DETERMINANTS OF DIVIDEND DECISIONS

DETERMINANTS OF DIVIDEND DECISIONS

The dividend policy is affected by the following factors:

1. Availability of funds: If the business is in requirement of funds, then retained earnings could be a good source. Since it saves the floatation cost and further the control will not be diluted as in case of further issue of share capital.

2. Cost of capital: If the financing requirements can be financed through debt (relatively cheaper source of finance), then it should be preferred to distribute more dividend but if the financing is to be done through fresh issue of equity shares, it is better to use retained earnings as much as possible.

3. Capital structure: An optimum Debt equity ratio should also be under consideration for the dividend decision.

4. Stock price: Stock price here means market price of the shares. Generally, higher dividends increase value of shares and low dividends decrease it.

5. Investment opportunities in hand: The dividend decision is also affected, if there are investment opportunities in hand, the company may prefer to retain more from the earnings

6. Internal rate of return: If the internal rate of return is more than the cost of retained earnings, it’s better to distribute the earnings as much as possible.

7. Trend of industry: Few industries have been seen by investors for regular income, hence in such cases, the firm will have to pay dividend for survival.

8. Expectation of shareholders: The shareholders can be categorised in two categories: (i) those who invests for regular income, & (ii) those who invests for growth. Generally, the investor prefers current dividend more than the future growth.

9. Legal constraints: Section 123 of the Companies Act, 2013 came into force from 1st April, 2014 which provides for declaration of dividend. According to this section:

(i) Dividend shall be declared or paid by a company for any financial year only:

(a) out of the profits of the company for that year arrived at after providing for depreciation in accordance with the provisions of section 123(2), or

(b) out of the profits of the company for any previous financial year or years arrived at after providing for depreciation in accordance with the provisions of that sub-section and remaining undistributed, or

(c) out of both; or

(d) out of money provided by the Central Government or a State Government for the payment of dividend by the company in pursuance of a guarantee given by that Government.

10. Taxation: As per Section 115-O, dividend is subject to dividend distribution tax (DDT) in the hands of the company. Under the existing provisions of Section 10(34) of the Income Tax Act, 1961, dividend which suffer dividend distribution tax (DDT) under section 115-O is exempt in the hands of the shareholder.

Further, any income by way of dividend in excess of ` 10 lakhs shall be chargeable to tax in the case of an individual, HUF or a firm who is resident in India, at the rate of ten percent.

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LIMITATION OF STOCK DIVIDEND

Limitations of Stock Dividend

Limitations of stock dividend to shareholders and to company are as follows:

1. To Shareholders: Stock dividend does not affect the wealth of shareholders and therefore it has no value for them. This is because the declaration of stock dividend is a method of capitalising the past earnings of the shareholders and is a formal way of recognising earnings which the shareholders already own. It merely divides the company’s ownership into a large number of share certificates. James Porterfield regards stock dividends as a division of corporate pie into a larger number of pieces. Stock dividend does not give any extra or special benefit to the shareholder. His proportionate ownership in the company does not change at all. Stock dividend creates a favourable psychological impact on the shareholders and is greeted by them on the ground that it gives an indication of the company’s growth.

2. To Company: Stock dividends are more costly to administer than cash dividend. It is disadvantageous if periodic small stock dividends are declared by the company as earnings. This result in the measured growth in earnings per share being less than the growth based on per share for small issues of stock dividends are not adjusted at all and only significant stock dividends are adjusted. Also, companies have to pay tax on distribution.

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ADVANTAGES OF STOCK DIVIDEND

Advantages of Stock Dividend

There are many advantages both to the shareholders and to the company. Some of the important ones are listed as under:

(1) To Share Holders: (a) Tax benefit –At present there is no tax on dividend received.
(b) Policy of paying fixed dividend per share and its continuation even after declaration of stock dividend will increase total cash dividend of the shareholders in future.

(2) To Company: (a) Conservation of cash for meeting profitable investment opportunities.
(b) Cash deficiency and restrictions imposed by lenders to pay cash dividend.

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FORMS OF DIVIDEND

FORMS OF DIVIDEND

Generally, the dividend can take any of the following forms (depending upon some factors will be discussed later):

1. Cash dividend: It is the most common form of dividend. Cash here means cash, cheque, warrant, demand draft, pay order or directly through Electronic Clearing Service (ECS) but not in kind

2. Stock dividend (Bonus Shares): It is distribution of shares in lieu of cash dividend to existing shareholders. When the company issues further shares to its existing shareholders without consideration it is called bonus shares. Such shares are distributed proportionately thereby retaining proportionate ownership of the company. If a shareholder owns 100 shares at a time, when 10% dividend is declared he will have 10 additional shares thereby increasing the equity share capital and reducing reserves and surplus (retained earnings). The total net worth is not affected by bonus issue.

