School of Management and Languages

School of Management & Languages Heriot-Watt University Edinurgh, EH14 4AS Tel: +44(0)131 451 3542 Fax: +44 (0)131 451 3079 Mail: enquiries@sml.hw.ac.uk We: www.sml.hw.ac.uk School of Management and Languages The Role of Leasing in UK Corporate Financing Decisions Sarah Jane Thomson Discussion Paper Series in Accountancy & Finance ISSN 1741-8232 DP2004-AF04 Aug-05

The Role of Leasing in UK Corporate Financing Decisions Sarah Jane Thomson Heriot-Watt University (Email: s.thomson@hw.ac.uk) Draft date: June 2005 Address for correspondence: Sarah Jane Thomson Department of Accountancy and Finance School of Management and Languages Heriot-Watt University Riccarton Campus Edinurgh EH14 4AS UK Email: s.thomson@hw.ac.uk

The Role of Leasing in UK Corporate Financing Decisions ABSTRACT Leasing provides a significant source of finance across European firms, especially those in the UK. Historically, its use has een attriuted to favourale accounting and tax treatments, oth of which have eroded over time and may soon e further eroded. Lease accounting treatment is currently under review. The UK is undertaking a project to inform the International Accounting Standards Board. Proposals (ASB, 1999) essentially remove the off-alance sheet accounting treatment of operating leases. Furthermore, the UK tax authority has proposals to award capital tax allowances to lessees rather than lessors as part of corporation tax reform. If accounting and/or tax treatments currently provide incentives to use operating leases, the role of leasing may susequently change. This paper offers survey evidence on the leasing decision across UK listed companies. The results, ased on 198 responses, show that avoiding large capital outlay and cash flow considerations are of paramount importance for the group as a whole in the decision to lease all asset types. However, the current accounting treatment and the award of capital allowances to the lessor are the most important factors for significant su-groups of companies. Given that accounting and tax treatments are of key importance for a wide range of companies in terms of size, gearing and industry classification, the extent to which proposed changes will influence leasing activity is difficult to predict. However, the importance attached to reasons other than accounting and taxation indicates that the popularity of leasing as a source of finance is set to continue. Keywords: leasing decisions, operating leases, UK listed companies, questionnaire survey 2

The Role of Leasing in UK Corporate Financing Decisions 1. Introduction Lease use is oth significant and widespread across European firms. In 2003, it accounted for more than 14% of gross fixed capital formation in Europe, and new usiness amounted to 193 illion euros (Leaseurope, 2003). The UK accounted for 17% of total European leasing activity, coming second to Germany (22%) and matching the level undertaken in Italy. Why do firms otain the use of usiness assets through leasing, rather than orrowing to finance purchase? A range of theoretical reasons for leasing, such as accounting treatment, tax savings, orrowing capacity, repayment and risk sharing, exist in the literature. However, related empirical evidence generated via survey and regression modelling is incomplete for several reasons. First, the majority of UK studies providing direct evidence through survey investigation were conducted efore the introduction of accounting regulation and prior to the current tax status. The nature of lease agreements has altered over time. On-alance sheet finance leases provided the focus for the majority of prior research and such leases are now in relative decline. Off-alance sheet operating leases appear to e a growth market, providing a significant source of finance for UK firms. For example, for the top 100 UK listed companies 2002/03 year-ends, the median ratio of operating lease liaility to det was estimated at 0.11, and the median ratio of operating lease liaility to finance liaility was 6.2 (Beattie, Goodacre and Thomson, 2004). Second, studies that provide indirect evidence y investigating the characteristics of UK leasing firms are limited, oth in numer and in the extent to which qualitative reasons can e investigated. Third, UK findings also appear to conflict with similar studies of US firms. However, as Bancel and Mittoo (2004) highlight, managerial motivations are unlikely to remain static, creating difficulties in interpreting evidence from studies conducted in different time periods and addressing different aspects of the leasing decision. Historically, leasing use has een significantly attriuted to its off-alance sheet accounting treatment. If this explains the use of operating leases in the current climate, then the role of leasing in future financing decisions may change if this off-alance sheet treatment is removed. Many accounting standard-setting odies have considered this option. In 1996, the G4+1 group pulished a report (McGregor, 1996) which formed the asis of a discussion paper in the UK, Leases: implementation of a new approach (ASB, 1999). It is proposed that all leases should e recognised on the alance sheet rather than just finance leases. The UK is currently undertaking a project on lease accounting to inform the International Accounting 3

