Types of lease and their implications

-

Types of Leases and Their Implications

1. Financial Lease (Capital Lease)

Definition: A financial lease, also known as a capital lease, is a long-term lease agreement where the lessor aims to recover the full capital outlay plus the required return on investment over the lease period. This form of leasing is essentially a financing arrangement for acquiring assets.

Characteristics:

  • Usage and Control: The lessee uses and controls the asset during the lease term but does not hold the title to it.
  • Economic Ownership: The lessee acquires most of the economic benefits and risks of owning the asset without actually owning it.
  • Maintenance Responsibility: The lessee is responsible for the upkeep, maintenance, insurance, and repairs of the asset.
  • Irrevocability: The lease agreement is typically irrevocable, meaning it cannot be canceled.
  • Lease Payments: Lease payments usually cover 90% of the fair value of the asset, and the lease period spans 75% of the asset's economic life.
  • End-of-Lease Option: The lessee often has the option to purchase the asset at the end of the lease term for a nominal amount.
  • Risk and Rewards: The lessee bears all risks related to the asset and enjoys the benefits, while the lessor retains legal ownership.

Preferred Situations:

  • Ownership Desire with Insufficient Funds: When the lessee wants to own the asset eventually but lacks the immediate funds for outright purchase.
  • Long-Term Use: When the asset is needed for a long period, and lower lease rentals are favorable.

2. Operating Lease

Definition: An operating lease is a short-term lease agreement that grants the lessee the right to use an asset without transferring substantial ownership risks and rewards. This type of lease is often used for assets that are subject to rapid obsolescence or are needed for temporary purposes.

Characteristics:

  • Limited Right to Use: The lessee has a limited right to use the asset for a short period.
  • Short-Term Nature: Typically for a shorter term compared to financial leases.
  • Manufacturer Involvement: The lessor is often the manufacturer of the asset, using the lease to facilitate sales.
  • Maintenance Responsibility: The lessee is responsible for the maintenance and upkeep of the asset during the lease term.
  • Depreciation and Expenses: The lessor claims depreciation, while the lessee can deduct lease payments and maintenance expenses as business costs.
  • Residual Value: At the end of the lease, the lessor may sell the asset to recover the residual value.

Preferred Situations:

  • Uncertain Long-Term Suitability: When the asset's long-term usefulness is uncertain.
  • Rapid Obsolescence: When the asset is likely to become obsolete quickly.
  • Temporary Needs: When the asset is required for a short-term or temporary project.

3. Sale and Lease Back

Definition: In a sale and lease back arrangement, the lessee sells an asset to a lessor and then leases it back. This allows the lessee to free up capital while still using the asset.

Characteristics:

  • Asset Quality Verification: The lessee can ensure the asset's quality before leasing it back.
  • Capital Release: The lessee receives a lump sum from the sale, improving liquidity.
  • Continued Use: The lessee continues to use the asset without ownership.
  • Tax Benefits: The lessor benefits from depreciation, and the lessee can deduct lease payments.

Preferred Situations:

  • Liquidity Issues: When the lessee needs to improve liquidity.
  • Asset Utilization: When the lessee wants to continue using an asset without owning it.

4. Leveraged Lease

Definition: A leveraged lease involves the lessor financing a part of the asset cost, with the major part financed by a third-party financier. This arrangement allows the lessor to undertake larger lease transactions with limited capital.

Characteristics:

  • Three Parties Involved: The lessor, lessee, and financier are all part of the agreement.
  • Partial Financing: The lessor finances a smaller portion, while the financier covers the majority.
  • Assignment of Rights: Title deeds and lease rentals are often assigned to the financier as security.
  • Increased Leasing Capacity: The lessor can expand their leasing business with limited capital.

Preferred Situations:

  • Large-Scale Leasing: When large asset investments are needed with limited capital.
  • Significant Financing Requirements: For assets requiring substantial funding.

5. Sales Aid Leasing

Definition: Sales aid leasing is a partnership between a leasing company and an equipment seller (usually the manufacturer) to lease the seller’s products. This arrangement helps boost the manufacturer's sales through leasing options.

Characteristics:

  • Partnership with Manufacturer: The leasing company works with the manufacturer to lease out equipment.
  • Commission-Based: The leasing company earns commissions on sales.
  • Market Expansion: Helps manufacturers increase sales by offering leasing options to customers.

Preferred Situations:

  • Boosting Sales: For manufacturers looking to increase sales through leasing.
  • Profit Increase: For leasing companies aiming to enhance profitability through commissions.

Summary

  • Financial Lease: Long-term, lessee manages and benefits from the asset, with potential ownership at the end.
  • Operating Lease: Short-term, lessor retains more control, lessee handles maintenance, suitable for rapidly obsolescing or temporarily needed assets.
  • Sale and Lease Back: Lessee sells the asset to lessor, then leases it back, improving liquidity while retaining asset use.
  • Leveraged Lease: Involves third-party financing, allowing lessor to undertake large transactions with limited capital.
  • Sales Aid Leasing: Partnership with manufacturers to lease products, boosting sales and profits through commissions.