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SIGNIFICANCE OF DIVIDEND POLICY

SIGNIFICANCE OF DIVIDEND POLICY

Dividend policy of the firm is governed by: 

(i) Long Term Financing Decision
As we know that one of the financing option is ‘Equity’. Equity can be raised externally through issue of equity shares or can be generated internally through retained earnings. But retained earnings are preferable because they do not involve floatation costs.

But whether to retain or distribute the profits forms the basis of this decision. Since payment of cash dividend reduces the amount of funds necessary to finance profitable investment opportunities thereby restricting it to find other avenues of finance.

Under this purview, the decision is based on the following:

1. Whether the organization has opportunities in hand to invest the amount of profits, if retained?

2. Whether the return on such investment (ROI) will be higher than the expectations of shareholders 

(ii) Wealth Maximization Decision

Under this head, we are facing the problem of amount of dividend to be distributed i.e. the Dividend Payout ratio (D/P) in relation to Market price of the shares (MPS).

1. Because of market imperfections and uncertainty, shareholders give higher value to near dividends than future dividends and capital gains. Payment of dividends influences the market price of the share. Higher dividends increase value of shares and low dividends decrease it. A proper balance has to be struck between the two approaches.

2. When the firm increases retained earnings, shareholders’ dividends decrease and consequently market price is affected. Use of retained earnings to finance profitable investments increases future earnings per share.

On the other hand, increase in dividends may cause the firm to forego investment opportunities for lack of funds and thereby decrease the future earnings per share.

Thus, management should develop a dividend policy which divides net earnings into dividends and retained earnings in an optimum way so as to achieve the objective of wealth maximization for shareholders. Such policy will be influenced by investment opportunities available to the firm and value of dividends as against capital gains to shareholders.

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MEANING OF DIVIDEND

MEANING OF DIVIDEND

Dividend is that part of profit after tax which is distributed to the shareholders of the company. In other words, the profit earned by a company after paying taxes can be used for:

i. Distribution of dividend or

ii. Can be retained as surplus for future growth

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INTRODUCTION (DIVIDEND DECISIONS)

INTRODUCTION  (DIVIDEND DECISIONS)

Financial management is the process of making financial decisions. Financial decision broadly covers three areas:

i. Financing decision

ii. Investment decision

iii. Dividend decision

Dividend decision is one of the most important areas of management decisions. It is easy to understand but difficult to implement. Let’s understand this with the help of an example, suppose a company, say X limited, which is continuously paying the dividend at a normal growth rate, earns huge profits this year. Now the management has to decide whether continue to pay dividend at normal rate or to pay at an increasing rate? Why this dilemma?

The reason is that, if the management decides to pay higher dividend, then it might be possible that next year, the company will not achieve such higher growth rate, resulting the next year’s dividend will be low as compared. However, if the company decides to stay on the normal rate of dividend then surplus amount of retained earnings would remain idle which will result in over capitalization, if no opportunity existing to utilize the funds.

Also there are more factors which will affect the dividend decision (will be discussed later) There are few theories which put light on the complexities involved in dividend decision. These theories will be discussed under two categories

Irrelevance theory: MM approach

Relevance theories: Walter model & Gordon Model

CURRENT ASSET TO FIXED ASSET RATIO

 Current Assets to Fixed Assets Ratio

• The finance manager is required to determine the optimum level of current assets so that the shareholders’ value is maximized. 
• A firm needs fixed and current assets to support a particular level of output. 
• As the firm’s output and sales increases, the need for current assets also increases. Generally, current assets do not increase in direct proportion to output; current assets may increase at a decreasing rate with output. As the output increases, the firm starts using its current asset more efficiently. 
• The level of the current assets can be measured by creating a relationship between current assets and fixed assets. Dividing current assets by fixed assets gives current assets/fixed assets ratio. 
• Assuming a constant level of fixed assets, a higher current assets/fixed assets ratio indicates a conservative current assets policy and a lower current assets/fixed assets ratio means an aggressive current assets policy assuming all factors to be constant.
• A conservative policy implies greater liquidity and lower risk whereas an aggressive policy indicates higher risk and poor liquidity. Moderate current assets policy will fall in the middle of conservative and aggressive policies. The current assets policy of most of the firms may fall between these two extreme policies. 
• The following illustration explains the risk-return trade off of various working capital management policies, viz., conservative, aggressive and moderate.