Standards Board (IASB wesite, visited April 2005). The future recognition of all lease agreements on-alance sheet is not eyond the realms of possiility. Leasing use has also historically een associated with tax treatment through legal ownership, with the right to claim capital tax allowances remaining with the lessor. Tax treatment now looks set to change dramatically with the Inland Revenue intending to switch the award of capital tax allowances from lessors to lessees in a financing arrangement, as part of a reform of the UK corporation tax system (HMSO, 2003). The aim of this paper is to investigate whether theoretical explanations for leasing translate into practice, and to assess the relative importance of financial and non-financial factors in the decision to lease in the current climate. A questionnaire survey of UK finance directors is used to allow a wide range of potential influential factors to e considered. This paper contriutes to the understanding of lease financing y providing comprehensive up-to-date evidence of leasing decisions across UK listed industrial companies. This paper also provides policy-relevant ex ante evidence in support of the standard setting process (as advocated y Schipper, 1994) y providing an indication of the potential consequences of intended changes to the lease accounting and tax regulations. The remainder of this paper is structured as follows. Section two provides a literature review on the rationale for leasing. Section three outlines the method employed, including sampling and data collection procedures. Empirical analysis of results is presented in section 4 and summary and conclusions are presented in the final section. 2 Literature review 2.1 Theoretical reasons for leasing Several authors have considered reasons why leasing may e considered preferale to financing purchase y non-leasing det alternatives. These reasons are grouped into six categories: accounting treatment; tax savings; orrowing capacity; repayment; risk sharing and other reasons. 2.1.1 Accounting treatment At present, oth UK (SSAP 21, ASC 1984) and international lease accounting standards (IAS17) require the capitalisation of only finance leases. Thus, operating leases could e 4

favoured for their off alance sheet nature as rental payments are expensed in the profit and loss account, with neither the leased asset nor leased liaility appearing on the alance sheet. Under SSAP 21, finance lease classification requires the present value of minimum lease payments to e 90% or more of the fair value of the leased asset. This 90% test is said to e open to manipulation and provides the opportunity for lease agreements to e classified as operating leases. Further, UK managers appear unwilling to disclose methods used in lease classification (Loveday, 1994). Tweedie and Whittington (1990, p.88) noted, when considering prolems in financial reporting, that there are companies whose effective asset ase and liailities are not wholly on the alance sheet as a result of the extensive use of leasing and the aritrary nature of the leasing standards rules. 2.1.2 Tax savings At present, legal ownership and the right to claim capital tax allowances on qualifying plant and machinery remains with the lessor. If the lessor can make etter use of capital tax allowances than the lessee, then potential lessees may e enticed with the offer of lower rental payments (Smith and Wakeman, 1985; Schallheim, 1994; Belkaoui, 1998; Day, 2000). Capital tax allowances normally involve a 25% writing down allowance. However, capital expenditure in respect of finance leases is now time apportioned in the first year and the writing down allowance is reduced to 6% in respect of long-life (25 year) capital expenditure (1997 Finance Act). Tax savings on ehalf of the lessee may still arise, even though an asset does not qualify for capital allowances ecause lease rentals paid are tax deductile. Although the increased cost of lease rentals, imposed to compensate the lessor for the asence of capital allowances, may reduce the tax savings, leasing can still potentially e eneficial. This is especially true if the lessee makes rental payments in respect of commercial uildings/offices and if the lessor is of non-tax paying status. 2.1.3 Borrowing capacity Leasing might e used to extend a firm s capacity for orrowing if managers perceive that leasing oligations consume less or even no det capacity compared to non-leasing det alternatives (Schallheim, 1994; Day, 2000). Further, lease agreements may contain less restrictive covenants and thus have less impact on otaining future finance (Smith and Wakeman, 1985; Schallheim, 1994; Day, 2000). 5

2.1.4 Repayment Leasing may e favoured in terms of cash flow considerations. It provides 100% finance for an asset with a limited deposit of a rental payment in advance. Lease agreements are flexile, incorporating features such as alloon rentals to enale repayment to accommodate fluctuations in cash flows (Schallheim, 1994; Day, 2000). 2.1.5 Risk sharing reasons Operating leases are said to reduce the risk of osolescence and provide the flexiility to otain modern or upgraded equipment (Smith and Wakeman, 1985; Schallheim, 1994; Belkaoui, 1998; Day, 2000). If lessors have a diversified portfolio, then the cost of osolescence can e orne more cheaply, reflected in the cost of rental payments. Lessors may e in a etter position to acquire standardised assets, which they supply to numerous lessees, through ulk purchase (Smith and Wakeman, 1985; Schallheim, 1994; Day, 2000). This could e eneficial to small firms who suffer from diseconomies of scale. However, large firms may themselves e in a etter position to acquire purchase discounts, and the introduction of the lessor, a third party etween the uyer and seller may actually result in a higher purchase price. This may not necessarily deter large firms from leasing if they can achieve the est of oth worlds through sale and lease ack arrangements. Lessors may have easier access/more opportunity to dispose of equipment at the end of a lease agreement, which could e reflected in lower rental costs, or enefit lessees if they participate in disposal proceeds. Leasing eliminates the risk of significant costs of transferring ownership. This is eneficial in relation to the transfer of ownership of assets such as property, when the legal fees and taxes are significant. 2.1.6 Other reasons Leasing can e arranged for any size of operations. It is equally availale for individual assets, smaller scale operations and larger scale acquisitions; whereas medium/long-term det is usually arranged on a large scale (Schallheim, 1994; Belkaoui, 1998). Operating leases might e classed as revenue expenditure and thus has the potential to avoid the formal sanctioning process applicale to capital expenditure (Schallheim, 1994; Day, 2000). It is suggested that the application process for lease finance is easier than with other sources of finance, and carries minimum paper work (Day, 2000). Also, leasing is conveniently offered at points of sale. The overall cost of an asset may e reduced if a manufacturer offers 6

