The Basics
A lease is a contractual agreement between a lessee and lessor. The agreement establishes that the lessee has the right to use an asset and in return must make periodic payments to the lessor, the owner of the asset. The lessor is either the asset’s manufacturer or an independent leasing company. If the lessor is an independent leasing company, it must buy the asset from a manufacturer. Then the lessor delivers the asset to the lessee, and the lease goes into effect.
As far as the lessee is concerned, it is the use of the asset that is most important, not who owns the asset. The use of an asset can be obtained by a lease contract. Because the user can also buy the asset, leasing and buying involve alternative financing arrangements for the use of an asset. This is illustrated in Figure 21.1.
The specific example in Figure 21.1 happens often in the computer industry. Firm U, the lessee, might be a hospital, a law firm, or any other firm that uses computers. The lessor is an independent leasing company who purchased the equipment from a manufacturer such as IBM or Apple. Leases of this type are called direct leases. In the figure, the lessor issued both debt and equity to finance the purchase.
Of course, a manufacturer like IBM could lease its own computers, though we do not show this situation in the example. Leases of this type are called sales-type leasing. In this case, IBM would compete with the independent computer-leasing company.
Operating Leases
Years ago, a lease where the lessee received an operator along with the equipment was called an operating lease. Though the operating lease defies an exact definition today, this form for leasing has several important characteristics.
1. Operating leases are usually not fully amortized. This means that the payments required under the terms of the lease are not enough to recover the full cost of the asset for the lessor. This occurs because the term or life of the operating lease is usually less than the economic life of the asset. Thus, the lessor must expect to recover the costs of the asset by renewing the lease or by selling the asset for its residual value.
2. Operating leases usually require the lessor to maintain and insure the leased assets.
3. Perhaps the most interesting feature of an operating lease is the cancellation option. This option gives the lessee the right to cancel the lease contract before the expiration date.
If the option to cancel is exercised, the lessee must return the equipment to the lessor. The value of a cancellation clause depends on whether future technological and/or economic conditions are likely to make the value of the asset to the lessee less than the value of the future lease payments under the lease.
To leasing practitioners, the above characteristics constitute an operating lease.
However, accountants use the term in a slightly different way, as we will see shortly.
Financial Leases
Financial leases are the exact opposite of operating leases, as is seen from their important characteristics:
1.
Financial leases do not provide for maintenance or service by the lessor.
2.
Financial leases are fully amortized.
3.
The lessee usually has a right to renew the lease on expiration.
4.
Generally, financial leases cannot be canceled. In other words, the lessee must make all payments or face the risk of bankruptcy.
Because of the above characteristics, particularly (2), this lease provides an alternative method of financing to purchase. Hence, its name is a sensible one. Two special types of financial leases are the sale and lease-back arrangement and the leveraged lease.
Sale and Lease-Back A sale and lease-back occurs when a company sells an asset it owns to another firm and immediately leases it back. In a sale and lease-back, two things happen:
1. The lessee receives cash from the sale of the asset.
2. The lessee makes periodic lease payments, thereby retaining use of the asset.
An example of a sale and lease-back occurred when the city of Oakland, California, used the proceeds of a sale of its city hall and 23 other buildings to help meet the liabilities of the $150 million Police and Retirement System. As part of the same transaction, Oakland leased back the buildings to obtain their continued use.
Leveraged Leases A leveraged lease is a three-sided arrangement among the lessee, the lessor, and the lenders:
1. As in other leases, the lessee uses the assets and makes periodic lease payments.
2. As in other leases, the lessor purchases the assets, delivers them to the lessee, and collects the lease payments. However, the lessor puts up no more than 40 to 50 percent of the purchase price.
3. The lenders supply the remaining financing and receive interest payments from the lessor. Thus, the arrangement on the right-hand side of Figure 24.1 would be a leveraged lease if the bulk of the financing was supplied by creditors.
The lenders in a leveraged lease typically use a nonrecourse loan. This means that the lessor is not obligated to the lender in case of a default. However, the lender is protected in two ways:
1. The lender has a first lien on the asset.
2. In the event of loan default, the lease payments are made directly to the lender.
The lessor puts up only part of the funds but gets the lease payments and all the tax benefits of ownership. These lease payments are used to pay the debt service of the nonrecourse loan. The lessee benefits because, in a competitive market, the lease payment is lowered when the lessor saves taxes.