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APPROACHES OF WORKING CAPITAL

 Approaches of working capital investment
Based on the organisational policy and risk-return trade off, working capital investment decisions are categorised into three approaches i.e. aggressive, conservative and moderate.

(a) Aggressive: Here investment in working capital is kept at minimal investment in current assets which means the entity does hold lower level of inventory, follow strict credit policy, keeps less cash balance etc. The advantage of this approach is that lower level of fund is tied in the working capital which results in lower financial costs but the flip side could be that the organisation could not grow which leads to lower utilisation of fixed assets and long term debts. In the long run firm stay behind the competitors.

(b) Conservative: In this approach of organisation use to invest high capital in current assets. Organisations use to keep inventory level higher, follows liberal credit policies, and cash balance as high as to meet any current liabilities immediately. The advantage of this approach are higher sales volume, increased demand due to liberal credit policy and increase goodwill among the suppliers due to payment in short time. The disadvantages are increase cost of capital, higher risk of bad debts, shortage of liquidity in long run to longer operating cycles.

(c)Moderate: This approach is in between the above two approaches. Under this approach a balance between the risk and return is maintained to gain more by using the funds in very efficient manner.

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INVESTMENT OF WORKING CAPITAL

Investment of working capital:

How much to be invested in current assets as working capital is a matter of policy decision by an entity. It has to be decided in the light of organisational objectives, trade policies and financial (cost-benefit) considerations. There is not set rules for deciding the level of investment in working capital. Some organisations due to its peculiarity require more investment than others. For example, an infrastructure development company requires more investment in its working capital as there may be huge inventory in the form of work in process on the other hand a company which is engaged in fast food business, comparatively requires less investment. Hence, level of investment depends on the various factors listed below:

(a) Nature of Industry: Construction companies, breweries etc. requires large investment in working capital due long gestation period.

(b) Types of products: Consumer durable has large inventory as compared to perishable products.

(c) Manufacturing Vs Trading Vs Service: A manufacturing entity has to maintain three levels of inventory i.e. raw material, work-in-process and finished goods whereas a trading and a service entity has to maintain inventory only in the form of trading stock and consumables respectively.

(d) Volume of sales: Where the sales are high, there is a possibility of high receivables as well.

(e) Credit policy: An entity whose credit policy is liberal has not only high level of receivables but requires more capital to fund raw material purchases. 

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DETERMINANTS OF WORKING CAPITAL

DETERMINANTS OF WORKING CAPITAL
Working capital management is concerned with:-

a) Maintaining adequate working capital (management of the level of individual current assets and the current liabilities) and

b) Financing of the working capital.

For the point a) above, a Finance Manager needs to plan and compute the working capital requirement for its business. And once the requirement has been computed he needs to ensure that it is financed properly. This whole exercise is nothing but Working Capital Management.
Sound financial and statistical techniques, supported by judgment should be used to predict the quantum of working capital required at different times.

Some of the factors which need to be considered while planning for working capital requirement are:-

1. Cash – Identify the cash balance which allows for the business to meet day-to- day expenses, but reduces cash holding costs.

2. Inventory – Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials and hence increases cash flow; the techniques like Just in Time (JIT) and Economic order quantity (EOQ) are used for this.

3. Receivables – Identify the appropriate credit policy, i.e., credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa). The tools like Discounts and allowances are used for this.

4. Short-term Financing Options – Inventory is ideally financed by credit granted by the supplier; dependent on the cash conversion cycle, it may however, be necessary to utilize a bank loan (or overdraft), or to “convert debtors to cash” through “factoring” in order to finance working capital requirements.

5. Nature of Business - For e.g. in a business of restaurant, most of the sales are in Cash. Therefore need for working capital is very less.

6. Market and Demand Conditions - For e.g. if an item’s demand far exceeds its production, the working capital requirement would be less as investment in finished goods inventory would be very less.

7. Technology and Manufacturing Policies - For e.g. in some businesses the demand for goods is seasonal, in that case a business may follow a policy for steady production through out over the whole year or instead may choose policy of production only during the demand season.

8. Operating Efficiency – A company can reduce the working capital requirement by eliminating waste, improving coordination etc.

