To lease or borrow to buy Leasing A way of gaining use without legal ownership. Finance lease.

e. o Transfers the risks and rewards of ownership to the lessee. o Period of the lease usually matches the expected asset life. o The cost of the asset is effectively recovered over the lease period. o The finance provider expects to recover the full cost (or almost the full cost) of the equipment, plus interest, over the period of the lease. o No right of cancellation or termination. o The lessee is responsible for maintenance, insurance, repairs and obsolescence. o Accounting treatment is capitalisation of leased asset in balance sheet, which shows both asset and liability. o Operating lease. o Lessor rents out equipment often for specific tasks o Short-term contract. o Not expected to last for the entire useful life of the asset. o Finance house bears the risk of ownership. o Several lessees over useful economic life of asset. o Maintenance costs borne by lessor. o Lease payments are tax-allowable. o Effectively a rental agreement. o Accounted for off-balance sheet. o Includes cars, computers etc Advantages of Leasing o Advantages listed for hire purchase also apply to leasing: small initial outlay, certainty, available when other finance sources are not, fixedrate finance and tax relief. o For operating leases transfer of obsolescence risk. o Tax rules. o Finance leases have to be capitalized to bring them on to the balance sheet. o The asset is depreciated. o The liability is reduced. o Depreciation and interest are both deducted as expenses. Evaluating Leasing o Both financing decision and investment decision. o Method 1: Evaluate investment decision, then make financing decision. o Method 2: Make financing decision, then evaluate investment decision. o Method 3: Evaluate financing and investment decisions simultaneously. Relevant cash flows o lease rentals and tax benefits.

Year

Item

Cash flow

Discount factor

PV

Sum of PV1 Tax savings on lease Tax times lease cost Sum of PV2 Total NPV of lease= SPV1 SPV2

Borrow to buy The appropriate discount rate is the lessees cost of borrowing. What discount rate does lessee use? o For investment decisions, discount relevant cash flows at companys cost of capital, e.g. WACC. o For financing decisions, discount relevant cash flows at companys after-tax cost of borrowing. Relevant cash flows o purchase cost and scrap value; o capital allowances; o balancing charges or allowances; o Maintenance costs and tax effects.
Capital allowance rate = Tax rate = Pre-tax rate of borrowing = Equipment to buy value = Scrap value = Working capital = Discount rate for the project =

Step 1- work out capital allowances and written down value Step 2- work out after tax cost of borrowing= Pre-tax rate of borrowing x (1 - Tax rate) Step 3Year Item Cash flow Discount factor PV

Sum of PV1 Tax saved from capital allowances Tax times lease cost Sum of PV2 Total NPV of borrow to buy= SPV1 SPV2