Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance(^898) 26. Leasing © The McGraw−Hill
Companies, 2002
own computers, and many companies, including HP and some of the other companies
mentioned previously, have set up wholly owned subsidiaries called captive finance
companiesto lease out their products.^3
As shown in Figure 26.1, whether it leases or buys, Sass Company ends up using the
asset. The key difference is that in one case (buy), Sass arranges the financing, pur-
chases the asset, and holds title to the asset. In the other case (lease), the leasing com-
pany arranges the financing, purchases the asset, and holds title to the asset.
Operating Leases
Years ago, a lease in which the lessee received an equipment operator along with the
equipment was called an operating lease. Today, an operating lease (or service lease) is
difficult to define precisely, but this form of leasing has several important characteristics.
First of all, with an operating lease, the payments received by the lessor are usually
not enough to allow the lessor to fully recover the cost of the asset. A primary reason is
that operating leases are often relatively short-term. Therefore, the life of the lease may
be much shorter than the economic life of the asset. For example, if you lease a car for
two years, the car will have a substantial residual value at the end of the lease, and the
lease payments you make will pay off only a fraction of the original cost of the car. The
lessor in an operating lease expects to either lease the asset again or sell it when the
lease terminates.
A second characteristic of an operating lease is that it frequently requires that the
lessor maintain the asset. The lessor may also be responsible for any taxes or insurance.
Of course, these costs will be passed on, at least in part, to the lessee in the form of
higher lease payments.
The third, and perhaps most interesting, feature of an operating lease is the cancella-
tion option. This option can give the lessee the right to cancel the lease before the expi-
ration date. If the option to cancel is exercised, the lessee returns the equipment to the
lessor and ceases to make payments. The value of a cancellation clause depends on
whether technological and/or economic conditions are likely to make the value of the as-
set to the lessee less than the present value of the future lease payments under the lease.
To leasing practitioners, these three characteristics define an operating lease. How-
ever, as we will see shortly, accountants use the term in a somewhat different way.
Financial Leases
Afinancial leaseis the other major type of lease. In contrast to the situation with an op-
erating lease, the payments made under a financial lease (plus the anticipated residual,
or salvage, value) are usually sufficient to fully cover the lessor’s cost of purchasing the
asset and pay the lessor a return on the investment. For this reason, a financial lease is
sometimes said to be a fully amortized or full-payout lease, whereas an operating lease
is said to be partially amortized. Financial leases are often called capital leasesby the
accountants.
With a financial lease, the lessee (not the lessor) is usually responsible for insurance,
maintenance, and taxes. It is also important to note that a financial lease generally can-
not be canceled, at least not without a significant penalty. In other words, the lessee must
make the lease payments or face possible legal action.
CHAPTER 26 Leasing 875
(^3) In addition to arranging financing for asset users, captive finance companies (or subsidiaries) may purchase
their parent company’s products and provide debt or lease financing to the users. General Motors
Acceptance Corporation (GMAC) and Caterpillar Financial are examples of captive finance companies.
operating lease
Usually a shorter-term
lease under which the
lessor is responsible for
insurance, taxes, and
upkeep. May be
cancelable by the lessee
on short notice.
Web sites for equipment
leases include
http://www.fortuneleasegroup.
comand
http://www.assetcapitallease.
com.
financial lease
Typically a longer-term,
fully amortized lease
under which the lessee
is responsible for
maintenance, taxes, and
insurance. Usually not
cancelable by the lessee
without penalty.