advantageous lease terms. It is also suggested that leasing can provide an economical means of otaining excellent servicing and maintenance of equipment (Belkaoui, 1998). 2.2 Empirical evidence 2.2.1 Survey evidence The majority of UK survey evidence was otained efore the introduction of SSAP 21 in 1984 and prior to the current tax status. Fawthrop and Terry (1975) investigated how UK corporate financial managers perceived and used leasing. They found that the relevance of factors in determining the use of leasing varied across companies and concluded that leasing policies are a product of individual financial circumstances. Sykes (1976) found leasing to e used mainly ecause of cash flow advantages, although large companies (annual turnover> 1000million) attached some importance to tax allowances. Tomkins, Lowe and Morgan (1979) found that only a minority of small companies engaged in leasing mainly to avoid capital outlay, or ecause no other sources of finance were availale. Hull and Huard (1980) concluded that non-tax paying reasons for leasing are important and that incorrect lease evaluation affects leasing use. In the aftermath of SSAP 21 and changes to the UK tax system, Mayes and Nicholas (1988) found a predominant use of finance leases. The use of leasing to avoid large capital outlay appeared to e of most importance to smaller firms and tax advantages were more important to larger firms. These findings were confirmed y Drury and Braund (1990) who documented that the relative cost of leasing, along with tax considerations, appeared to dominate the leasing decision for large firms; little importance appeared to e placed on other qualitative and cash flow considerations. Although cost considerations were also dominant for smaller firms, they also appeared to attach importance to qualitative and cash flow factors. In the US, O Brien and Nunnally (1983) found that oth tax reasons and risk sharing reasons in terms of residual values and osolescence were considerations in the leasing decision. Mukherjee (1991) found that avoiding the risk of osolescence appeared to e the most important advantage to leasing, followed y a lower cost compared to orrowing. The tax and off-alance sheet advantages to leasing appeared to e insignificant. Bathala and Mukherjee (1995) found that lease covenants appeared to e less restrictive than those imposed y other creditors. Small firms appeared to favour leasing for off-alance sheet advantages, and the provision of 100% financing. 7

2.2.2 Indirect evidence Several studies analyse company accounting data using regression analysis to identify firm characteristics that appear to e associated with leasing and non-leasing firms. In the US, Kare and Herst (1990) found financial gearing to e higher for leasing firms and leasing firms to e of larger size. Krishnan and Moyer (1994) also found leasing firms to have higher levels of long-term det, as well as higher growth rates, lower retained earnings, lower interest coverage and higher operating risk. Further, firms in manufacturing were found to employ less leasing than retailing, transportation and mining, whose assets are less firm specific. They concluded that as ankruptcy potential increases, lease finance ecomes attractive. In the UK, Lasfer and Levis (1998) found companies using finance leases to e larger in terms of sales turnover and to exhiit higher gearing ratios and market to ook ratios. Leasing companies were found to have higher growth levels as measured y additions to other tangile fixed assets. There was evidence to support the argument that leasing was used to transfer capital allowances to lessors. In large companies, profitaility, financial gearing and taxation were found to e positively correlated with leasing, whereas in small companies the leasing decision did not appear to e driven y profitaility or taxation reasons, ut y growth opportunities. On alance, firms using finance leases appeared to have higher levels of financial gearing, higher growth in assets and a lower aility to service det, in comparison to firms that didn t. However, the profitaility and investment opportunities experienced y firms using finance leases in comparison to those who did not use finance leases was unclear. Unfortunately this study excluded operating leases. Several studies 1 have provided evidence regarding relationships etween leasing and other firm characteristics, either y focusing on the determinants of leasing policy, or as a yproduct when investigating the extent to which lease and det are sustitutes. Although US findings suggest that financial gearing is positively related to finance leasing, UK evidence suggests that the relationship is negative when operating leases are also given consideration. In the US and the UK, the existence of a linear relationship etween leasing and firm size is not clear. UK evidence suggests that firms at oth extremes of the size spectrum employ less leasing compared to firms of medium size. Although a positive relationship was oserved etween liquidity and finance leasing for a sample of US firms, the relationship appears 8

negative for UK firms in relation to oth finance and total leasing. In the US, firms in a high tax position or with sustantial cash flows appear to employ less operating leases. High levels of leasing in US firms appear to e associated with operating in a national/international environment, possessing a large proportion of fixed assets in relation to total assets, a high financial distress potential and large proportion of managerial ownership. Industry classification appears to exert influence on the use of leasing in oth the UK and US. Leasing is exceptionally prominent in the UK retail trade. In summary, there is some evidence that off-alance sheet accounting and tax reasons influence the leasing decision. Although firms have failed to acknowledge that leasing is used to expand det capacity, total leasing oligations do appear to displace less than an equivalent amount of non-leasing det. There is US evidence to suggest that lease covenants are less restrictive than det covenants. Leasing appears to e favoured for cash flow considerations. High technology firms appear to use more leasing, which coincides with the importance placed on safeguarding against osolescence. The convenience associated with the application process for lease financing does not seem to e an issue. Suggestions that leasing is favoured for availaility on any scale, availaility at point of sale, or avoidance of capital expenditure application processes do not appear to e supported. Further, there is little evidence otained in relation to the lessor s aility to acquire/dispose of assets eing an advantage, or the avoidance of significant transfer of ownership costs. The differences found in the relationships etween levels of leasing and other firm characteristics in the US and UK may partly e due to differences in the time periods in which previous studies were conducted, as well as differences in the proxies used. However, the evidence arising from the UK is limited, the latest UK survey having een conducted over a decade ago when finance leases predominated. 3. Methods and sample of respondents 3.1 Sample selection The questionnaire was sent to the finance directors of a systematic sample, of two-thirds (831) of the population of industrial and commercial UK listed companies contained in the UKQI list on Datastream in March 2000. 9