9. Price Level Changes – For e.g. rising prices necessitate the use of more funds for maintaining an existing level of activity. For the same level of current assets, higher cash outlays are required. Therefore the effect of rising prices is that a higher amount of working capital is required.

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OPTIMUM WORKING CAPITAL

 Optimum Working Capital

• If a company’s current assets do not exceed its current liabilities, then it may run into trouble with creditors that want their money quickly.
• Current ratio (current assets/current liabilities) (along with acid test ratio to supplement it) has traditionally been considered the best indicator of the working capital situation. 
• It is understood that a current ratio of 2 (two) for a manufacturing firm implies that the firm has an optimum amount of working capital. This is supplemented by Acid Test Ratio (Quick assets/Current liabilities) which should be at least 1 (one). Thus it is considered that there is a comfortable liquidity position if liquid current assets are equal to current liabilities. 
• Bankers, financial institutions, financial analysts, investors and other people interested in financial statements have, for years, considered the current ratio at ‘two’ and the acid test ratio at ‘one’ as indicators of a good working capital situation. As a thumb rule, this may be quite adequate. 
• However, it should be remembered that optimum working capital can be determined only with reference to the particular circumstances of a specific situation. Thus, in a company where the inventories are easily saleable and the sundry debtors are as good as liquid cash, the current ratio may be lower than 2 and yet firm may be sound. 
• In nutshell, a firm should have adequate working capital to run its business operations. Both excessive as well as inadequate working capital positions are dangerous.

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IMPORTANCE OF ADEQUATE WORKING CAPITAL

 Importance of Adequate Working Capital

Management of working capital is an essential task of the finance manager. He has to ensure that the amount of working capital available with his concern is neither too large nor too small for its requirements.

A large amount of working capital would mean that the company has idle funds. Since funds have a cost, the company has to pay huge amount as interest on such funds.

If the firm has inadequate working capital, such firm runs the risk of insolvency. Paucity of working capital may lead to a situation where the firm may not be able to meet its liabilities.

The various studies conducted by the Bureau of Public Enterprises have shown that one of the reasons for the poor performance of public sector undertakings in our country has been the large amount of funds locked up in working capital. This results in over capitalization. Over capitalization implies that a company has too large funds for its requirements, resulting in a low rate of return, a situation which implies a less than optimal use of resources. A firm, therefore, has to be very careful in estimating its working capital requirements.

Maintaining adequate working capital is not just important in the short-term. Sufficient liquidity must be maintained in order to ensure the survival of the business in the long- term as well. When businesses make investment decisions they must not only consider the financial outlay involved with acquiring the new machine or the new building, etc., but must also take account of the additional current assets that are usually required with any expansion of activity. For e.g.:-

•  Increased production leads to holding of additional stocks of raw materials and work-in-progress. 
• An increased sale usually means that the level of debtors will increase. 
• A general increase in the firm’s scale of operations tends to imply a need for greater levels of working capital. 

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MEANING AND CONCEPT OF WORKING CAPITAL

MEANING AND CONCEPT OF WORKING CAPITAL

In accounting term working capital is the difference between the current assets and current liabilities. If we break down the components of working capital we will found working capital as follows:

               Working Capital = Current Assets – Current Liabilities

Current Assets: An asset is classified as current when:

(i) It is expected to be realised or intends to be sold or consumed in normal operating cycle of the entity;

(ii) The asset is held primarily for the purpose of trading;

(iii) It is expected to be realised within twelve months after the reporting period;

(iv) It is non- restricted cash or cash equivalent.

Generally current assets of an entity, for the purpose of working capital management can be grouped into the following main heads:

(a) Inventory (raw material, work in process and finished goods)

(b) Receivables (trade receivables and bills receivables)

(c) Cash or cash equivalents (short-term marketable securities)

(d) Prepaid expenses

Current Liabilities: A liability is classified as current when:

(i) It is expected to be settled in normal operating cycle of the entity.

(ii) The liability is held primarily for the purpose of trading

(iii) It is expected to be settled within twelve months after the reporting period

 Generally current liabilities of an entity, for the purpose of working capital management can be grouped into the following main heads:

(a) Payable (trade payables and bills receivables)

(b) Outstanding payments (wages & salary etc.)

In general Working capital management is essentially managing Current Assets management of working capital arises as a part of the process of such management.

