Illustrate the difference between Capital Lease and Operating Lease

 Capital Lease

The concept of the capital lease as the name suggests, is a capital investment that is used to lease out equipment, property or any other asset. As the name suggests, the lease contract has long term duration (i.e. a long time period of lease), high rate of rent and the principal cost of the asset that is being leased out is also quite high. The following are some important characteristics of capital lease.

 I) The title of ownership is transferred from the lessor to lessee, when the time period of the lease commences.

 2) The lessee, has to show the depreciation of these assets in the annual profit and loss statement.

 3) In some case, where the title of ownership is not passed on to the lessee, these assets are shown on the liability side of the balance sheet.

 4) Usually the term of the lease exceeds 75% of the useful estimated lifetime of the asset.

 5) In some cases, the lease also contains a clause which enables the lessee to purchase the asset.

 6) The monetary value or consideration for the lease contract is usually high and often expensive.

 Heavy machinery, real estate and large-sized automobiles such as buses and trucks are some prominent examples of assets that come under the heading of capital lease. Tax advantages that are received by the lessee are greater for capital leases.

Operating Lease

 An operating lease as the name suggests is a contract that rents out assets for operation. The cost of getting an operating lease is smaller and affordable, if compared to the capital lease contract. The operating lease is also for smaller assets and for shorter time duration. The following are some important characteristics of operating leases.

 1) An operating lease, has a shorter time duration, that may stretch only for a few months.

 2) The cost of obtaining such leases, is often low and the total sum can be easily repaid in a few months time. Some companies tend to offer a lump sum payment to avoid repetitive transactional costs.

 3) The total cost of the lease is shown only in the profit and loss statement as the title of ownership does not pass on to the lessee.

 4) Usually the contract agreement of such a lease does not mention a purchase clause at the end of the term of the lease.

 5) In some cases, the lessee has to pay the lessor, a monetary sum that is equal to the value of the assets, before taking over the assets. This sum is repaid to the lessee after the term of the lease gets over. This transaction is referred to as the 'deposit' of the lease, and is taken to ensure that the assets are not damaged beyond repair. In case if the assets get damaged. the amount of repair or replacement,  is deducted from the deposit.

 For small business, the operating lease receives the favorable end. An excellent example of an operating lease is the computers that are rented out to companies for a year or so.

 While comparing capital lease and operating lease the important thing is to use the appropriate lease in appropriate situations.

 Problem No.1( May'2011): Y Ltd. is considering an investment project, which will require an equipment costing Tk. 10,00,000. Two options are available to (i) term loan for 5 years. or (ii) to lease such equipment from a leasing company at an annual installment of Tk. 2,00,000 for five years. The asset would be depreciated at straight line method with a salvage value 10% of the asset. The asset will also require an annual repair costs of Tk. 20,000. The company is at 40% tax bracket and its cost of capital (required rate of return) is 10%. Preliminary negotiations with the bank reveal that the company may have a hypothecation loan to be adequate to purchase the asset of Tk. 10,00,000 at 10% interest rate for 5 years to be paid on equal annual installments. The loan is available at 20% compensating balance. As a manager, decide which one is acceptable-leasing or borrow-buy. (The present values of Tk. 1 for five years at 10% are 0.909; 0.826; 0.751; 0.683 and 0.620)

(i ) If the company take lease

Statement of payment procedure in the context of lease perspective

Year	Amount of Rent (Tk.)	Rebate of Tax (c~45%	Cash outflow 3=1-2	PV flow	PV g10%
0	1	2	3	4	5
0	2,00,000	0	2,00,000	1.00	2,00,000
1-4	2,00,000	90,000	1,10,000	3.17	3,48,000
	0	90,000	(90,000)	0.621	(55,890)
Total                                                                                                                =4,92,810

 

(ii) I f the company take loan

First find out the installment size:

Installment size =Principal= [1/R-1/R(1+R)"]

=	10,00,000  = [1/o.lo-vo.lo(l+o.lo)s]
=	10,00,000 =	[1/0.10-1/0.000016]
=	10,00,000 =	[0.000016-1 /0.000016]

 

= 10,00,000 = 3.789

= 2,63,922

Table of principal amount & amount of interest for loan perspective

Year	Balance of loan	Amount of installment	Interest @ 10%	Payment of principal amount
0	10,00,000	2,00,000	-	-
1	10,00,000	2.63,922	1,00,000	1,63,922
2	8,36,078	2,63,922	83,608	1,80,314
3	6,55,764	2,63,922	65,576	1,98,346
	4,57,418	2,63,922	45,742	2,18,180
	2,39,238	2,63,922	23,924	2,39,238

 

[Tk. 2,00,000 adjusted which is paid at the period of loan disbursement]

 

