Model Answer
0 min readIntroduction
In modern finance, businesses often seek alternatives to traditional borrowing for acquiring assets. Leasing, leveraged buying, and hire-purchase are prominent options, each with distinct characteristics. These methods allow companies to utilize assets without immediate outright purchase, impacting their financial statements and cash flows differently. ‘Sale and leaseback’ is another crucial financial tool, particularly useful for unlocking capital tied up in owned assets. Understanding the nuances of each option is vital for effective financial management and strategic decision-making. This answer will delve into the comparative analysis of these options and the conditions under which ‘sale and leaseback’ proves advantageous.
Leasing, Leveraged Buying, and Hire-Purchase: A Comparative Analysis
Let's begin by defining each option:
- Leasing: A contractual agreement where an asset owner (lessor) grants another party (lessee) the right to use the asset for a specified period in exchange for periodic payments. Ownership remains with the lessor.
- Leveraged Buying: A financing method where a significant portion of the asset's cost is financed through debt, often involving a loan secured by the asset itself. The buyer gains ownership but carries the debt burden.
- Hire-Purchase: An agreement where a buyer hires an asset with an option to purchase it at the end of the hire period. Payments are made in installments, and ownership transfers upon final payment.
The following table provides a detailed comparison:
| Feature | Leasing | Leveraged Buying | Hire-Purchase |
|---|---|---|---|
| Ownership | Remains with Lessor | With Buyer | Transfers after final payment |
| Risk & Responsibility | Lessor bears risk of obsolescence & maintenance (often) | Buyer bears all risks & responsibilities | Buyer bears risk after possession; seller responsible until final payment |
| Cost | Total cost often higher than purchase | Interest cost on loan adds to the price | Total cost usually higher than outright purchase due to interest |
| Tax Implications | Lease payments are tax deductible as an expense | Depreciation & interest are tax deductible | Depreciation & interest are tax deductible |
| Balance Sheet Impact | Off-balance sheet financing (Operating Lease) or recognized as a Right-of-Use asset and liability (Finance Lease) under Ind AS 116 | Asset & Liability both appear on the balance sheet | Asset & Liability both appear on the balance sheet |
Choosing Among the Options
The optimal choice depends on the specific circumstances of the business:
- Leasing is preferable when: The asset is subject to rapid technological obsolescence (e.g., computers), the business lacks the capital for outright purchase, or tax benefits from lease payments are significant.
- Leveraged Buying is suitable when: The business wants to own the asset, has sufficient cash flow to service the debt, and can benefit from depreciation tax shields.
- Hire-Purchase is advantageous when: The business intends to eventually own the asset, cannot secure a loan, and prefers to spread the cost over time. It's often used for smaller assets.
Sale and Leaseback: A Preferable Option
‘Sale and leaseback’ involves a company selling an asset it owns to another party and then leasing it back from them. This is a preferable option under the following conditions:
- Need for Immediate Cash: When a company urgently requires cash for working capital, debt repayment, or investment in core business activities.
- Underutilized Assets: If a company owns assets that are not fully utilized, selling and leasing them back can free up capital without disrupting operations.
- Tax Benefits: Lease payments are tax-deductible, potentially reducing the overall cost of using the asset.
- Maintaining Operational Control: The company retains the right to use the asset, ensuring continuity of operations.
Example: A manufacturing company owns a factory building. Facing a cash crunch, it sells the building to a real estate investment trust (REIT) and leases it back. This provides the company with immediate funds while allowing it to continue production in the same facility.
However, it's crucial to note that ‘sale and leaseback’ can result in a long-term higher cost of using the asset compared to outright ownership. Therefore, a thorough cost-benefit analysis is essential.
Conclusion
Choosing between leasing, leveraged buying, and hire-purchase, or opting for a ‘sale and leaseback’ arrangement, requires a careful evaluation of a company’s financial position, operational needs, and tax implications. Leasing offers flexibility and off-balance sheet financing, while leveraged buying and hire-purchase lead to ownership but involve debt and higher costs. ‘Sale and leaseback’ is a powerful tool for unlocking capital but should be considered strategically. Ultimately, the best option is the one that aligns with the company’s long-term goals and maximizes shareholder value.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.