Advantages and Disadvantages of Leasing - Financial Management

Advantages and Disadvantages of Leasing to Lessor and Lessee

Leasing offers a number of potential advantages. However, the prudent financial manager should also be aware of the disadvantages.

Advantages

Perhaps the major advantage of leasing is that it provides flexible financing. Most lease arrangements tend to have fewer restrictive covenants than loan agreements. In addition, leasing is well suited to piecemeal financing. A firm that is acquiring assets over time may find it more convenient to lease them than to negotiate term loans or sell securities each time it makes a new capital outlay.

In the case of real estate leasing, the lessee may effectively be able to depreciate land. Because the lease payments will reflect both the lessor’s investment in any buildings and the cost of the land, the lessee is able to effectively depreciate the land by deducting the full amount of the lease payment for tax purposes. To keep this benefit in perspective, however, it should be noted that the lessee also loses any salvage value associated with the property at the end of the lease.

Diagram of a Typical Leveraged Lease

Diagram of a Typical Leveraged Lease

The lessee may also be able to make lower payments because of the tax benefits enjoyed by the lessor. This is especially important in the case of a leveraged lease, when the lessee is a firm with insufficient taxable income to take advantage of the tax benefits of ownership. In fact, the majority of lease transactions made are tax motivated.

In addition, it may be possible for the lessee to avoid some of the risks of obsolescence associated with ownership. This is the second most cited reason why lessees choose lease financing. The lessor will charge a lease rate intended to provide a specified return on the required net investment. The net investment is equal to the cost of the asset minus the present value of the expected salvage value at the end of the lease. If the actual salvage is less than originally expected, the lessor bears the loss. For the small or marginally profitable firm, leasing is often the only available source offinancing because the title to leased property remains with the lessor and reduces the lessor’s risk in the event of failure.

If the lessee does fail, the lessor can recover the leased property more quickly than a secured lender. Leasing tends to smooth out expenses for the lessee. Because lease payments are a constant annual outlay, whereas MACRS depreciation expenses are large in the early years of ownership and less in later years, earnings tend to appear more stable when assets are leased rather than owned. In addition, reported earnings per share normally may be higher in the early years of a lease, compared with ownership, because of the use of MACRS depreciation when the asset is owned.

Leasing is said to provide 100 percent financing, whereas most borrowing requires a down payment. This is the major reason cited by lessees for why they choose lease financing. However, because lease payments are normally made in advance of each period, this 100 percent financing benefit is diminished by the amount of the first required lease payment. From the lessee’s perspective, leases can increase a firm’s liquidity. For example, a sale and leaseback transforms some of a firm’s fixed assets into cash in exchange for an obligatio to make a series of fixed future payments.

This has been the primary motivation for sale and leaseback transactions undertaken by several troubled airlines. And, finally, leasing gives some plant or divisional managers additional flexibility inacquiring assets if lease agreements are not subject to internal capital expenditure constraints. In recent years, local school districts, municipalities, and the U.S. Navy, among other organizations, have used leasing to circumvent capital outlay restrictions.

Disadvantages

The primary disadvantage of leasing is cost. For a firm with a strong earnings record, good access to the credit markets, and the ability to take advantage of the tax benefits of ownership, leasing is often a more expensive alternative.

Of course, the actual cost difference between ownership and leasing depends on a number of factors and varies from case to case. Another disadvantage of leasing is the loss of the asset’s salvage value. In real estate, this loss can be substantial. A lessee may also have difficulty getting approval to make propertyimprovements on leased real estate. If the improvements substantially alter the property or reduce its potential range of uses, the lessor may be reluctant to permit them.

In addition, if a leased asset (with a financial lease) becomes obsolete or if the capital project financed by the lease becomes uneconomical, the lessee may not cancel the leasewithout paying a substantial penalty.
Also, in bankruptcy, lease payments normally must be made, whereas interest and principal payments are suspended.


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