Lease Financing
A lease is a contract whereby the owner of an asset (the lessor) grants to another party (the lessee) the exclusive right to use the asset, usually for an agreed period of time, in return for the payment of rent.' Most of us are familiar with leases of houses, apartments, offices, or telephones. Recent decades have seen an enormous growth in the leasing of business assets such as cars and trucks, computers, and manufacturing plants. An obvious advantage to the lessee is the use of an asset without having to buy it. For this advantage, the lessee incurs several obligations. First and foremost is the obligation to make periodic lease payments, usually monthly or quarterly and in advance. Also, the lease contract, specifies who is to maintain the asset. Under a maintenance lease, the lessor pays for maintenance, repairs, taxes, and insurance. Under a net lease, the lessee pays these costs.
The lease may be cancellable or noncancellable. When cancellable, there sometimes is a penalty. An operating lease for office space, for example, is relatively short term in length and is cancellable with proper notice. The term of this type of lease is shorter than the asset's economic life. In other words, the lessor does not recover its investment during the first lease period. It is only in releasing the space over and over, either to the same party or to others, that the lessor recovers its cost.' Other examples of operating leases include the leasing of copy
ing machines, certain computer hardware, word processors, and automobiles. In contrast, a financial lease is longer term in nature and is noncancellable. The lessee is obligated to make lease payments until the lease's expiration, which corresponds to the useful life of the asset. These payments not only amortize the cost of the asset but provide the lessor an interest return. Our focus in this chapter is on financial as opposed to operating leases.
Finally, the lease contract typically specifies some kind of option to the lessee at expiration. It may involve renewal, where the lessee has the right to renew the lease for another lease period, either at the same rent or at a different, usually lower, rent. The option might be to purchase the asset at expiration. For tax reasons, the purchase price must not be signficantly lower than what the asset would fetch from another party in the market. If the lessee does not exercise its option, the lessor takes possession of the asset and is entitled to any residual value associated with it.
Because of the contractual nature of a financial lease obligation, it must be regarded as a form of financing. It is used in place of other methods of financing to acquire the use of an asset. An alternative method of financing might be to purchase the asset and finance its acquisition with debt. Both the lease payment and the payment of principal and interest on debt are fixed obligations that must be met. Inability to meet these obligations will result in financial embarassment. Thus, lease financing and debt financing are very similar from the standpoint of analyzing the ability of the firm to service fixed obligations.
Virtually all lease financing arrangements fall into one of three main types of lease financing: a sale and leaseback arrangement, the direct acquisition of an asset under a lease, and leveraged leasing. Before analyzing lease financing or its basic valuation implications, let us look at the three categories.
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