Sunday, October 4, 2009

Advantages of leasing

The basic advantages commonly cited for leasing are the ability it gives the lessor to, in effect, depreciate land, its effects on financial ratios, its effect on the firm's liquidity, the ability it gives the firm to obtain 100 percent financing, the limited claims of lessors in the event of bankruptcy or reorganization, the fact that the firm may avoid assuming the risk of obsolescence, the lack of many restrictive covenants, and the flexibility provided. Each of these often cited advantages is described and critically evaluated below.
-Effective depreciation of land. Leasing allows the lessee to, in effect; depreciate land, which is prohibited under a purchase of land. Since the lessee who leases land is permitted to deduct the total lease payment as an expense for tax purposes, the effect is the same as it would be if he or she purchased the land and then depreciated it. The greater the amount of land included in a lease agreement, the more advantageous this factor becomes from the point of view of the lessee. However, this advantage is somewhat tempered by the fact that land generally has a savage value for its purchaser, which it does not for a lessee.
- Effects on financial ratios. Leasing, since it results in the receipt o services from an asset possibly without increasing the assets or liabilities on the firm's balance sheet, may result in misleading financial ratios. With the passage of FASB No.13, this advantage no longer applies to financial lease, although in the case o operating leases it remains a potential advantage. Of course, even in the case of operating leases, the American Institute of Certified Public Accounts requires disclosure of the lease in a footnote to the Firm's statements. Today, most analysts are aware of the significance of leasing for the firm's financial position and will not view the firm's financial statements strictly as presented; instead, they will make certain adjustments to these statements that will more accurately reflect the effect of any existing operating leases on the firm's financial position.
- Increased liquidity .The use of sale-leaseback arrangements may permit the firm to increase its liquidity by converting an existing asset into cash, which can be used as working capital. A firm short of working capital or in a liquidity squeeze can sell an owned asset to a lessor ad lease the asset back for a specified number of years. Of course, this action binds the firm to making fixed payments over period years. The benefits of the increase in current liquidity are therefore tempered somewhat by added fixed financial payments incurred through the lease.
-100 percent financing; another advantage of leasing is that it provide 100 percent financing. Most loan agreements for purchase of fixed assets require the borrower to pay a portion of the purchase price as adown payment. As a result, the borrower receives only 90 to 95 percent of the purchase price of the asset. In the case of a lease, the lessee is not required to make any type of down payment; he or she must make only a series of periodic payments. in essence, a lease permits a firm to receive the use of an asset for a smaller initial out-of-pocket cost than borrowing. However, since large initial lease payments are often required in advance, it is possible to view the initial advance payment as type of down payment.
-Limited claims in the event of bankruptcy or reorganization; when a firm becomes bankrupt or is reorganized, the maximum claim of lessors against the corporation is three years of lease payments. If debt is used to purchase an asset, the creditors have a claim equal to the total amount of unpaid financing. Of course, in such a case an owned asset may have a salvage value that can be used to defray the firm's obligations to its creditors.
-Avoidance of the risk of obsolescence; in a lease arrangement, the firm may avoid assuming the risk of obsolescence if he lessor in setting the lease payments fails accurately to anticipate the obsolescence of assets. This is especially true in the case of operating leases, which generally have relatively short lives. However, most lessors are perceptive enough to require sufficient compensation in both the term and the amount of lease payments to protect themselves against obsolescence.
-Lack of many restrictive covenants; a lessee avoids many restrictive covenants that are normally included as part of a long-term loan. Requirements with respect to minimum working capital, subsequent financing, changes in management, and so on are not normally found in a lease agreement; the only restrictive covenant occasionally included in the lease relates to subsequent lease commitments. The general lack of restrictive covenants allows the lease much greater flexibility in its operations. This many be viewed as an important advantage by the lessee.
-Flexibility provided; In the case of low-cost assets that are infrequently acquired, leasing-especially operating leases-may provide the firm with needed financing flexibility. This flexibility is attributable to the fact that the firm does not have to arrange other financing for these assets and can somewhat conveniently obtain them through a lease, thereby preserving its funds-raising power for the acquisition of more costly assets. The firm also retains its ability to raise funds in economically preferred quantities at the right time, again helping to lower its overall capital costs. Flexibility is also provided in the sense that with a short-term operating lease the firm can buy time to shop around for an owned asset that may be more advantageous from the standpoint of long-run owners´ wealth maximization.

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