Chapter 07: Leasing

Companies
A contract between two parties where one party
provides the right to another party to use an asset
without being owner for a lump sum or periodic
receipts and that another party agrees to use that
asset in exchange of making lump sum or periodic
payments is called lease. The party presently owns
the asset and provides the using right to another
party is called lessor and the party uses the asset is
called lessee. The company doing this type of
business i.e. providing asset using right through
contracts for earning profit is known as leasing
company.
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Advantages of leasing

Leasing is less capital-intensive than Purchasing.

Capital assets may fluctuate in value and it shifts risks
to the lessor.
New businesses are formed by using the fund saved
from leasing solve unemployment problem.
iv. Leasing may provide more flexibility to a business
which expects to grow or move in the relatively short
term.
v. In some cases a lease may be the only practical
option; such as for a small business that wishes to
locate in a large office building within tight locational
parameters.
7-2

Types of leases
1. Operating lease: The short-term and
cancelable lease contract where the owner/lessor
assumes all repairs and maintenance expenses is
called operating lease.
2. Capital or financial lease: The long-term
and non-cancelable lease contract where the
user/lessee assumes all repairs and maintenance
expenses is called capital lease. This capital
lease is categorized into the followings:
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Types of leases
(a) Direct financing lease: The long-term lease agreement where
after participating the contract the lessor places an order to the
supplier or manufacturer of the asset for making delivery
directly to the lessee is called direct financing lease.
(b) Sale and lease back: The long-term lease agreement where
after selling an asset to the buyer, the seller i.e. previous owner
takes back the asset under lease for using as lessee is called
sale and lease back.
(c) Leveraged lease: The long-term lease agreement where after
participating the contract the lessor borrows the deficit fund
from the lender for buying the asset from the supplier or
manufacturer and then delivers the asset to the lessee is called
leveraged lease.
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Criteria for capital

lease

1. The lessee should have bargain purchase option at

the end of the lease period.
2. The lessee should have renewal option of the lease.
3. The ownership of the leased asset should be
automatically transferred from the lessor to the
lessee.
4. The present value of all rental payments should be
equal or more than 90% of the market value of the
leased asset.
5. The lease period should be equal or more than 75%
of the assets economic life.
7-5

Rational for leasing

1. Shifting equipment disposal
problem.
2. Shifting equipments obsolescence
risk.
3. Preserving credit capacity.
4. Conserving working capital.
5. Maintaining liquidity.
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Rational for leasing

6. Enjoying tax benefit on rental
payments.
7. Improving financial position of the
statement i.e. balance sheet.
8. Accelerating the acquisition of required
asset.
9. Facilitating the using opportunity of an
asset without owning and buying.
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Example
Annual revenue Tk.4000
Expected useful life 4 years
Tax rate 40%
If the asset is bought
Purchase price Tk.6000
Class life 3 years
Estimated salvage value is zero
Straight-line depreciation method
with half-year convention
Annul operating expenses Tk.1000
Required rate of return is 12%

If the asset is leased

Annual lease payment Tk.2800
Annual operating expense Tk.1000
Incremental borrowing rate of
the lessor is 10%

Which option will be chosen?

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Solution: Calculation of NPV

under buy alternative
Year

CFBT

Depre
ciation

Taxable Tax
income Payment

CFAT

PV @
12%

-6000

-6000

3000

1000

2000

800

2200

1965

3000

2000

1000

400

2600

2072

3000

2000

1000

400

2600

1851

3000

1000

2000

800

2200

1399

Net present value (NPV)

1287
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Calculation of NPV under

lease alternative:
Year

Initial
savings

Lost
tax
shield

Net
Lease
payment

Total
payment

PV @ 6%

+6000

+6000

6000

400

1680

2080

-1962

800

1680

2480

-2207

800

1680

2480

-2082

400

1680

2080

-1648

Net present value (NPV)

-1899
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Decision
Since NPV of buy alternative is
positive and NPV of lease alternative
is negative buy alternative will be
chosen.

7-11

Problem
The buy alternative of a company has
NPV= -8000. The cost of asset is
Tk.250000 and will be depreciated under
straight-line method for 3 years period.
By leasing initially Tk.250000 can be
saved. An annual lease payment is
Tk.80000, tax rate is 45% and borrowing
rate is 10%. Comment about the
financing decision.
7-12

Leasing in Islamic
Finance
Operating ijarah (ijarah tashgheeliah):
According to operating ijarah, an owner of a
property leases it to others for a specified
period. The ownership of the leased property
remains with the owner at the end of the lease
tenor. For example, an Islamic bank could have
some properties/assets on its books for lease.
These properties/assets will remain on the
banks books at the end of ijarah. Typically, this
operating lease is not preceded by a promise
by the owner to sell it to the lessor.
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Leasing in Islamic
Finance
Financial
ijarah
(ijarah
muntahia
bittamleek): This is a modern form of ijarah
that has been created following the evolution
of Islamic banking and finance. It constitutes a
form of ijarah in which ownership is transferred
to the lessee at the end of a specific period.
According to the method of ownership transfer,
this particular type of ijarah can be classified
into following types:
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Leasing in Islamic
Finance
i) Ijarah muntahia bittamleek through
hibah (gift): where legal title is transferred to
the lessee without any more payments. The
financial lease that is associated with hibahtype transfer is widely used by Islamic banks.
ii) Ijarah muntahia bittamleek through
ba'i (sale): in this type of ijarah, the lease
agreement is executed with an understanding
that the lessor will sell the property to the
lessee at the end of ijarah tenor.
7-15