3.2 Questionnaire design and administration The content of the questionnaire was derived from an extensive review of existing theory and empirical evidence (reviewed aove). The initial draft was modified to incorporate useful comments received during piloting (several finance directors, The Finance and Leasing Association and The Association of Corporate Treasures participated in piloting). The questionnaire generally used close-form questions and adopted a five-point Likert scale with veral anchors. Ten questions (120 question elements) relating to leasing decisions were included. It was mailed in June 2000 accompanied y a covering letter explaining the purpose of the survey and assuring the confidentiality of responses. Several techniques were adopted to enhance response rate: clear questionnaire layout; piloting; personally addressed covering letters (all finance director details were individually clarified y telephone) individually signed; reminder letters sent 14 days after the initial mailing and another copy of the questionnaire 28 days after the initial mailing to all non-respondents; stamped reply envelopes (rather than pre-paid envelopes) and non-respondents were asked to return the questionnaire. 3.3 Respondent firms A total of 198 completed questionnaires were received, 192 from the 831 mailed (approximately 23% response rate) and 6 companies who requested a copy of the questionnaire when replying to a questionnaire on a related topic. 2 Of the remaining 639, 225 returned the questionnaire uncompleted, whilst 414 failed to acknowledge receipt. The response is relatively favourale given the increasing questionnaire fatigue of corporate personnel. 3 Tests for response ias included a comparison of responding companies and the population of UKQI companies on the asis of size (measured y total assets) and industry group. A chisquared test indicated that there was no statistically significant difference on the asis of industry (chi-squared = 7.695 p=0.464). A 2-tailed t-test confirmed that the mean total assets for the population and responding sample were not statistically significantly different. Responses to key questions on leasing policy were compared for early responders to those of late responders, using late responders as a proxy for non-responders (Oppenheim, 1966). Responses to key questions (66 question elements) were further compared ased on the degree of operating lease use (measured y the ratio of operating lease rental expensed in the profit and loss account to total sales). 4 The numer of significant differences (at the 10% 10

level) in responses given y early and late respondents and high and low operating lease users were relatively few, and there was no indication of strongly opposing views. 3.4 Nature of further analysis Questionnaire responses were analysed y firm size, financial gearing and industry, additional data eing otained from Datastream. 5 Respondents were divided into three equal groups for size and gearing purposes (small, medium and large sized firms; and low, medium and high geared firms), with firms in the medium categories eing omitted from further analysis. Thus, comparisons were made etween large and small firms and low and high geared firms. Nine industry groups were compared. Descriptive statistics are shown in Appendix 1. 4. Results Responses to survey questions are first descried under five headings: use of leasing; general approach to the leasing decision, relative importance of factors in the decision to lease; relative importance in decision not to lease; and lease agreement features. Responses are further analysed y firm characteristics: size, financial gearing and industry. Finally, the survey evidence is then considered in relation to the theoretical set of reasons for leasing. Further consideration is given to accounting and tax treatments in light of anticipated changes. 4.1 Use of leasing The popularity of leasing as a source of company finance is evident, with approximately 84% of respondents indicating that their companies currently used, had previously used or would consider using leasing. The use of oth finance and operating leases to acquire different usiness asset types is shown in Tale 1. The use of operating leases to acquire vehicles appears to e most popular. Operating leases are also predominantly used / considered to acquire land and uildings and office equipment. Finance and operating leases appear to e equally considered for computer equipment. Only in the acquisition of plant and machinery are finance leases predominant. This contrasts with prior research conducted after the introduction of SSAP 21 and changes to the UK tax system, which document a predominance of finance leases (Mayes and Nicholas, 1988) [Tale 1] 11

4.2 General approach to the leasing decision Approximately 70% indicated that the decision to lease was the product of a process of quantitative analysis (rows 1-2, panel A, Tale 2). The remainder indicated that their company approached the leasing decision non-quantitatively, y preferring to lease certain asset types or y relying on judgement and experience (rows 3-4). Quantitative analysis was undertaken y 51% of respondents only if purchase would have een profitale (row 1), inferring that leasing is a financing rather than an investment decision. Slightly more than half of all respondents indicated that these decisions were taken centrally (row 1, panel B, Tale 2). [Tale 2] Despite the popularity of leasing among respondents, only a minority admitted to preferring to lease assets whenever possile or adopting a target proportion of assets to e financed y leasing (rows 8-9, panel B, Tale 2). Haitual comparison with alternative sources of finance is not apparent, with only 23% of respondents indicating that the leasing alternative was considered in all asset financing decisions, and 35% indicating that only specific assets were leased (rows 3& 5, panel B, Tale 2). When leasing is compared with other sources, ank orrowing appears to e most popular (row 1, panel C, Tale 2). Approximately 35% of respondents indicated that they take advantage of good leasing deals if/when they arise (row 4, panel B, Tale 2). 4.3 The relative importance of factors in the decision to lease The relative importance of factors in the decision to lease oth land and uildings and other assets is shown in Tale 3 (factors ranked in descending order of importance for land and uildings). In all cases, mean responses were found to e significantly greater than 1, i.e. not important at all. [Tale 3] The most important factor in the decision to lease land and uildings was to avoid large capital outlays (row 1). Conservation of cash flow (row 2) and the rate of interest implicit in the lease compared to the cost of orrowing to purchase (row 3) were also considered very important. These three factors were also considered most important in the decision to lease other assets (rows 1-3). However, the rate of interest implicit in the lease was of paramount importance in the decision to lease other assets. Responses to avoiding large capital outlay eing important in the decision to lease land and uildings and other assets were significantly different (row 1). Avoiding large capital outlay appears to e more important in leasing land and uildings which is hardly surprising considering the purchase of land and uildings would 12

