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Leveraged Leases




Sale and Lease-Back

Financial Leases

Financial leasesare the exact opposite of operating leases, as is seen from their important characteristics:

1. Financial leases do not provide for maintenance or service by the lessor.

2. Financial leases are fully amortized.

3. The lessee usually has a right to renew the lease on expiration.

4. Generally, financial leases cannot be canceled. In other words, the lessee must make all payments or face the risk of bankruptcy.

Because of the above characteristics, particularly (2), this lease provides an alternative method of financing to purchase. Hence, its name is a sensible one. Two special types of financial leases are the sale and lease-back arrangement and the leveraged lease.

A sale and lease-back occurs when a company sells an asset it owns to another firm and immediately leases it back. In a sale and lease-back, two things happen:

1. The lessee receives cash from the sale of the asset.

2. The lessee makes periodic lease payments, thereby retaining use of the asset.

An example of a sale and lease-back occurred in July 1985 when the city of Oakland, California, used the proceeds of a sale of its city hall and 23 other buildings to help meet the liabilities of the $150 million Police and Retirement System. As par of the same transaction, Oakland leased back the buildings to obtain their continued use.

A leveraged lease is a three-sided arrangement among the lessee, the lessor, and the lenders

1. As in other leases, the lessee uses the assets and makes periodic lease payments

2. As in other leases, the lessor purchases the assets, delivers them to the lessee and collects the lease payments. However, the lessor puts up no more than 40 to 50 percent of the purchase price.

3. The lenders supply the remaining financing and receive interest payments from the lessor. Thus, the arrangement on the right-hand side of Figure.1 would be a leveraged lease if the bulk of the financing was supplied by creditors.

The lenders in a leveraged lease typically use a nonrecourse loan. This means that the lessor is not obligated to the lender in case of a default. However, the lender is protected in two ways:

1. The lender has a first lien on the asset.

2. In the event of loan default, the lease payments are made directly to the lender.

The lessor puts up only part of the funds but gets the lease payments and all the tax benefits of ownership. These lease payments are used to pay the debt service of the nonrecourse loan. The lessee benefits because, in a competitive market, the lease payment is lowered when the lessor saves taxes.

 





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