A lease is a contractual agreement between a lessee and lessor. The agreement establishes that the lessee has the right to use an asset and in return must make periodic payments to the lessor, the owner of the asset. The lessor is either the asset’s manufacturer or an independent leasing company. If the lessor is an independent leasing company, it must buy the asset from a manufacturer. Then the lessor delivers the asset to the lessee, and the lease goes into effect.
As far as the lessee is concerned, it is the use of the asset that is most important, not who owns the asset. The use of an asset can be obtained by a lease contract. Because the user can also buy the asset, leasing and buying involve alternative financing arrangements for the use of an asset. This is illustrated in Figure 21.1.
The specific example in Figure 21.1 happens often in the computer industry. Firm U, the lessee, might be a hospital, a law firm, or any other firm that uses computers. The lessor is an independent leasing company who purchased the equipment from a manufacturer such as IBM or Apple. Leases of this type are called direct leases. In the figure, the lessor issued both debt and equity to finance the purchase.
Of course, a manufacturer like IBM could lease its own computers, though we do not show this situation in the example. Leases of this type are called sales-type leasing. In this case, IBM would compete with the independent computer-leasing company.
Operating Leases
Years ago, a lease where the lessee received an operator along with the equipment was called an operating lease. Though the operating lease defies an exact definition today, this form for leasing has several important characteristics.
1. Operating leases are usually not fully amortized. This means that the payments required under the terms of the lease are not enough to recover the full cost of the asset for the lessor. This occurs because the term or life of the operating lease is usually less than the economic life of the asset. Thus, the lessor must expect to recover the costs of the asset by renewing the lease or by selling the asset for its residual value.
2. Operating leases usually require the lessor to maintain and insure the leased assets.
3. Perhaps the most interesting feature of an operating lease is the cancellation option. This option gives the lessee the right to cancel the lease contract before the expiration date.
If the option to cancel is exercised, the lessee must return the equipment to the lessor. The value of a cancellation clause depends on whether future technological and/or economic conditions are likely to make the value of the asset to the lessee less than the value of the future lease payments under the lease.
To leasing practitioners, the above characteristics constitute an operating lease.
However, accountants use the term in a slightly different way, as we will see shortly.
Financial Leases
Financial leases are the exact opposite of operating leases, as is seen from their important characteristics:
1.
Financial leases do not provide for maintenance or service by the lessor.
2.
Financial leases are fully amortized.
3.
The lessee usually has a right to renew the lease on expiration.
4.
Generally, financial leases cannot be canceled. In other words, the lessee must make all payments or face the risk of bankruptcy.
Because of the above characteristics, particularly (2), this lease provides an alternative method of financing to purchase. Hence, its name is a sensible one. Two special types of financial leases are the sale and lease-back arrangement and the leveraged lease.
Sale and Lease-Back A sale and lease-back occurs when a company sells an asset it owns to another firm and immediately leases it back. In a sale and lease-back, two things happen:
1. The lessee receives cash from the sale of the asset.
2. The lessee makes periodic lease payments, thereby retaining use of the asset.
An example of a sale and lease-back occurred when the city of Oakland, California, used the proceeds of a sale of its city hall and 23 other buildings to help meet the liabilities of the $150 million Police and Retirement System. As part of the same transaction, Oakland leased back the buildings to obtain their continued use.
Leveraged Leases A leveraged lease is a three-sided arrangement among the lessee, the lessor, and the lenders:
1. As in other leases, the lessee uses the assets and makes periodic lease payments.
2. As in other leases, the lessor purchases the assets, delivers them to the lessee, and collects the lease payments. However, the lessor puts up no more than 40 to 50 percent of the purchase price.
3. The lenders supply the remaining financing and receive interest payments from the lessor. Thus, the arrangement on the right-hand side of Figure 24.1 would be a leveraged lease if the bulk of the financing was supplied by creditors.
The lenders in a leveraged lease typically use a nonrecourse loan. This means that the lessor is not obligated to the lender in case of a default. However, the lender is protected in two ways:
1. The lender has a first lien on the asset.
2. In the event of loan default, the lease payments are made directly to the lender.
The lessor puts up only part of the funds but gets the lease payments and all the tax benefits of ownership. These lease payments are used to pay the debt service of the nonrecourse loan. The lessee benefits because, in a competitive market, the lease payment is lowered when the lessor saves taxes.
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