proaly involve a greater capital outlay than the purchase of most other assets. A positive outcome to quantitative analysis was ranked fourth in importance in the decision to lease oth land and uildings and other assets (row 4). These findings are somewhat surprising, considering approximately 30% of respondents had previously acknowledged that they did not undertake quantitative analysis (Tale 2, panel B). One major difference etween the decision to lease land and uildings and the decision to lease other assets appears to e incentives offered y the lessor, such as rent-free periods or reverse premiums. This factor was ranked fifth in importance in the decision to lease land and uildings ut ranked twentieth in the decision to lease other assets (row 5). The difference was also found to e statistically significant etween the two. Perhaps incentives are more readily availale and/or more valuale in lease agreements for land and uildings. Further differences etween asset categories emerge in the importance placed on the aility of leasing to offer a complete package (row 11), and the ease with which leasing can e arranged from an administrative point of view (row 17). These two factors are more important in the decision to lease other assets. However, in the case of land and uildings, maintenance contracts, etc., could just as easily e availale on freehold property through appointed property managers at the time of purchase, as through lease agreements. In relation to administrative arrangements, a long term property lease, with the exception of additional finance arrangements required to purchase, could require as close a scrutiny and involve the same legal checks as a purchase contract. Further, the administration involved could e considered increasingly insignificant in relation to the acquisition of an asset as significant as property. The relative importance of other factors in the decision to lease oth land and uildings and other assets are relatively similar. The transfer of capital allowances to the lessor only applies in the decision to lease other assets and was considered fairly important (Panel B, row 1). Although reductions in the amount of capital allowances transferred seem less influential (Panel B, rows 2 & 3). 4.4 The relative importance of factors in the decision not to lease The relative importance of nine factors in the decision not to lease oth land and uildings and other assets in a particular circumstance are shown in Tale 4. In all cases, mean responses were found to e significantly greater than 1, i.e. not important at all. [Tale 4] 13

The most important factor in the decision not to lease appeared to e the expense involved compared to other sources of finance (row 1). This was found to e statistically more important in the decision not to lease other assets compared to land and uildings, which may reflect the ease with which other assets could e otained using other sources of finance. General comments made y respondents provide some indication of this eing the case, e.g., the alternative to leasing is not always availale and the properties we operate from are only availale on lease. Company preference for legal ownership was ranked second in importance (row 2). The least important factor in the decision not to lease oth land and uildings and other assets appeared to e the notion that leasing indicates a source of financial weakness (row 9). Three factors suggested in the decision not to lease (Tale 4) correspond to factors suggested in the decision to lease (Tale 3). To test for consistency in the responses provided, a comparison was made and correlation coefficients otained. First, if leasing eing more expensive than other sources of finance was important in the decision not to lease (row 1, Tale 4), the rate of interest implicit in leasing compared to orrowing (row 3, Panel A, Tale 3) might e expected to e equally important in the decision to lease. The Spearman correlation coefficient etween the two sets of responses is 0.603 (p<0.001) for land and uildings and 0.396 (p<0.001) for other assets. Therefore, the importance of the cost of leasing compared to other sources appears consistent across respondents decisions to lease and not to lease. Second, if the loss of grants/taxation allowances was important in the decision not to lease other assets (row 4, Tale 4), this might suggest that respondents derive more enefit from their own use of such allowances. The opposite would e true if transferring capital tax allowances to the leasing company reflected in lower lease rental cost were important in the decision to lease other assets (row 1, Panel B, Tale 3). The Spearman correlation coefficient etween the two sets of responses is 0.234 (p=0.011). If respondents mostly derived enefit from either their own use of tax allowances or transferring them to the leasing company, a negative correlation coefficient might have een expected. However, the positive relationship might merely reflect that, in some leasing situations, the loss of tax allowances rings no additional enefit and is, therefore, a deciding factor in the decision not to lease. In other situations, the enefit derived from transferring the tax allowances could e a deciding factor in the decision to lease. As more importance appears to e placed on transferring allowances (mean=3.08) compared to the loss (mean=2.43), leasing appears to offer a net tax advantage for the respondents as a whole. 14

