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What is a lease?

What is a lease?

Leases come in many forms, but in all cases the lessee (user) promises to make a series of payments to the lessor (owner). The lease contract specifies the monthly or semiannual payments, with the first payment usually due as soon as the contract is signed. The payments are usually level, but their time pattern can be tailored to the user’s needs. For example, suppose that a manufacturer leases a machine to produce a complex new product. There will be a years “shakedown” period before volume production starts. In this case, it might be possible to arrange for lower payments during the first year of the lease. When a lease is terminated, the leased equipment reverts to the lessor. However, the lease agreement often gives the user the option to purchase the equipment or take out a new lease.

Some leases are short-term or cancelable during the contract period at the option of the lessee. These are generally known as operating leases. Others extend over most of the estimated economic life of the asset and cannot be canceled or can be canceled only if the lessor is reimbursed for any losses. These are called capital, financial, or full-payout leases.

Financial leases are a source of financing. Signing a financial lease contract is like borrowing money. There is an immediate cash inflow because the lessee is relieved of having to pay for the asset. But the lessee also assumes a binding obligation to make the payments specified in the lease contract. The user could have borrowed the full purchase price of the asset by accepting a binding obligation to make interest and principal payments to the lender. Thus the cash-flow consequences of leasing and borrowing are similar. In either case, the firm raises cash now and pays it back later. A large part of this chapter will be devoted to comparing leasing and borrowing as financing alternatives.

Leases also differ in the services provided by the lessor. Under a full-service, or rental, lease, the lessor promises to maintain and insure the equipment and to pay any property taxes due on it. In a net lease, the lessee agrees to maintain the asset, insure it, and pay any property taxes. Financial leases are usually net leases. Most financial leases are arranged for brand new assets. The lessee identifies the equipment, arranges for the leasing company to buy it from the manufacturer, and signs a contract with the leasing company. This is called a direct lease. In other cases, the firm sells an asset it already owns and leases it back from the buyer.

These sale and lease-back arrangements are common in real estate. For example, firm X may wish to raise cash by selling a factory but still retain use of the factory. It could do this by selling the factory for cash to a leasing company and simultaneously signing a long-term lease contract for the factory. Legal ownership of the factory passes to the leasing company, but the right to use it stays with firm X.

You may also encounter leveraged leases. These are financial leases in which the lessor borrows part of the purchase price of the leased asset, using the lease contract as security for the loan. This does not change the lessees obligations, but it can complicate the lessors analysis considerably.

Taken from Principles of Corporate Finance by Richard A. Brealey and Stewart C. Myers (7th edition)

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