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FINANCIAL LEASES

A financial lease is the other major type of lease. In contrast to the situation with an operating 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 leases by 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 cannot be canceled, at least not without a significant penalty. In other words, the lessee must make the lease payments or face possible legal action.

The characteristics of a financial lease, particularly the fact that it is fully amortized, make it very similar to debt financing, so the name is a sensible one. There are three types of financial leases that are of particular interest: tax- oriented leases, leveraged leases, and sale and leaseback agreements. We consider these next.

Tax-Oriented Leases

A lease in which the lessor is the owner of the leased asset for tax purposes is called a tax-oriented lease. Such leases are also called tax leases or true leases. In contrast, a conditional sales agreement lease is not a true lease. Here, the ¬lessee ­ is the owner for tax purposes. Conditional sales agreement leases are really just secured loans. The financial leases we discuss in this material are all tax leases.

Tax-oriented leases make the most sense when the lessee is not in a position to use tax credits or depreciation deductions that come with owning the asset. By arranging for someone else to hold title, a tax lease passes these benefits on. The lessee can benefit because the lessor may return a portion of the tax benefits to the lessee in the form of lower lease costs.

Leveraged Leases

A leveraged lease is a tax-oriented lease in which the lessor borrows a substantial portion of the purchase price of the leased asset on a nonrecourse basis, meaning that if the lessee stops making the lease payments, the lessor does not have to keep making the loan payments. Instead, the lender must proceed against the lessee to recover its investment. In contrast, with a single-investor lease, if the lessor borrows to purchase the asset, the lessor remains responsible for the loan payments regardless of whether or not the lessee makes the lease payments.

Sale and Leaseback Agreements

A sale and leaseback occurs when a company sells an asset it owns to another party and immediately leases it back. In a sale and leaseback, two things happen:

1. The lessee receives cash from the sale of the asset.

2. The lessee continues to use the asset.

Often, with a sale and leaseback, the lessee may have the option to repurchase the leased asset at the end of the lease.

An example of a sale and leaseback occurred in July 1985 when the city of Oakland, California, used the proceeds from the sale of its city hall and 23 other buildings to help meet the liabilities of its $150 million Police and Retirement System, which was underfunded by about $60 million. As part of the same transaction, Oakland leased back the buildings to provide for their continued use.

A little more recently, in March 1998, cash-strapped Korean Airlines announced plans to sell 14 of its aircraft and then lease them back from the purchaser. Although the purchaser was not revealed, it was widely understood that KAL was working with General Electric Capital Aviation Services, one of the largest lessors specializing in aircraft. Under terms of the deal, KAL would raise about $386 million in badly needed cash without giving up control of its planes.

CONCEPT QUESTIONS

What are the differences between an operating lease and a financial lease?

What is a tax-oriented lease?

What is a sale and leaseback agreement?

LEVERAGED LEASE A financial lease in which the lessor borrows a substantial fraction of the cost of the leased asset on a non recourse basis.

SALE AND LEASEBACK A financial lease in which the lessee sells an asset to the lessor and then leases it back.

FINANCIAL LEASE Typically a longer-term, fully amortized lease under which the lessee is responsible for main-tenance, taxes, and insurance. Usually not cancelable by the lessee without penalty.

TAX-ORIENTED LEASE A financial lease in which the lessor is the owner for tax purposes. Also called a true lease or a tax lease.