Third, the repossession of leased assets from lessees in default does not appear to e an important consideration in the decision not to lease land and uildings and other assets (row 6, Tale 4). This could indicate that respondents either don t contemplate default or don t consider repossession a serious consequence. However, the legal consequence of default eing less severe for leasing also does not appear to e an important consideration in the decision to lease either land and uildings or other assets (row 19, Panel A, Tale 3). The correlation coefficients etween the two sets of responses are 0.406 (p<0.001) for land and uildings and 0.5000 (p<0.001) for other assets. Therefore, respondents don t appear to contemplate default in the leasing decision, in which case the less severe consequences of leasing don t appear to e an advantage. 4.5 Lease agreement features In lease agreements with a contingent element to rental payments, a fixed repayment cost is converted to one which varies with use, operating performance or market prices. The use of contingent elements in lease agreements y respondents is shown in Panel A of Tale 5. The most common contingent element appeared to e rentals which vary in line with prices in respect of leased land and uildings (row 1). However, approximately 41% of respondents currently engaged in leasing land and uildings indicated this was never or seldom the case. This is somewhat surprising given that property leases in the UK are typically long-term leases in which rentals are increased to prevailing market prices at regular intervals. Further, according to the Finance and Leasing Association, property leases without rent rises are virtually non-existent in the UK. Although rentals that vary with usage appeared the most popular contingent element in lease agreements for other assets (row 3), the vast majority (69% of respondents) indicated that they were never a feature. [Tale 5] The risks associated with asset disposal at the end of a lease agreement can e appropriated etween lessee and lessor via various residual arrangements. The extent of respondents interest in residual value is shown in Panel B of Tale 5. The most common form of residual interest appeared to e the transfer of ownership at the end of lease contracts (row 1), this eing far more commonplace in the leasing of other assets (mean=2.71) compared to land and uildings (mean=1.58). Receiving a share of the sales proceeds of other leased assets (mean=2.13) was more common than receiving a share of the sale proceeds of leased land and uildings (mean=1.44). Giving a guarantee to pay compensation for a residual value elow a certain amount appeared least common in the leasing of oth land and uildings and other assets (mean=1.26 and 1.74 respectively). 15

4.6 Further analysis Statistical analysis revealed that firm size and level of gearing do not influence the dichotomous choice etween lease use / non-use. 6 However, industry classification appears influential, with firms operating in Information Technology, General Industries and Cyclical Services more likely to use or consider leasing. 7 This may reflect the nature of assets employed in these industries. Assets employed in Information Technology are suject to rapid osolescence, and assets employed in General Industries / Cyclical Services may e more standardised and thus conducive to eing the suject of lease contracts. Significant differences in the reasons for leasing are apparent across company size (Appendix 2). Small companies appear to place more importance on qualitative factors such as avoiding large capital outlay, conservation of cash flow, ease of administration, and availaility on any scale. Large companies appear more concerned with quantitative factors the cost. However, large companies appear to have a greater preference for legal ownership of land and uildings compared to small firms. Not surprisingly, highly geared companies appear to e more concerned with the impact leasing has on restrictive covenants, and also prefer legal ownership in relation to land and uildings. The reasons for leasing do not appear constant across firms operating in different industries (Appendix 3). Utility firms such as those providing water, electricity and gas attach more importance to avoiding large capital outlay and the cost of leasing. However, firms operating in these industries compete in terms of costs and are unale to pass sustantial costs on to customers owing to the presence of industry regulators. Firms operating in Non-Cyclical Services (food & drug retailers and telecommunication services) appear more concerned with the limited duration of occupancy / control over leased land and uildings. These firms appear less concerned with the loss of grants / taxation allowances through leasing and avoiding large capital outlay. Firms operating in Cyclical Services (support services; media & photography; general retailers; leisure, entertainment and hotels; distriutors) and Information Technology appear to attach less importance to the cost of leasing. 4.7 Survey evidence in relation to theoretical reasons for leasing The survey evidence in relation to theoretical reasons for leasing is summarised in Tale 6. To aid an evaluation of the relative importance of factors influencing the leasing decision, responses were classified into five categories ased on the strength of evidence otained. The strength of evidence related to the percentage of respondents who indicated that a factor was fairly to very important to them, or that they sometimes to always entered into a lease 16

agreement with a certain feature. Percentages were classified as follows: 0% to 20% - strongly unsupported; 21% to 40% - unsupported; 41% to 60% - neutral; 61% to 80% - in support; 81% to 100% strongly in support. [Tale 6] The evidence in relation to the impact of accounting treatment on the leasing decision was neutral (Panel A). Tax considerations still exert some influence over the leasing decision (Panel B). Respondents lease land and uildings ecause the lease rentals are a tax-deductile expense, when the asset itself does not qualify for capital tax allowances. Respondents also claim that other assets are leased ecause the aility to transfer capital tax allowances to the lessor is reflected in lower lease rental payments. Time apportionment of qualifying expenditure under finance leases in first year, and the restriction of writing down allowances to 6% on qualifying expenditure on long-life assets, did not influence the leasing decision. Leasing is not used with the intention of expanding overall det type capacity (Panel C). The evidence in relation to lease covenants eing less restrictive was neutral. In relation to repayment reasons (Panel D), avoiding large capital outlay and conservation of cash flow were most influential in the decision to lease oth land and uildings and other assets. However, repayment flexiility does not feature. The provision of 100% finance is important in the decision to lease other assets. The flexiility to shift the risks and rewards etween parties to a lease agreement does not feature significantly in the decision to lease (Panel E). Respondents did not attach any importance to risk-sharing reasons for leasing and lease agreements with risk-sharing features were not widely employed y respondents. However, with the exception of operating leased land and uildings with rentals that vary in line with prices, the features investigated may e more commonly employed in finance lease agreements. As respondents predominantly use operating leases, the lack of use of such risk-sharing features may not e surprising. These findings contrast with a prior US survey which found the avoidance of osolescence risk to e the most important advantage to leasing (Mukherjee, 1991). The cost of leasing in relation to other sources is important in the leasing decision (Panel F). It appears more important when deciding to lease other assets than in the decision to lease land and uildings. However, cost may not e the deciding factor to lease land and uildings if access to a particular property is not availale y any other means. Incentives given y the lessor in terms of rent-free periods are influential in the decision to lease land and uildings, ut not in relation to other assets. The opportunity to otain finance on any scale appears 17

