Question

Bradley Co. is expanding its operations and is in the process of selecting the method of financing this program. After some investigation, the company determines that it may (1) issue bonds and with the proceeds purchase the needed assets or (2) lease the assets on a long-term basis. Without knowing the comparative costs involved, answer these questions:

1. What might be the advantages of leasing the assets instead of owning them?
2. What might be the disadvantages of leasing the assets instead of owning them?
3. In what way will the balance sheet be differently affected by leasing the assets as opposed to issuing bonds and purchasing the assets?

Short answer

Leasing permits 100% financing of assets, but interest rates for leasing often are higher, and a profit factor may be included in addition.

Step-by-step solution

Meaning of Lease

In exchange for one or more payments, a lessor agrees to allow a lessee to have authority over the use of a specific property, plant, or equipment for a specified length of time. Depending on whether an entity is a lessee or a lessor, there are different types of lease designations.

(a) Explaining the advantage of leasing the assets instead of owning them.

Possible leasing benefits include:

1. The complete cost of the assets (including any land and residual value) can be written off, potentially resulting in a tax benefit.
2. Since the lease agreement may have fewer restrictive restrictions, leasing may be more flexible than bonding.
3. Assets can be financed entirely through leasing.
4. Leasing allows for faster equipment upgrades, lowers the risk of obsolescence, and transfers the risk of residual value to the lessor or a third party.
5. There may be tax benefits to leasing.
6. Off-balance-sheet financing possibilities for certain types of leases.

If money is easily available through debt financing, there may not be many advantages to signing a non-cancelable, long-term lease (apart from the ones listed above). One of the most common benefits of leasing is that it may be used when other forms of debt financing are unavailable.

(b) Explaining the disadvantages of leasing the assets instead of owning them.

Possible leasing disadvantages:

1. Keeping title to assets may be helpful as an inflation hedge in an ever-increasing inflationary climate.
2. Leasing interest rates are frequently higher, and a profit element may be added on top of that.
3. In other circumstances, such as when bonus depreciation is allowed, owning the asset gives distinct tax benefits.

(c) Explaining the ways in which the balance sheet is differently affected by leasing the assets as opposed to issuing bonds and purchasing the assets.

The comparative impact is not particularly different from purchase and ownership since a long-term and non-cancelable lease utilized as a financing mechanism often results in the capitalization of leased assets and recognition of the lease commitment in the balance sheet. Assets leased under such circumstances would be capitalized at the present value of future lease payments, which is likely to be close to the asset's purchase price.

Bonds issued at par would be close to the present value of future lease payments and interest would not be capitalized in either instance. The balance sheet numbers and overall categories would be very similar; however, the specific labels would be different.