Substance is always been preferred over matter. Similar is the case with the ownership of the asset and the use of it. Hence, the use of the asset is important than the ownership.Leasing provides a way out to use the asset without owning it.Based on the fact that the decision for leasing is a financing decision therefore, the analysis for leasing is carried out only after the decision for acquiring the asset has been finalized. For instance, in the case of persistent learning the company is performing the lease analysis after finalizing that the increased demands can only be fulfilled if the firm has new high end desktops for programmed developments and laptops for marketing demonstrations.
Advantages of leasing:
- Leasing provides tax benefits to the one who owns the assets. Therefore, the tax benefits are transferred from those who need the asset (lessee) to those who own it (lessor). However, in return the lessee benefits from the funding costs which are reduced due to transference of tax benefits.
- As compared to the borrowing from the banks, in case of leasing less cash is required with lesser restrictions and stringent conditions and faster approval of lessors.
- Another main advantage is leasing provides one hundred percent off- balance sheet financing.
- It is more advantageous in the case when there is a threat of the technological obsolescence. Through leasing the risk is transferred to the lessors, hence, letting the lessee benefits from the technologically advanced equipments.
- Leases receive favorable treatment in the case of bankruptcy hence; it is more preferable as compared to the bankruptcy situation faced by using debt.
Disadvantages of Leasing:
- Leasing the assets make the company to compromise on the benefits of the salvage value of the assets which would have been of use if the assets was owned
- Leasing often leads to the higher costs as the effective interest expense for leasing the asset is greater as compared to the interest cost of borrowing.
- Cancellation of financial leases requires substantial amount of penalty.
a)Pros and Cons for Purchasing:
Likewise as the leasing has its own advantages and disadvantages the buying decision has its own implications and benefits. In the following paragraph some of them are mentioned:-
Advantages of Purchasing:
- Through purchasing the asset, the ownership is transferred so the buyer in this case owns the asset
- It is a one-time cost but the buyer does not have to pay any payment regarding that particular purchase later at any stage contrary to the leasing process whereby lessee has to make annual lease payments
- Moreover, the owner of the asset can use the asset in the long term and saves itself from the costs of renewing the contracts as in the case of leasing along with that it gains benefit from the salvage value of the asset.
Disadvantages of Purchasing:
- The buyer has to bear the loss of technological obsolescence. For instance in the case of Leasing Computers at Persistent Learning, buying the high-end desktops and laptops possess the threat of technological obsolescence.
- The purchasing of the asset results into significant amount of capital investment which could otherwise be used in the company core operations.
- The cost of borrowing for the purchase of asset is higher as compared leasing. For instance, in the case the company has to borrow $ 6,300 in order to buy the computer equipment for their firm. It is because the company also needed money to focus in expansion of their product therefore, it cannot spend the cash in hand on buying equipment.
- Purchase through borrowing money is a slow and long process as it requires complying with the stringent conditions of the lender which in most cases are banks; followed by the approval of the loan.
b)Evaluate the company’s lease or buy decisions:
The educational software company, persistent learning has now moved on from their stage of the initial growth which was financed by the venture capitalist. The company has its first initial public offering in 2004 with future plans of financing the expansion through going public. With the expectation of the rapid growth in the near future, the company realized that it is not possible to fulfill all the demands with the existing obsolete technology. Therefore, the concept of procuring new high end technology was devised which later on get finalized. However, the decision is still pending whether to buy the computer equipment or to lease it out. Moreover, while finalizing this decision it has to be kept under consideration that the decision should have positive impact on the company’s financial reporting.
Based on the company’s own calculations for borrowing the money to buy the equipment, the option of buying equipment through borrowing is already ruled out. Moreover, the company is unable to decide between the one-dollar purchase of the equipment and the fair market value purchase. From the exhibit 2 of the case it is seen that one-dollar purchase option is costing $300 annually more than the fair market value option. It is because it has the option of buying the equipment at the end of the contract for one dollar.
Considering the scenario, the buying option cannot be ruled out without comparing it with the lease option. Therefore, to evaluate the company’s decision whether to buy or lease the net advantage of leasing is calculated. If the net advantage of leasing is positive the company should lease the asset otherwise it has to buy the asset. Therefore, the after tax cost of the annual lease payments are calculated which is the cash outflow of the company along with the depreciation tax shield which is the benefit transferred from the lessee to the lessor. The cost of the asset is saved by the company through leasing hence that is a positive cash flow for the company. Lastly, the after tax net salvage value is the benefit transferred to the lessor, therefore; it is a cash outflow for the Persistent Learning. The Net Advantage of Leasing is calculated which is a positive value of $ 705,840. Hence, the computer equipment should be leased out.
Besides, considering the financial reporting motive of the Persistent Learning, the fair market value lease is most advisable. It is because; it appears as the liability on the financial statements for which the company will benefit from the interest savings. Hence, the company’s outflow will also be reduced thus enabling a positive impact on the company’s financial statements. Therefore, the fair market value lease is more preferable.
Lessee does not have to pay the leased asset, Thus it is said that leases provide 100 percent financing. Explain why this is not true advantage to the lessee.
Hundred percent financing is not the true advantage to the lessee because of the following reasons:
- The lessee is still required to pay annual lease payments hence the notion of hundred percent financing is offset. Therefore, while making a decision the company cannot stay indifferent between buying the asset and paying the lessor cost of capital for the equipment.
- Moreover, if the lessor required large security deposits or substantial advance lease payments then leasing certainly does not provide hundred percent financing.
- The agency costs are also involved when the asset is leased due to the reason that the ownership is in the hands of the lessor while the use of the asset is by the lessee.
- Besides, based on the leasing contracts the lessee often has to pay the cost of repair and maintenance of the equipment.
- Furthermore, it has said that in the case of bankruptcy the leasing the assets are advantageous over borrowing the money and buying the asset. However, it is observed that in case of bankruptcy the lessor can easily get hold of its assets from the lessee.
Why do you think that the leasing of trucks, airplanes and computers is such a big business? What efficiencies offset the costs of running these leasing operations?
Leasing, now-a-days, has grown into a big business because the companies dealing in the transporting the goods required the proper trucking system on large scale. The cost of procuring those trucks in order to run the business is not possible to bear for one company at most. Similar is the case of the airplanes, the costs of planes are so substantial that neither the airline companies are able to buy them nor they are financed by a single leasing company. Therefore, multiple leasing companies are required to serve the purpose which in turn leads to the growing business of leasing. Lastly, in the case of the computers the rapid technological advancement leads to the obsolescence of the existing technology. Hence, there are high costs of technological obsolescence. Hence, it requires multiple leasing companies to share these costs.
Besides, there are benefits associated with the leasing companies which offset the substantial costs associated with the business. The leasing companies receive huge tax benefits as a result of leasing the assets. Moreover, if the equipment has the salvage value these companies also benefits from the after tax net salvage value of the equipment. If the lessee undergoes bankruptcy, leasing companies can easily take charge of their leased assets therefore, the risk of losing the asset in case of lessee bankruptcy does not exist.