FM12 Ch 20 Tool Kit - 1/4/2007 Chapter 20. Tool Kit for...

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1/4/2007 Chapter 20. Tool Kit for Lease Financing TYPES OF LEASES (Section 20.1) FINANCIAL STATEMENT EFFECTS (Section 20.3) Before the increase in assets Firms B and L Curr. Assets 50 Debt 50 Debt Ratio Fixed Assets 50 Equity 50 50% Total Assets 100 100 After the increase in assets Firm B Curr. Assets 50 Debt 150 Debt Ratio Fixed Assets 150 Equity 50 75% Total Assets 200 200 Firm L Curr. Assets 50 Debt 50 Debt Ratio Fixed Assets 50 Equity 50 50% Total Assets 100 100 EVALUATION BY THE LESSEE (Section 20.4) PROBLEM Input Data (all dollar figures in thousands) New Equipment cost $100 KEY OUTPUT Leasing provides firms with a flexible alternative when it comes to acquiring productive assets. Instead of buying fixed assets and having them on the balance sheet, companies may opt to lease. About 30% of all new capital equipment acquired by businesses is leased. Leasing generally takes one of three forms: (1) sale-and-leaseback arrangements, (2) operating leases, and (3) straight financial, or capital, leases. A sale-and-leaseback arrangement is one whereby a firm sells land, buildings, or equipment and simultaneously leases the property back for a specified period under specific terms. An operating lease is one in which the lessor maintains and finances the property. A financial lease does not provide for maintenance services and is not cancelable. This kind of lease is fully amortized over its life (and therefore is also called a capital lease). Lease payments are shown as operating expenses on a firm's income statement. Under certain conditions, neither the leased assets nor the liabilities under the lease contract appears on the firm's balance sheet. For these reasons, leasing is often called "off balance sheet financing". This can be illustrated by looking at the hypothetical firms, B and L. These two firms are identical in every way, except Firm B has decided to buy its new assets, while Firm L has chosen to lease. From this simple example, we see that by leasing the assets Firm L did not change its capital structure at all. Whereas, Firm B would be increasing their debt ratio from 50% to 75%. Recall from Chapter 16, increased debt, amongst other effects, increases the risk of the firm, its assets, and its equity. In fact, this example typifies the use of operating and financial leverage. Firm is increasing its fixed costs, and its debt in one action. Any prospective lease must be evaluated by both the lessee and the lessor.
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FM12 Ch 20 Tool Kit - 1/4/2007 Chapter 20. Tool Kit for...

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