14: Long-Term Debt and Leasing14 - 4b LEASE ARRANGEMENTS
Lessors use three primary techniques for obtaining assets for leasing. The method selected depends
largely on the desires of the prospective lessee. A direct lease results when a lessor acquires the assets to
lease out. In other words, the lessee did not previously own the assets that it is leasing. In a sale-leaseback
arrangement, one company sells an asset to another for cash and then leases the asset back from its new
owner. You can see the resemblance of this arrangement to a collateralised loan. In such a loan, the
lender gives the company cash up front in exchange for a stream of future payments. If the borrower
defaults on those payments, the lender keeps the collateral. In a sale-leaseback, the lessee receives
cash immediately (by giving up ownership of the asset) and effectively repays this loan by leasing back
the underlying asset. Sale-leaseback arrangements are therefore akin to borrowing, and are attractive to
companies that need cash for operations.
Leasing arrangements that include one or more third-party lenders are leveraged leases. Unlike in
direct and sale-leaseback arrangements, the lessor in a leveraged lease acts as an equity participant,
supplying on average about one-fifth of the asset’s cost and borrowing the balance of the funds. In recent
years, leveraged leases have become especially popular in connection with very expensive assets.
A lease agreement usually specifies whether or not the lessee is responsible for maintenance of the
leased assets. Both operating and finance leases generally include maintenance clauses specifying who is
to maintain the assets and make insurance and tax payments. Under operating leases, these costs are
typically the lessor’s responsibility (for example, a technician comes to repair a broken photocopier),
whereas under finance leases the lessee is typically responsible for these costs. The lessee often has
the option to renew a lease at its expiration. Renewal options are especially common in operating leases,
because their term is generally shorter than the useful life of the leased assets. Purchase options, which
allow the lessee to purchase the leased asset when the lease expires, occur in both operating and
finance leases.
The lessor can be one of a number of parties. With operating leases, the lessor is quite likely to be
a manufacturer’s leasing subsidiary or an independent leasing company. Finance leases are frequently
handled by independent leasing companies or by the leasing subsidiaries of large financial institutions,
such as commercial banks and life insurance companies. Life insurance companies are especially active
in real estate leasing. Superannuation funds and commercial banks have recently increased their leasing
activities.14 - 4c THE LEASE CONTRACT
The key items in a lease contract generally include a description of the leased assets, the term or duration
of the lease, provisions for cancellation, lease payment amounts and dates, provisions for maintenance
and associated costs, renewal options, purchase options and other provisions specified in the lease
negotiation process. Furthermore, lease contracts spell out the consequences of the violation of any
lease provision by either the lessee or the lessor.14 - 4d THE LEASE-VERSUS-PURCHASE DECISION
Companies often have to make the lease-versus-purchase (or lease-versus-buy) decision when contemplating
the acquisition of new assets. The alternatives available are to: (1) lease the assets; (2) borrow funds to
purchase the assets; or (3) purchase the assets using available liquid resources. Similar financial analysis
applies to alternatives (2) and (3). Even if the company has the liquid resources with which to purchasedirect lease
A lessor acquires the assets
that are leased to a given
lessee
sale-leaseback
arrangement
One company sells an asset to
another for cash, then leases
the asset back from its new
ownerleveraged lease
A lease under which the lessor
acts as an equity participant,
supplying part of the cost of
the asset, and borrowing the
balance of the funds
maintenance clause
A clause in a lease that
specifies who is to maintain
the assets and make
insurance and tax payments
renewal option
In an operating lease, an
option that allows the lessee
to renew the lease at its
expiration
purchase option
An option allowing the lessee
to purchase the leased asset
when the lease expiresLO 14.6
lease-versus-purchase
(or lease-versus-buy)
decision
The alternatives available
are to: (1) lease the assets;
(2) borrow funds to purchase
the assets; or (3) purchase
the assets using available
liquid resources. Even if
the company has the liquid
resources with which to
purchase the assets, the use
of these funds is viewed as
equivalent to borrowingWhat information do you need
to be able to make a reliable
decision to lease rather than
buy a fixed asset?thinking cap
question