4.11 Comparative Asset Financing Options Advantages and Disadvantages

Benefits / Demerits of Operating Lease

(A) A small – or no – cash outlay is required.

(B) Lessee may lease property for only a portion of its economic life; an operating lease can be useful for temporary equipment needs.

(C) Lessor retains risk of ownership; there may be a purchase option.

(D) Lessor’s expert service is available.

(E) Lessee avoids capitalization and liability recognition, with, presumably the negative impact of the Lease Obligation on the firm’s debt ratio. This may positively impact ROI, given lower recorded investment and higher potential inflows.

(F) There is less concern about violating any restrictive bond covenants.

(G) Lease payments are a tax-deductible expense.

Benefits / Demerits of Financing Lease

(H) Typically, higher long-term cost; no build-up of any equity.

(I) Lessee capitalizes and depreciates the asset.

(J) Interest costs are typically higher than on debt.

(K) Lease payments are recorded as “principal and interest” and may be a tax-deductible expense.

(L) If tenable, this serves as a means of transferring an asset to a higher tax bracket entity (depending on business opportunity and the state of tax laws).

• Historically, higher tax bracket entities tended to capitalize leases to take advantage of the tax-deductible depreciation expense. Long-term leases tend to be higher than short-term leases, thus the tax deduction is beneficial.

(M) Lessee, in many cases, cannot make improvements to leased property, as s/he is not the owner.

Benefits / Demerits of Buy and Borrow

(N) Lease Payments are fully tax-deductible as “lease expense”.

(O) Only the interest portion of the loan, but not the amortization, is tax-deductible.

(P) The firm will depreciate an owned asset, most probably, at a different rate than it amortizes the leased asset.

(Q) The interest rate on a loan may differ from the internal lease rate (implied by its IRR)