important in the decision to lease other assets. Practical considerations such as administrative arrangements and availaility at point of sale are not of particular importance. The avoidance of capital expenditure controls plays no part whatsoever in the decision to lease. 4.8 Importance of current accounting and tax treatments If accounting and / or tax treatments currently provide incentives to use operating leases, the role of leasing can e expected to change in response to accounting and tax reform. The evidence for the entire sample of respondents was neutral in relation to the impact of the current lease accounting treatment. However, 27 companies (approximately 14%) indicated that the off-alance sheet nature of operating leases with no impact on financial accounting ratios was very important / important in the decision to lease land and uildings. Further, 32 companies (approximately 16%) indicated it was very important / important in the decision to lease other assets. For these companies, the off-alance sheet nature of operating leases was considered the most important factor in the leasing decision, and significantly more important than any other factor. 8 To explore this finding, the characteristics of these companies were examined and found to represent a wide range of size and financial gearing levels. They also operated across a wide range of industries, although high lease industries such as Information Technology, General industries and Cyclical Services were significantly represented. For the entire sample, there was supporting evidence in relation to the importance attached to the award of capital tax allowances to the lessor in the decision to lease other assets. Fifty companies (approximately 26%) indicated it was very important / important. For these companies, it was considered the most important factor in the leasing decision (mean response of 4.14), and significantly more important than any other factor (mean response of 3.6 in response to the importance attached to the interest rate implicit in the lease). These companies also represented a wide range of size and gearing levels and industry classifications. In total, 13 companies (approximately 7%) considered oth the current accounting and tax treatments to e very important / important in the decision to lease. 5. Summary and conclusions This paper uses a questionnaire survey of 198 UK finance directors to investigate the relative importance of financial and non-financial factors in the decision to lease. Avoiding large capital outlay and cash flow considerations appear of paramount importance in the decision to lease all asset types. Other advantages to leasing in comparison to other sources of finance include: tax enefits, availaility to finance on any scale and the opportunity to otain service and maintenance packages. The importance attached to these advantages is likely to depend 18

on individual circumstances, and is not consistent across firm size. Small firms appear more concerned with qualitative factors such as avoiding large capital outlay, conservation of cash flow and availaility on any scale. Large firms appear more concerned with cost. Although Drury and Braund (1990), the most recent prior UK survey, found cost to dominate the leasing decision for large firms, they documented a lack of importance of other qualitative and cash flow considerations to large firms which was not apparent in the present study. However, Drury and Braund s study was conducted over a decade earlier when finance leases were predominant. Also, they did not consider the relative importance of factors in the decision to lease alternative asset types. Across all respondents, the evidence was neutral in relation to the importance attached to the off-alance sheet accounting treatment of operating leases. However, for a significant sugroup of companies, it was found to e the most important factor in the decision to lease. Supporting evidence was otained in relation to the importance attached to the award of capital tax allowances to the lessor. For over a quarter of responding companies it was found to e very important / important in the decision to lease other assets. These findings contradict previous US survey findings which document the insignificance of off-alance sheet and tax advantages to leasing (Mukherjee, 1991). In the UK, Drury and Braund (1990) suggested that tax considerations dominate the leasing decision for large firms. The present study indicates that the importance attached to the award of capital allowances to the lessor is not a function of company size. This paper contriutes to the understanding of lease financing y providing comprehensive up-to-date evidence of leasing decisions across UK listed industrial companies. It provides policy-relevant ex ante evidence in support of the standard setting process y providing an indication of the potential consequences of intended changes to the lease accounting and tax regulations. It follows from the importance attached to off-alance sheet accounting treatment y some companies that ringing operating leases on-alance sheet may influence their leasing decision. The importance attached to the award of capital allowances to the lessor indicates that corporation tax reform has the potential to significantly influence leasing activity. Given that accounting and tax treatments are important for a wide range of companies in terms of size, gearing and industry classification, the extent to which proposed changes will influence leasing activity is difficult to predict. However, given the importance attached to reasons other than accounting and taxation, the popularity of leasing as a source of finance is set to continue. 19

