A lease in its most basic form is the renting of some sort of property. For instance, a company requires a forklift for its business, but cannot afford to buy one outright or, alternatively, does not need the forklift for a long period of time. As a result, the company leases the forklift for a period of time. The lease can either be an operating lease or a capital lease.
When purchasing an asset, the buyer acquires ownership of the asset and all benefits and risks embodied in the asset. A firm may acquire use of an asset, including some or all of its benefits and risks, for specified periods of time by making payments through a contractual arrangement called a lease
. Using leases, a firm can avoid tying up too much capital in fixed asset investment.
General incentives for leasing:
- Lessee ownership is closely held; risk reduction is important.
- Lessor has market power and can generate higher profits by leasing the asset than selling it.
- Asset is not specialized to the firm.
- Asset's value is not sensitive to use or abuse (as owner takes better care of asset than lessee).
- Tax incentives. If the lessee is in a low tax bracket and the lessor in a high tax bracket, there are tax benefits to structuring the lease as an operating lease. The reason for this is that by leasing the asset the lessor can retain greater tax benefits from owning the asset (such as accelerated depreciation methods for tax purposes).
Factors favoring an operating lease:
- Period of use is short relative to the overall life of the asset.
- Lessor has a comparative advantage in reselling the asset.
- Corporate bond covenants contain specific covenants relating to financial policies that firms must follow. An operating lease results in lower leverage ratios and higher asset turnover ratios.
- Management compensation contracts contain provisions expressing compensation as a function of returns on invested capital.