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REASONS FOR LEASING

REASONS FOR LEASING/ADVANTAGES OF LEASING

(1) Lease may be low cost alternative: Leasing is alternative to purchasing. As the lessee is to make a series of payments for using an asset, a lease arrangement is similar to a debt contract. The benefit of lease is based on a comparison between leasing and buying an asset. Many lessees find lease more attractive because of low cost. For example – you are transferred to another city for 6 months. For daily travel you need a car. If you buy car in your own name then as per Motor Vehicles Act you have to pay one time road tax and incur other expenses besides cost of car. You can always sell the car after 6 months before leaving. It may be economical to take a car on lease for 6 months as lease rental may be less than net cash outflow arising from difference between total cost of the car and sale value you realise.

(2) Tax benefit: In certain cases tax benefit of depreciation available for owning an asset may be less than that available for lease payment. In other words, differential tax treatment between owning an asset and taking it on lease may result in a decision in favour of lease. For example – if a firm owns an asset, it gets tax saving for depreciation on book value as per the I-T law ( in case of MAT, depreciation on the book value is as per the depreciation schedule of the Companies Act, 2013, based on useful life), but in case of lease rent entire lease rental is tax deductible. In some cases this differential tax treatment means a higher tax savings for lease, implying lease is a smarter decision subject to other factors.

(3) Working capital conservation: When a firm buy an equipment by borrowing from a bank (or financial institution), they never provide 100% financing. Depending upon the firm’s credit rating bank may finance 75% or 60% (say) of total cost of equipment. The rest 25% or 40% (as the case may be), the firm has to bring in – the amount that the firm provides as down payment from its own source is called margin money. Margin money requirement naturally reduces firm’s working capital (and liquidity). In case of high value asset the amount may be substantial having an adverse impact on operation. But in case of lease one gets normally 100% financing in the sense that one needn’t bring in margin money generally for taking an asset on lease. This enables conservation of working capital.

(4) Preservation of Debt Capacity: As per the accounting standard operating lease is not capitalised in the books of the lessee. Operating lease payment is treated as expenditure in the profit and loss account. Neither the asset taken on lease appears as asset nor does the liability representing present value of future lease payment (cost of leased asset) appear as liability in the balance sheet. That is, operating lease doesn’t have any balance sheet impact. So, operating lease does not matter in computing debt equity ratio. This enables the lessee to go for debt financing more easily. The access to and ability of a firm to get debt financing is called debt capacity (also, reserve debt capacity). Operating lease, if it is properly structured, can work efficiently as a substitute of debt though there may hardly be any difference between the two in respect of regular cash out flow; but at the same time it keeps the debt capacity in fact.

However, it is to be noted the above preservation of debt capacity is not generally applicable for finance lease as the present value of future lease payment (cost of leased asset) appears as liability in the balance sheet of the lessee and to be duly considered in calculating debt equity ratio.

(5) Obsolescence and Disposal: After purchase of leased asset there may take place technological obsolescence of the asset. That means a technologically upgraded asset with better capacity may come into existence after purchase. To retain competitive advantage the lessee as user may have to go for the upgraded asset. The obsolete old asset may fetch a small portion of the book value upon disposal resulting in capital loss. In case of cancellable operating lease the lessee can terminate the contract in such circumstances. However, it is to be kept in mind that where there is a possibility of technological obsolescence the lessor will cover the risk by fixing a higher lease rental.

(6) Restrictive Conditions for Debt Financing: When a company takes loan to purchase equipment (say), in the loan agreement lender may impose several restrictions on the borrower company to protect his interest. Apart from creating charge on the equipment purchased ( primary security), lender may ask for collateral securities on other assets, like -mortgage of landed property, pledging fixed deposit receipts with the bank, asking for guarantor etc. The lender can impose other conditions too - like restriction on payment of dividend, putting lender’s representative on the board to ensure proper utilization of fund etc. In case of lease such tight conditions are not imposed as lessor remains the owner of the asset legally and he can recover the asset if the lessee fails to abide by the lease terms and conditions.

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CLASSIFICATION OF FINANCIAL LEASE

 Classification of Financial Lease
(i) Tax-oriented Lease: In financial lease, we have pointed out that risk and reward of ownership are substantially transferred to lessee in economic sense. Nevertheless in a financial lease if the lessor is considered as the owner of the asset for claiming tax benefit of depreciation, then the financial lease is considered as ‘tax -oriented lease’. Deduction of depreciation from lease rental reduces profit of lessor which is then subjected to tax. In other words, depreciation reduces the tax burden. Depreciation is a non-cash expenditure that results in ‘tax saving’. Putting differently we can say there is a cash inflow arising out of tax saving due to depreciation. This is a genuine benefit that arises from depreciation being a tax deductible non-cash expenditure. The lesser can pass on a part of depreciation benefit to the lessee making the arrangement attractive for the lessee. This enhances the competitive advantage of the lessor. If in place of lessor, lessee is entitled to claim depreciation for tax purpose then it is not a ‘tax oriented lease’. In that case, the tax treatment will be same as that of owning an asset through borrowing.

