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Introduction u Leasing and hire purchase are financial facilities which allow a business to use an asset over a fixed period, in return for regular payments.

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Presentation on theme: "Introduction u Leasing and hire purchase are financial facilities which allow a business to use an asset over a fixed period, in return for regular payments."— Presentation transcript:

1 Introduction u Leasing and hire purchase are financial facilities which allow a business to use an asset over a fixed period, in return for regular payments. The business customer chooses the equipment it requires and the finance company buys it on behalf of the business.

2 Where u Many kinds of business asset are suitable for financing using hire purchase or leasing, including: - Plant and machinery - Business cars - Commercial vehicles - Agricultural equipment - Hotel equipment - Medical and dental equipment - Computers, including software packages -Office equipment

3 Hire purchase u With a hire purchase agreement, after all the payments have been made, the business customer becomes the owner of the equipment. This ownership transfer either automatically or on payment of an option to purchase fee. u For tax purposes, from the beginning of the agreement the business customer is treated as the owner of the equipment and so can claim capital allowances. Capital allowances can be a significant tax incentive for businesses to invest in new plant and machinery or to upgrade information systems. u Under a hire purchase agreement, the business customer is normally responsible for maintenance of the equipment.

4 Lease Financing Examples of familiar leases ApartmentsHouses OfficesAutomobiles Lease Lease -- A contract under which one party, the lessor (owner) of an asset, agrees to grant the use of that asset to another, the lessee, in exchange for periodic rental payments.

5 Advantages Leasing u Certainty u Budgeting u Effect of security u Maximum finance u Tax advantages

6 Issues in Lease Financing u Advantage u Advantage: Use of an asset without purchasing the asset u Obligation u Obligation: Make periodic lease payments u Contract specifies who maintains the asset u Full-service lease u Full-service lease -- lessor pays maintenance u Net lease u Net lease -- lessee pays maintenance costs u Cancelable or noncancelable lease? u Operating lease (short-term, cancellable) vs. financial lease (longer-term, noncancelable) u Options at expiration to lessee

7 Finance Leasing u The finance lease or 'full payout lease' is closest to the hire purchase alternative. The leasing company recovers the full cost of the equipment, plus charges, over the period of the lease. u Although the business customer does not own the equipment, they have most of the 'risks and rewards' associated with ownership. They are responsible for maintaining and insuring the asset and must show the leased asset on their balance sheet as a capital item. u When the lease period ends, the leasing company will usually agree to a secondary lease period at significantly reduced payments. Alternatively, if the business wishes to stop using the equipment, it may be sold second-hand to an unrelated third party. The business arranges the sale on behalf of the leasing company and obtains the bulk of the sale proceeds.

8 Operating lease u If a business needs a piece of equipment for a shorter time, then operating leasing may be the answer. The leasing company will lease the equipment, expecting to sell it secondhand at the end of the lease, or to lease it again to someone else. It will, therefore, not need to recover the full cost of the equipment through the lease rentals. u This type of leasing is common for equipment where there is a well-established secondhand market (e.g. cars and construction equipment). The lease period will usually be for two to three years, although it may be much longer, but is always less than the working life of the machine. u Assets financed under operating leases are not shown as assets on the balance sheet. Instead, the entire operating lease cost is treated as a cost in the profit and loss account.

9 Types of Leasing u The lessor realizes any residual value. u There may be a tax advantage as land is not depreciable, but the entire lease payment is a deductible expense. u Lessors u Lessors: insurance companies, institutional investors, finance companies, and independent companies. Sale and Leaseback Sale and Leaseback -- The sale of an asset with the agreement to immediately lease it back for an extended period of time.

10 Types of Leasing u The firm often leases an asset directly from a manufacturer (e.g., IBM leases computers and Xerox leases copiers). u Lessors u Lessors: manufacturers, finance companies, banks, independent leasing companies, special- purpose leasing companies, and partnerships. Direct Leasing direct leasing Direct Leasing -- Under direct leasing a firm acquires the use of an asset it did not previously own.

11 Leveraged leasing u Under leveraged leasing arrangement, a third party is involved beside lessor and lessee. u The lessor borrows a part of the purchase cost (say 80%) of the asset from the third party i.e., lender and the asset so purchased is held as security against the loan. u The lender is paid off from the lease rentals directly by the lessee and the surplus after meeting the claims of the lender goes to the lessor. The lessor, the owner of the asset is entitled to depreciation allowance associated with the asset.

12 Accounting and Tax Treatment of Leases u In the past, leases were “off-balance-sheet” items and hid the true obligations of some firms. u The lessee can deduct the full lease payment in a properly structured lease. To be a “true lease” the IRS requires: 1. Lessor must have a minimum “at-risk” (inception and throughout lease) of 20% or more of the acquisition cost. 2. The remaining life of the asset at the end of the lease period must be the longer of 1 year or 20% of original estimated asset life. 3. An expected profit to the lessor from the lease contract apart from any tax benefits.

13 Economic Rationale for Leasing u Leasing allows higher-income taxable companies to own equipment (lessor) and take accelerated depreciation, while a marginally profitable company (lessee) would prefer the advantages afforded by leases. u Thus, leases provide a means of shifting tax benefits to companies that can fully utilize those benefits. u Other non-tax issues u Other non-tax issues: economies of scale in the purchase of assets; different estimates of asset life, salvage value, or the opportunity cost of funds; and the lessor’s expertise in equipment selection and maintenance.

14 Thank You


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