What is a Finance Lease? Cash Flow Consequences of Financial Lease

finance lease

What is a Finance Lease?

Long term and non- cancellable lease contract is known as finance lease. In India, this type of lease contract is highly popular in terms of high technology equipment with high cost. It amortizes the cost of the asset over the term of lease. Hence, it is also called as capital or full payout lease.

Almost all the financial leases are direct leases. In other words, financial lease is one of the type of leasing contract where lessor buys the asset identified by the lessee from the manufacturer and signs a contract to lease it out to the lessee.

Features of Finance Lease

  • At the end of the lease term, ownership of the property is transferred to lessee.
  • Lessee has the option to pay the lease amount either in the form of balloon or residual payment.
  • There is no inclusion of running costs such as servicing, registration,insurance, etc.
  • Finance lease treated as an asset in the lessee Balance Sheet.

Cash Flow Consequences of a Financial Lease

There are cash flow consequences in case of finance lease. It is a way of normal financing for a company. Suppose, a firm finds it financially worthwhile to acquire an equipment costing Rs. 500 lac. The life of the equipment is say 10 years. Instead of buying the equipment, there is another option available for the company. It can lease the equipment for 10 years for lease rental of Rs 110 lac. Now assume, company will have to provide for the maintenance, insurance and other operating expenses related to use of the assets.

Company is using straight line method for depreciation which is 14%. The tax rate is 35 per cent. So the consequences of the lease as compared to buying option are as follows –

  • The company can acquire the asset immediately. The cash saved is equivalent to cash inflow. This means there is cash inflow of Rs 500 lac.
  • Depreciation is a deductible expense which saves tax. The tax shield is equal to the amount of depreciation each year multiplied by tax rate. When the organisation takes leases, it loses the depreciation tax shield.

So, tax shield lost = 50 × 0.35

                           = 17.5 lac.

  • There is a cash out flow of Rs. 110 lac per year as lease payments. But these payment will yield tax shield of Rs 110 × 0.35 that is 38.5 lac per year. Hence the after tax lease payments would be Rs 110 – 38.5 = 71.5 lac per year.

However, the tax shield is available only when company pays taxes. In case, it did not, then depreciation is worth noting for it.

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