stepped-down Plan: The periodic lease rent decreases over time, often at a specified rate.
• Balloon Payment Plan: Initial periodic lease rents are smaller, followed by a larger lump sum payment in the later periods of the lease.
• Deferred Payment Plan: No lease rent is paid during an initial specified period, with payments commencing later in equal amounts that account for the financing cost of the deferred period.

Hire Purchase is a related concept often contrasted with lease financing. In a hire purchase agreement, goods are delivered at the beginning, and the hirer pays periodical instalments. The key distinction is that the title of ownership passes to the hirer only after the last instalment is paid. Hire purchase instalments include both interest and principal repayment.

Leasing services can be defined as one party agreeing to rent property owned by another, guaranteeing the lessee the use of the asset, and guaranteeing the lessor regular payments from the lease. The choice of the most effective type of lease for a company depends on factors such as the asset’s life, intended use at the end of the term, the company’s tax situation, cash flow, and specific future growth needs. At the end of the lease, the lessee typically has options like returning the asset, purchasing it, or renewing the lease.