Depreciation benefit of tax is of paramount importance in lease versus buy decision in determining cash flow implication to the lessor and lessee and the subsequent value of the lease to the respective parties.

(ii) Leveraged Lease: A leveraged lease is tax oriented lease where the lessor borrows substantial amount from the lender to purchase the asset he leases. But an arrangement is made in such a way through tripartite agreement between the lender ( financier of the leased asset), lessor and the lessee , so that, in case of default of payment of lease rental by the lessee , the lessor is not liable to make loan repayment to the lender. Instead of lessor, the lender has to take appropriate steps to recover the loan instalments due on loan to purchase the leased asset from the lessee. Leveraged lease is a complicated arrangement and normally entered in case of very high value transactions.

(iii) Sale and Lease Back: It is arrangement under which an entity sells the asset to another party and simultaneously takes it back from the other party under a lease arrangement.

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SIGNIFICANT FEATURES OF FINANCE LEASE

 The significant features of finance lease are :

•  Lease rental over the lease period covers the cost of leased asset plus a return on investment made by the lessor for the leased asset.
•  Though the lesser may continue to remain the legal owner of the asset, but for all practical purposes (i.e. in substance), risk and reward associated with ownership is substantially transferred to the lessee since the inception of the lease. 
• The lessee bears the maintenance cost, insurance and taxes of the asset. 
•  Under the lease agreement, the lessee is not entitled to cancel or terminate the lease except at a very high penalty. This means lessee must pay the lease instalment otherwise lessor will sue him for nonpayment of unpaid instalments with cost and damage in the capacity of a creditor.

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FINANCE LEASE

Finance Lease (Capital Lease)
Under finance lease the lease rental is fixed in such a manner that the lessor recovers the entire price of the leased equipment plus a return on investment ( made for purchasing the equipment leased) within the lease period through lease rent. In such a situation the lessee normally retains the possession of the equipment even after the lease period is over as he pays the price of the equipment. In this case, in substance there is no difference between – ‘borrow to buy’ and lease. Example 3 will clarify the matter.

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EXAMPLE OF OPERATING LEASE

EXAMPLE OF OPERATING LEASE

Example 2 : Suppose in example 1 above, the cost of the car given on lease by X rental is ` 20 lacs. The economic life of the car is 8 years - implying that the car will create cash flow for next 8 years. Now, from the lease rental for 2 years total recovery will be ` 600,000 (` 25000 X 12X 2). In 2 years’ lease cost of car remains unrecovered. The economic life of the asset is far more so that the cost can be recovered by further leasing or selling the car. Hence, this is an example of operating lease.

The significant features of operating lease are :

•  Payments by way of lease rental over the period of lease are not enough to cover the cost of leased asset. 
•  The lesser generally takes back the possession of the asset on the expiry of the lease period. 
•  The lesser bears the cost of insurance, maintenance, tax etc. of the leased asset 
•  The lessee has the right to cancel the lease before the expiry of the lease term. 
• The lessor remains the owner of the asset in the legal and economic sense (in substance). 
•  Operating lease is always a tax oriented lease.

OPERATING LEASE

Operating Lease

• If under the lease agreement the lessor is entitled to take back the possession of the asset leased from the lessee – the arrangement is considered as operating lease. Operating lease is a genuine lease where ownership for tax and accounting purpose remains with the owner.
•  When ownership remains with the owner for tax purpose then the lease is called tax oriented lease. Tax orientation has a significant importance in determining and measuring cash flow impact of lease transactions and their valuation.
•  Operating lease is always a tax oriented lease. Under lease agreement lessor is required to maintain and service the leased asset. A common example is licensing agreement of flats in big cities. Under the agreement the landlord leases his (her) flat for eleven months for monthly rental renewable at the option of the landlord after the expiry of eleven months. 
• The landlord bears the cost of maintenance and service (security, lift etc). An important feature of operating lease is - lease period is sufficiently less than the economic life of the asset. This means total lease rental recovered based on the lease period is substantially less than the cost of the asset.

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