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Financial Management Concepts in Layman's Language

Types of Lease

By on August 4, 2009 in Sources of Finance with 0 Comments

Leases are classified into different types based on the variation in the elements of a lease. Very popularly heard leases are financial and operating lease. Apart from these, there are sale and lease back and direct lease, single investor lease and leveraged lease, and domestic and international lease.

Types of LeaseLease is a very important financing option for an entrepreneur with no or inadequate money for financing the initial investment required in plant and machinery. In lease, the lessor finances the asset or equipment and the lessee uses it in exchange of fixed lease rentals. In other words, lease financing is an arrangement where the lessee who requires the equipment or machinery gets the finance from the lessor for the agreed rental payments. Such kind of lease is called finance lease. There are many such arrangements and hence there are many types of lease. Let us have a look at the different kinds of lease.

Certain variation in the elements of lease classifies lease into different types. Such elements are as follows

  • The degree of ownership risk and rewards transferred to the lessee.
  • No. of parties involved
  • Location of lessor, lessee and the equipment supplier
  • The lessor and the lessee

Here, risk means the chance of technological obsolescence and reward refers to the cash flow generated from the use of equipment and the residual value of the equipment.

Types of Lease:

On the basis of above dimensions, leases are classified into following:

Finance Lease and Operating Lease: Finance lease, also known as Full Payout Lease, is a type of lease wherein the lessor transfers substantially all the risks and rewards related to the asset to the lessee. Generally, the ownership is transferred to the lessee at the end of the economic life of the asset. Lease term is spread over the major part of the asset life. Here, lessor is only a financier. Example of a finance lease is big industrial equipment.

            On the contrary, in operating lease, risk and rewards are not transferred completely to the lessee. The term of lease is very small compared to finance lease. The lessor depends on many different lessees for recovering his cost. Ownership along with its risks and rewards lies with the lessor. Here, lessor is not only acting as a financier but he also provides additional services required in the course of using the asset or equipment. Example of an operating lease is music system leased on rent with the respective technicians.

Sale And Lease Back and Direct Lease: In the arrangement of sale and lease back, the lessee sells his asset or equipment to the lessor (financier) with an advanced agreement of leasing back to the lessee for a fixed lease rental per period. It is exercised by the entrepreneur when he wants to free his money, invested in the equipment or asset, to utilize it at whatsoever place for any reason.

            On the other hand, direct lease is a simple lease where the asset is either owned by the lessor or he acquires it. In the former case, the lessor and equipment supplier are one and the same person and this case is called ‘bipartite lease’. In bipartite lease, there are two parties. Whereas, in the latter case, there are three different parties viz. equipment supplier, lessor, and lessee and it is called tripartite lease. Here, equipment supplier and lessor are two different parties.

Single Investor Lease and Leveraged Lease: In single investor lease, there are two parties – lessor and lessee. The lessor arranges the money to finance the asset or equipment by way of equity or debt. The lender is entitled to recover money from the lessor only and not from the lessee in case of default by lessor. Lessee is entitled to pay the lease rentals only to the lessor.

Leveraged lease, on the other hand, has three parties – lessor, lessee and the financier or lender. Equity is arranged by the lessor and debt is financed by the lender or financier. Here, there is a direct connection of the lender with the lessee and in case of default by the lessor; the lender is also entitled to receive money from lessee. Such transactions are generally routed through a trustee.

Domestic and International Lease: When all the parties of the lease agreement reside in the same country, it is called domestic lease.

International lease are of two types – Import Lease and Cross Border Lease. When lessor and lessee reside in same country and equipment supplier stays in different country, the lease arrangement is called import lease. When the lessor and lessee are residing in two different countries and no matter where the equipment supplier stays, the lease is called cross border lease.

 

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