Betatronics - Why Do Firms Engage in Leasing?

1.1 Why do firms engage in leasing?

Lease financing denotes procurement of assets through lease. The subject of leasing falls in the category of finance. Leasing has grown as a big industry worldwide. Lease as a concept involves a contract whereby the ownership, financing and risk taking of any equipment or asset are separated and shared by two or more parties. Thus, the lessor may finance and lessee may accept the risk through the use of it while a third party may own it.

Alternatively the lessor may finance and own it while the lessee enjoys the use of it and bears the risk. There are various combinations in which the above characteristics are shared by the lessor and lessee.

The important feature of a lease contract is separation of the ownership of the asset from its usage and thereby sharing of risk and that is why firms primarily engage in leasing.

1.2 What are the underlying sources of economic advantage in a leasing arrangement?

The underlying sources of economic advantage arises under a leasing arrangement due to the fact that lease rentals are considers as operating expenditure which is tax deductable. This gives the company tax advantages due to engaging in leasing agreement and can considered to be an economic advantage. Moreover, since the product that is being leased is still owned by the leasing company less risk is involved thereby giving birth to another source of economic benefit.

1.3 What are the Advantages of Leasing?

i. No Large Outlay

The biggest advantage of leasing equipment is that the cost is spread over a number of years; there is no need for you to pay the entire amount upfront. This can significantly help maintain cash flow, which is critical to all businesses. Poor cash flow is the main cause of small business failures, and leasing can help you to keep it under better control.

ii. Security

When you lease a product, it is still owned by the leasing company, meaning that they have better security on your finance. This means you are unlikely to need any further security to be able to start a leasing contract, and therefore you have a much better chance of acceptance (passing the credit check) than with other forms of finance.

Leasing can also allow you to use better equipment (e.g. a more efficient / faster / more accurate product) that would be too expensive to buy outright.

iii. Budgeting

As a lease agreement is almost always a fixed contract, it is relatively easy to budget and forecast with. The amount can be worked into your businesses budget much more easily than an irregularly occurring lump sum; allowing you to keep a much better control over current and future cash flow. In the event that you need an item replacing quickly, you can do so with a relatively minor monthly adjustment to the budget, instead of a lump sum that could seriously damage cash flow.

iv. Support

Leasing agreements usually come with some sort of technical support from the leasing company.

v. Keeping current

One of the best reasons to lease is that it means you always have access to the latest technologies.

vi. Tax Advantages

Lease rentals are considered as an operating cost, which means that it is often possible to deduct them from taxable profits (as a trading expense). If business pays no or minimal taxes, then some leasing companies will claim the capital allowance on your behalf, and lower the leasing costs accordingly.

1.3 What techniques should be used to evaluate leasing terms?

The rapid increase in asset leasing in recent year has encouraged the development of various analytical techniques that may be used to evaluate lease proposals and has generated a rather large and complex literature on this subject. Virtually of these techniques and discussions, however, focus on the lease-versus-purchase decision, and the impact on project profitability of leasing rather than buying has reviewed limited attention. However, calculating the internal rate of return (IRR) and net present value (NPV) for proposed capital investment projects are most popular. Given below are the details description of the two methods,

i. Internal rate of return (IRR)

The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular lease finance project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the lease shceme. As such, IRR can be used to rank several lease projects a firm is considering. Assuming all other factors are equal among the various projects, the lease project with the highest IRR would probably be considered the best and undertaken first.

ii. Net present value (NPV)

The difference between the present value of cash inflows and the present value of cash outflows. NPV can be used in capital budgeting to analyze the profitability of lease project.

NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield. Formula for NPV is given below,

NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective lease shceme is positive, it should be accepted. However, if NPV is negative, the lease agreement should probably be rejected because cash flows will also be negative.

2.1 What are the key factors that determine how leasing terms are set?

The key factors that determines the leasing terms are

i. The financial requirement of the lessor's

Whether the lessor itself is strong enough to provide the leasing terms based on their IRR and NPV calculation to figure out the lease terms.

ii. Competitors lease terms

What leasing terms are being provided by the competitors, whether their terms are more lucrative