REASONS FOR LEASING

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Category: Financial Management

  1. Short term Leases are Convenient

Assume that you want to use an asset for a short period e.g. a car for a week, you could buy the car and sell it after 7 days. You would spend a lot of time selecting the car and purchasing, arranging insurance registration etc. But at the end of the week, you have to re-negotiate sale, cancel registration and insurance etc. In such a case, it would be appropriate to organize for operating lease.

              1. Cancellation Options are Valuable

Equipment is frequently leased on a short-term cancelable basis because it’s difficult to estimate how rapidly such equipment would become obsolete because of changes in technology. Leasing with an opinion to cancel passes the risk of obsolescence from the user to the leasor. The lessee however, pays a higher rental due to the option to cancel.

              1. Maintenance is provided

Under a full service (operating) lease, the user receives maintenance and other services. Many leasors are well equipped to provide efficient maintenance.

              1. Low administration and Transaction Cost

Leasing is a relatively cheap source of funds for small companies. It offers long-term financing on a flexible piece-meal basis, with a lower transaction cost than in a private placement or public issue of bonds or stocks.

              1. Tax Shield Can be used

Sometimes the leaser can make better use of depreciation tax shield generated by an asset than the asset user. It may make sense therefore for the leasing company to own the equipment and pass over some of the tax benefits to the lessee in form of low lease payments.

In markets that are efficient, the following reasons are usually given are “Dubious” reasons for leasing

 (i) Leasing Is An Off Balance Sheet Financing

When a firm obtains off-balance sheet financing, the conventional measures of financial leverage such as the debt equity ratio understate the true degree of financial gearing. Some people believe financial analysis do not always notice off balance sheet lease obligation (which are still referred to as foot note) or the greater volatility of earnings that result from fixed lease payments. Note that in an efficient market, price would reflect all the available information including the lease obligation.

 (ii) Leasing Avoids Restrictive Covenants

When a company borrows money it must usually consent to certain restrictions on future borrowing. If the bond indenture does not include any restriction on leasing then leasing can be seen as a way of avoiding restrictive covenants. Note that loopholes such as this are easily stopped and most debt indentures include limits on leasing.

 (iii) Leasing Affects Book Income

A lease which qualifies as off-balance sheet financing affects book income in one way. The lease payment are an expense. If the firm buys the assets instead and borrows to finance it, then both depreciation and interest expenses are deducted. Leases are usually set up so that payment in the early years is less than depreciation and interest under the buy and borrow alternative. Leasing therefore increases book income in the early years of an asset life. The return on investment would increase more because the book value of assets (the denominator is understated).

 ROI = Capital Turnover x Profit Margin

or Reserves x Incomes

Investments Reserves

or Income

Investments

Note;

Leasing impact on book income should not in itself have any effect in firms value in efficient capital market.

 (iv) Leasing Avoids Capital Expenditure Control

In some companies, lease proposals are not subject to the elaborate capital expenditure approval procedures needed to buy an asset. This may be important in the public sector e.g. a public hospital may find it easier to lease medical equipment that to ask the government to provide funds for purchase.

Note: Bypassing such controls may result in poor investment decision on the part of the company.

 (v) Leasing Preserves Capital

Leasing companies provides 100% financing. They advance the full cost of the lease asset. It may be argued therefore that leasing preserves capital allowing the firm to save its cash for other things.