What is the meaning of lease financing? Explain its advantages and limitations.

  A lease can be defined as an arrangement between the lessor (owner of the asset) and the lessee (user of the asset) whereby the lessor purchases an asset for the lessee and allows him to use it in exchange for periodical payments called lease rentals or minimum lease payments (MLP). Leasing is beneficial to both the parties for availing tax benefits or doing tax planning. At the conclusion of the lease period, the asset goes back to the lessor (the owner) in an absence of any other provision in the contract regarding compulsory buying of the asset by the lessee (the user).

There are four different things possible post-termination of the lease agreement. A famous quote by Donald B. Grant says, “Why own a cow when the milk is so cheap? All you really need is milk and not the cow.” The concept of Lease is influenced by this quote. We can compare ‘milk’ with the ‘rights to use an asset’ and ‘cow’ with the ‘asset’ itself. Ultimately, a person who wants to manufacture a product using machinery can get to use that machinery under a leasing arrangement without owning it.

Advantages of Leasing:- 

1.Balanced Cash Outflow – The biggest advantage of leasing is that cash outflow or payments related to leasing are spread out over several years, hence saving the burden of one-time significant cash payments.

This helps a business to maintain a steady cash-flow profile.

2. Quality Assets – While leasing an asset, the ownership of the asset still lies with the lessor whereas the lessee just pays the rental expense.

Given this agreement, it becomes plausible for a business to invest in good quality assets which might look unaffordable or expensive otherwise.

3. Better Usage of Capital- Given that a company chooses to lease over investing in an asset by purchasing, it releases capital for the business to fund its other capital needs or to save money for a better capital investment decision.

4. Tax Benefit – Leasing expense or lease payments are considered as operating expenses, and hence, of interest, are tax-deductible. 

Disadvantages of Leasing:-

1. Lease Expenses- Lease payments are treated as expenses rather than as equity payments towards an asset.

2. Reduced Return for Equity Holders- Given that lease expenses reduce the net income without any appreciation in value, it means limited returns or reduced returns for an equity shareholder.

In such a case, the objective of wealth maximization for shareholders is not achieved.

3. Debt- Although a lease doesn’t appear on the balance sheet of a company, investors still consider a long-term leases as debt and adjust their valuation of a business to include leases.

4. Limited Access to Other Loans- Given that investors treat long-term leases as debt, it might become difficult for a business to tap capital markets and raise further loans or other forms of debt from the market. 

Subcribe on Youtube - IGNOU SERVICE

For PDF copy of Solved Assignment

WhatsApp Us - 9113311883(Paid)