A large fraction of America’s equipment is leased rather than purchased. This chapter has described different lease types, accounting and tax implications of leasing, and how to evaluate financial leases.
Leases can be separated into two types, financial and operating. Financial leases are generally longer-term, fully amortized, and not cancelable without a hefty termination payment. Operating leases are usually shorter-term, partially amortized, and cancelable.
The distinction between financial and operating leases is important in financial accounting. Financial (capital) leases must be reported on a firm’s balance sheet; operating leases are not. We discussed the specific accounting criteria for classifying leases as capital or operating.
Taxes are an important consideration in leasing, and the IRS has some specific rules about what constitutes a valid lease for tax purposes.
A long-term financial lease is a source of financing much like long-term borrowing. We showed how to go about an NPV analysis of leasing to decide whether leasing is cheaper than borrowing. A key insight was that the appropriate discount rate is the firm’s aftertax borrowing rate.
We saw that the existence of differential tax rates can make leasing an attractive proposition for all parties. We also mentioned that a lease decreases the uncertainty surrounding the residual value of the leased asset. This is a primary reason cited by corporations for leasing.
