LEASING

With a leasing contract the lessor (manufacturer, or specialised leasing company, often attached to a bank) undertakes to supply

the lessee with the use of a piece of equipment during a precise period of time. Leasing companies or bank subsidiaries do not maintain an inventory of equipment. They only purchase equipment which is immediately leased, thus acting as pure financial intermediaries between the manufacturer and the user.

The important clauses in the contract concern the definition of the leased item, the amount of the payments, the length of the lease and the disposal of the equipment at the end of the lease. The length of the contract, of course, cannot exceed the economic life of the item in question.

The following types of end-of-contract clauses could be stipulated:

- restore the item to its owner
- option to acquire the item at a predetermined price
- sign a new lease contract for the item

Such clauses only have a meaning if there is some residual value leftover at the end of the contract.

If a new more efficient or better adapted model of equipment appears on the market, then the lessor will have the right to trade in the old equipment and lease a new one.

A principal advantage of leasing is protection against the risk of obsolescence the cost of which - included in the lease payments - is, nevertheless, assumed by the lessee, even though the manufacturer is often responsible for this state of affairs. Another advantage of leasing is a higher quality of service (repairs, and technical assistance) assuming that the lessor maintains the equipment.

Maintenance is not always included in the cost of the lease. In this case, the lessee will be obliged to conclude a maintenance contract for the duration of the leasing period.

A leasing contract constitutes a means of financing : instead of paying the purchase price of an item up front, the lessor agrees to make periodic lease payments. Thus the lessee, in effect, contracts a debt which is equal to the sum of the lease payments. It can be concluded, therefore, that leasing is a form of debt financing.

Example :

Purchase price of an equipment : 2.000,000 €
Length of contract (irrevocable) : 5 years
Lease payment due at year end : 550,000 €
Market interest rate : 7.5 %
Maintenance included in lease payment

In order to simplify the calculation, we will assume that lease payments are annual and due at year end. In reality, such payments are typically monthly or quarterly due at the beginning of the period. We will also assume that the length of the lease corresponds exactly to the economic life of the equipment. Hence, there is no residual value. In fact, in the case of bank financing, the debt is serviced at the end of the period. (reimbursement and interest).

The cost of leasing (r)

2,000,000	=	550,000	+	550,000	+	550,000	+	550,000	+	550,000
		(1+r)1		(1+r)2		(1+r)3		(1+r)4		(1+r)5

 

 

 

Resultat : r = 11,65 %

At a rate of 11.65 %, the present value of lease payments is equal to the purchase price of the equipment which is 2,000,000. In this case, the lease contract adds up to a financing which costs 11.65 % per year.

This difference between the market interest rate of 7,5 % and the cost of leasing of 11,65 % is justified to the extent that the lessor offers additional services besides financing (maintenance, repairs, the possibility of exchanging the equipment in case of obsolescence, technical assistance, etc).

Calculation of the lease premium

This extra cost embedded in a lease contract, called the lease premium, can be calculated by decomposing the lease payment into two distinct parts : first, the elements linked to servicing the debt and, secondly, the rest which constitutes the lease premium.

If we wish to isolate the elements linked to the lessor's financing, we must consider that the company would have obtained the same financing at a rate of 7.5% for the 2'000'000 € borrowed.

PV of payments	=	550,000	+	550,000	+	550,000	+	550,000	+	550,000
		(1,075)1		(1,075)2		(1,075)3		(1,075)4		(1,075)5

 

 

 

PV of payments = 2'225'237 €

In signing the contract, the company agrees to make annual payments of € 550,000 during 5 years, or a total sum of €. 2,750,000. Nevertheless, the company could have borrowed at a rate of 7.5 %.

If the company had made the same payments with an effective interest rate of 7.5%, it would have been able to borrow € 2'225'237 instead of only € 2,000,000, as allowed by the contract for five payments of € 550,000.

Thus, we can conclude that this leasing contract is the equivalent of a borrowing of € 2,000,000 at 7.5 % over 5 years, plus an additional beginning payment to the lessor of € 225,237, which constitutes the lease premium.

Decomposing lease payments

If the company borrows € 2,000,000 at 7,5 % instead of contracting a leasing, the annuity (interest + reimbursement) will be calculated as follow :

2,000,000 (PV)	=	Annuity	+	Annuity	+	Annuity	+	Annuity	+	Annuity
		(1,075)1		(1,075)2		(1,075)3		(1,075)4		(1,075)5

Formula :

Annuity	=	PV	.	i
				(1 -r-n)

 

 

 

The amount of the annuity (service of the debt) is € 494,329,37. As the company pays € 550,000 each year, the lease premium year by year contained in the lease payment is € 55,670,63. The advantage of this approach is to identify the lease premium year by year instead of only at the beginning of the contract, as demonstrated above.

	Service of the debt				Lease premium
Year	Debt	Interest	Reimbursement	Annuity	Premium	PV of premium
1	2,000,000,00	150,000,00	344,329,37	494,329,37	55,670,63	51,786,63
2	1,655,670,63	124,175,30	370,154,07	494,329,37	55,670,63	48,173,61
3	1,285,516,56	96,413,74	397,915,63	494,329,37	55,670,63	44,812,66
4	887,600,94	66,570,07	427,759,30	494,329,37	55,670,63	41,686,20
5	459,841,64	34,488,12	459,841,25	494,329,37	55,670,63	38,777,86
6	Total	471,647	2,000, 000	2,471,647		225,237

Accounting

In most of companies lease payments are charged to the account "Lease" as a full expense. But, as demonstrated above, if we consider the leasing contract as a mean of financing, the lease payment contains three things : an interest, a reimbursement and a premium. Consequently, the equipment leased must be added to the fixed asset and the debt contracted must be added to the Long term Debts.

Balance sheet	31.12.
Total of Current Assets	680
Property & Equipment	2639
Equipment leased	2000
Total of Assets	5319
Current Liabilities	619
LT Debts	1050
LT Debt (leasing)	2000
Common Stock	1100
Retained Earnings	550
Total Owners' Equity	1650
Total Liabilities & Equity	5319

Accounting of the first lease payment of € 550,000,00 :

Accounts to be debited	Accounts to be credited	Debit	Credit
Interest expense	-	150,000,00	-
LT Debt (leasing)	-	344,329,37	-
-	Bank	-	494,329,37
Depreciation	Equipment leased	344,329,37	344,329,37
Lease expense	Bank	55,670,63	55,670,63

This method, which should be applied by every company, has the advantage to decompose the lease payment in three type of expenses : (available for the first lease payment)

Interest expense	150,000,00
Lease expense	55,670,63
Depreciation	344,329,37
Total of lease payment	550,000,00

 

 

 

With this method many key financial indicators will be different : Debt/Equity ratio, WACC, Risk, etc

(c) ECOFINE.COM, Bernard Jaquier, Professor in Economics & Finance, Lausanne, Switzerland, 2018