Page 54 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes 3.6 Leasing and Hire Purchase as a Source of Finance

A lease is a contractual arrangement under which the owner of an asset (called the lessor) agrees to
allow the case of its asset by another party (lessee) in exchange of periodic payments (lease-rental)
for a specified period. The lessee pays the lease rent as a fixed payment over a period of time at the
beginning or at the end of a month, quarter, half year or year. Although generally fixed, lease rents
can be tailored both in terms of amount and tuning to the profits and cash flow position of the lessee.
At the end of the lease contract, the asset reverts back to the real owner i.e., the lessor. However, in
long-term lease contract, the lessee is generally given the option to buy or renew the lease.
Lease agreements are divided into two major ones—operating lease and financial lease.

Operating lease is for periods shorter than the useful life of the asset and is cancelable at the
option of the lessee. On the other hand, financial lease involves a relatively longer-term
commitment on the part of the lessee and non-cancelable during the entire period specified in
the contract. Operating lease is common among equipments/assets exposed to technological
obsolescence such as computers, data processing equipments.
Financial leases are commonly used for leasing land, buildings and large pieces of fixed
equipments.

Advantages of Leasing

1. Shifting the risk of technological obsolescence to the owner (lessor) the leasing company.
2. Easy source of finance: A lessee (user of the machine) avoids many of the restrictive
covenants that are normally in the long-term loan agreements while borrowing from
financial institution or commercial banks.
3. Enhance liquidity: A firm having shortage of working capital or forecasting liquidity
problem may exercise the option of the selling the owned asset to a lesser (leasing company)
and take it back on lease basis (the transaction is known as sale cum lease back).
4. Conserving borrowing capacity through off the balance-sheet financing.
5. Improved performance as reflected through improved turnover of assets.
6. Governance and flexibility-by adjusting the term based on losses) requirements.
7. Maintenance and specialized services: Under a full service lease, the lessee receives
maintenance and other specialized services. Even in other types of lease, it is generally
common to have maintenance provided by the lessor, thus absolving the lessee of the
maintenance arrangement.
8. Lower administrative cuts as compared to other source of finance.

Disadvantages

1. Risk of being deprived of the use of equipment of the lessors (owners) financial condition
worsens, or if the leasing company is worried up, the lessee may be deprived of the use of
the equipment thus disrupting normal manufacturing operations.
2. Alteration/change in the asset: Under the lease, the lessee is generally prohibited from
making alterations/improvements on the leased asset without the prior approval of the
lessor (the owner).
3. Terminal value of the asset: In case of assets (such as land and buildings), which have high
terminal value at the end of the lease term, it would be more appropriate to own the asset
than to lease it.
4. To make lease payments even if the asset has become obsolete. If a lessee leases an asset
that subsequently becomes obsolete, it still must make lease payments over the remaining
term of the lease. This is true even if the asset is unsaleable.

48 LOVELY PROFESSIONAL UNIVERSITY