Depreciation +Maintenance Exp.=1,80,000

Statement of cash inflow and it's present value in the context of loan and purchase a reement

Year	Payment of loan installment	Interest exp.	Depreci ation+ Exp.	Tax shield able exp	Tax shield 4x45%	Net cash outflow	PV factor	PV of 10%
0	1	2	3	4=2+3	5	6=1-5	7	8=6X7
	2,00,000	-	-	-	-	2,00,000	-	2,00,000
1	2,63,922	1,00,000	_ 1,80,000	_ 2,80,000	_ 1,26,000	1,37,922	09	1,25,371
2	2,63,922 _	83,608	1,80,000	2,63,608	1,18624	1,45,298	0.8264	1,20,074              ,
	2,63,922	65,576	1,80,000	2,45,578	_ 1,10,510	1,53,412	_ 0.75131	1,15.260
	2,63,922 _	45,742	1,80,000	2,25,142	1.01.584	1,62,338	0.6830	1 10.877
5	2,63,922	23,924	1,80,000	2,03,924	91,760	(28,604)	0.620q~ ~(17,761)

Total   6,5 3.821

Less-Salvage value (2,00,OOOx0.62092)   (1.24,180)

Gross Total PV of net cash flow                  5.29.641

 

Here,

 

Total cash outflow Tk.4, 92,810 in case of leasing

Total cash outflow Tk.S, 29,641 in case of purchase and loan Amount sho^-vvn less in case of leasing Tk. 36.831

 

So, in the above circumstances leasing is acceptable.

 

Problem No.2 ( May'2011): XYZ Builders and Co. needs to acquire the use of a crane for construction business and is considering whether to buy or lease. The crane cost Tk. 10,00,000 and subject to straight line depreciation method to a zero salvage value at the end of 5 years. In contrast, lease rent of Tk. 2,20,000 per year to be paid in advance each year for 5 years. The XYZ Builders can raise debt at 14% payable in 5 equal installments, each installment becoming due at the beginning of the year. It is in 50% tax bracket.

 

Advice the company which one is will be beneficial.

Solution:

 

(i ) If the company take lease

Statement of payment procedure in the context of lease perspective

 

Year	Amount of Rent (Tk.)	Rebate of Tax @50%	Cash outflow 3=1-2	PV flow	PV @10%
0	1	2	3	4	5
0	2,20,000	0	2,20,000	1.00	2,20,000
1-4	2,20,000	1,10,000	1,10,000	3.17	3,48,700
	0	1,10,000	(1,10,000)	0.621	(68,310)
Total
=500,390

 

(ii) If the company take loan

 

First find out the installment size:

 

Installment size =Principal = [1/R-1/R(1+R)"]

= 10,00,000 = [1/0.14-1/0.14(1+0.14)⁵] = 10,00,000 = [1/0.14-1/0.14(1.14) ⁵] = 10.,00,000 = [7.14286-3.70975⁵] = 10,00,000 = 3.43311

                   =2,91,281

 

Table of principal amount & amount of interest for loan perspective

Year	Balance of loan	Amount of installment	Interest @14%	Payment of principal amount
0	10,00,000	-	-	-
1	10,00,000	2,91,281	1,40,000	1,51,281
2	8,48,719	2,91,281	1,18,821	1,72,460
3	6,76,259	2,91,281	94,676	1,96,605
4	4,79,654	2,91,281	67,152	2,24,129
	2,55,525	2,91,299	35,774	2,55,525

 

Depreciation =(10,00,000-0)/5=2,00,000

Statement of cash inflow and it's present value in the context of loan and purchase agreement

Y.	Payment of loan installment	Interest exp.	Depreciat ion+,Vop,	Tax shield able exp	Tax shield 4x50%	Net cash outflow	PV factor	PV of 10%
	1	2	3	4=2+3	5	6=1-5	7	8=6X7
1	2,91,281	1,40,000	2,00,000	3,40,000	1,70,000	1 21,281	0.909	1,10,244
2	2,91,281	1,18,821	2,00,000	3,18,821	159,411	1,31,870	0.8264	1,08,977
3	2,91,281	94,676	2,00,000	2,94,676	1,47,338	1,43,943	0.75131	1,08,146
4	2,91,281	67,152	2,00,000	2,68,152	1,33,576	1,57,705	0.6830	1,07,713
5	2,91,299	35,774	2,00,000	2,35,774	1,17,887	1,73,412	0.62092	10,7,675
Total 5,42,755
Gross Total PV of net cash flow 5,42,755

 

Here,

 

Total cash outflow Tk.500,390 in case of leasing

Total cash outflow Tk.5, 42,755 in case of purchase and loan Amount shown less in case of leasing Tk. 42365

So, in the above circumstances leasing is acceptable.