The capital lease is nothing but an alternative solution to borrowing. Also known as Finance Lease or Full Payout Lease, it is an agreement between two parties (Lessor and Lessee) whereby the lessor purchases the asset and transfers primarily all the rights, risks, and rewards to the lessee against a periodically fixed rental.
Finance / Capital Lease
A capital lease is a long-term, non-cancellable lease. It is more of an arrangement of funds rather than a lease. In situations other than leasing, a firm needs to finance its assets either through borrowing or from its capital. But, if a business has limited capital, not sufficient to buy an asset, it will have to go either for borrowing or any other option like leasing. The fundamental difference between borrowing and leasing is ownership. In borrowing, the ownership transfers initially, and in the capital lease, ownership transfers at the end of the lease term if agreed so (the term is generally the life of the asset).
For a lessor, the financial lease is nothing but utilization of his money. In essence, he finances the asset and earns the interest on his money.
He does not have any interest in the asset as the lessee chooses the asset for economic use. Assets like aircraft, railway wagons, lands, buildings, heavy machinery, diesel generating sets, ships, etc., are purchased under a financial lease. Smaller assets are financed by an operating lease, which differs from Finance Lease.
Features of a Capital Lease
In a capital lease, ownership transfers to the lessee at the end of the lease period. It may be transferred with or without a merger or residual amount as mentioned in the finance lease agreement.
The Term of Lease
The term of a capital lease extends over the economic life of an asset.
Monthly Lease Rentals
Monthly lease rentals or payments are the equated monthly payments that the lessee pays to the lessor. Lessor covers the investment made, interest thereon, repairs and maintenance, and profit in the lease rental.
Also read What is Capital Lease Obligation?
The lessor has nothing to do with the asset. As he is merely a financier to the asset, the lessee chooses the assets to purchase, who is the ultimate economic user.
Processing Time and Fee
Unlike a loan, there is no processing fee for the lease, and the time for processing is also relatively more petite than a loan.
In a loan, margin money has to be invested by the equipment buyer, but in the case of the lease, the lessee does not have to pay any margin money, and a full amount of the equipment can be financed here.
There is no such requirement of collateral security in the case of a lease which is a must when taking a huge loan from any bank or institution.
There are some criteria for capital lease classifications. If these criteria are not satisfied, it gets classified as an operating lease.
Step Wise Process of Capital Lease Structuring
- First of all, the lessee selects the equipment or the asset.
- Lessee only negotiates with the manufacturer about the price, features, and functionality of the assets.
- Lessor purchases it from either the manufacturer or, at times, from the lessee. When the lessor purchases an asset from the lessee and leases it back to the lessee, it is a different leasing arrangement called Sale and Leases Back.
- Post-purchase, the lessor leases the asset to the lessee. Lessor retains ownership while the lessee gets the right to use it against fixed monthly rentals.
- The capital lease provides the lessee an option to purchase at the end of the period.
- Initially, a lease is agreed upon for the non-cancellable period or the primary lease period. During this period, the lessor/investor seeks to recover his invested money with some profits.
In summary, a capital lease is an excellent option for those businessmen who neither have their capital nor are they eligible to take a loan. Loan-taking ability is generally restricted by its requirement of collateral security, which every person in business may not have.
Continue reading – Advantages and Disadvantages of Capital Lease