By way of a simple example, a lessor might acquire an asset
for £50m and expect it to have a value of between £20m
and £25m at the end of the lease term, with only a 5% chance
the value will be less than £20m. So the rentals may be
calculated much as they are for a finance lease except that, rather
than assuming little or no value at the end of the lease term, the
asset is assumed to have a value of £20m. In this simple
example the lease is broadly equivalent to a loan of £30m but
there is a 95% chance the lessor will make a profit in excess of
his interest turn. And if the lessor has a portfolio of operating
leases the risk of overall loss is very small.
You should note that although the lease is broadly equivalent
to a loan of £30m the lessee will not benefit from any
increase in value of the asset at the end of the lease term. If the
asset has a value in excess of £30m the lessee will have
‘lost out’; if the asset has a value of less than
£30m the lessee will have ‘won’ when compared to
borrowing.
This is very simple example to illustrate the point.
Commercial pressures will force the lessor into competitive terms,
and the taking of residual value risks (ie the risk that the value
will be less than £20m in the example above) involves a high
degree of skill and judgment because it may not be possible to
limit the risk of loss as much as in this simple example. The risk
of loss is real, which is a strong indication that the lease is an
operating lease, but that does not mean the lease is not broadly
commercially equivalent to a loan. If it were not, the term
‘off- balance sheet finance’ would be inappropriate and
yet it is frequently encountered in connection with lease finance.
Note that the schedules to operating leases of this type may
set out the cost and implied residual value, much in the same way
as happens with big ticket finance leases. (A ‘big
ticket’ lease is a lease where the leased assets have a high
value, generally accepted as £20m or more.) That is, the
arrangements between the parties are transparent, reflecting the
underlying nature of the arrangement as a loan.
A lack of transparency does not mean that the lease is not
performing a financing function. Sophisticated lessees can carry
out the calculations for themselves providing only that they know
or can estimate both the cost and the residual value of the asset
at the end of the lease term.