Notes 1 Ang and Peterson (1984); Bathala and Mukherjee (1995); Sharpe and Nguyen (1995), Graham, Lemmon and Schallheim (1998); Mehran, Taggart and Yermack (1999); Duke, Franz, Hunt and Toy (1999); Adedeji and Stapleton (1996); Beattie, Goodacre and Thomson (2000). 2 A questionnaire investigating lease accounting reform was sent out over a similar time period to the remaining third of the UKQI population. Respondents to this survey were invited to request the leasing and corporate financing decisions questionnaire and 6 requested and completed the questionnaire. 3 In earlier leasing surveys addressed to UK quoted companies, Taylor and Turley also otained 198 responses (response rate 39.6%) over 1982 to 1983, and Drury and Braund (1990) otained 273 responses (response rate 28%). In relation to prior capital structure surveys in the US of the Fortune 500/1000 firms, a notale decrease in response rate can e oserved over time. For example, Scott and Johnson (1982) achieved 39.6% and Pinegar and Wilricht (1989) achieved 35.2% compared to 12% y Trahan and Gitman (1995), 8.5% y Graham and Harvey (2001) and 12.7% y Bancel and Mittoo (1994). The response rate to this questionnaire is high relative to Graham and Harvey s latest US capital structure survey and Bancel and Mittoo s survey on convertile det issue across European firms. 4 The use of operating leases was selected on the asis that previous research has documented their significant and widespread use (Beattie, Edwards and Goodacre, 1998). Otaining a comination of oth finance and operating lease use would require the collection of a significant amount of data in order to follow an operating lease capitalisation process. 5 Measures of oth total assets and sales were used to proxy firm size. Measures of oth total gearing and long-term gearing were used. Total gearing was represented y the ratio of total loan capital plus orrowings repayale in less than one year to the value of equity. Borrowings repayale in less than one year were excluded from the long-term gearing measure. Datastream s level 3 industry classifications were used. 6 For oth large and small companies (size proxied y assets), 83% of respondents used, had used or would consider using leasing (chi-square = 0.002, p=0.969). In terms of total gearing, 86% of high geared and 78% of low geared respondents used, had used or would consider 20

using leasing (chi-square = 1.622, p=0.203). Similar percentages were found when sales were used as a proxy for size and long-term gearing measure used. 7 Percentage of respondents indicating that they used, had used or would consider using leasing: 94% in Information Technology, 88% in General Industries, 90% in Cyclical Services, 78% in Basic Industries, 78% in Non-Cyclical Consumer Goods, 71% in others - the remaining four groups containing a small numer of companies were comined(chisquare = 9.796, p=0.081). 8 The mean response in relation to the importance attached to the off-alance sheet nature of operating leases in the decision to lease land and uildings was 4.39 compared to a mean response of 3.9 for the second most important factor, avoiding large capital outlay. For the decision to lease other assets the mean response was 4.31 compared to 3.67 for the second most important factor, conservation of cash flow. Acknowledgements This research was conducted as part of a PhD project. The guidance provided y supervisors Professor Vivien Beattie (University of Glasgow) and Professor Alan Goodacre (University of Stirling) is greatly appreciated. The financial support of The Carnegie Trust for the Universities of Scotland in the form of a scholarship and the contriution made y the finance directors who gave so freely of their time in completing the questionnaire survey are also gratefully acknowledged. Comments made y Professor Vivien Beattie are very much appreciated. 21

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Tale 1: Use of leasing % of Respondents (n=196) Asset Category: Land and Plant and Office Computer Vehicles Buildings Machinery Equipment Equipment Last 2-3 years Finance leases 12% 35% 15% 18% 23% Operating leases 37% 23% 24% 20% 38% Currently Finance leases 11% 32% 14% 22% 23% Operating leases 43% 26% 29% 23% 49% Would consider Finance leases 16% 32% 17% 19% 20% Operating leases 33% 27% 23% 24% 38% Note: Respondents were asked to tick all applicale options 25

Panel A: Use of quantitative analysis Tale 2: General approach to leasing decision Question asked (areviated) In making a leasing decision which est descries your company s actions: 1 Quantitatively analyse a leasing alternative only if asset would have een profitale on purchase asis 2 Quantitatively analyse potential of leasing asset even if asset purchase would not e considered profitale 3 Do not perform any type of quantitative analysis ecause simply prefer to lease some asset types 4 Do not perform any type of quantitative analysis ut rely on judgement and experience % of Respondents (n=156) 51% 18% 15% 15% Panel B: How leasing fits in with overall company financing decisions Tick all applicale options % of Respondents (n=196) 1 Leasing decisions taken centrally 52% 2 Leasing policies are set centrally 44% 3 Only specific assets leased 35% 4 Take advantage of good leasing deals if/when they arise 35% 5 Leasing alternative considered in all asset financing decisions 23% 6 Use leasing to solve specific financing prolems 23% 7 Do not have general leasing policies 14% 8 Generally, prefer to lease whenever possile 8% 9 Target proportion of assets to e financed y leasing 3% Panel C: Comparison etween leasing and other sources of finance Question asked (areviated) With which alternative sources of finance is leasing compared (tick all that apply) % of Respondents (n=196) 1 Bank orrowing 53% 2 Internal profit (retained profit) 35% 3 Hire purchase 30% 4 All forms of det rather than a specific type 21% 5 No comparison made 5% 26

Tale 3: Relative importance of factors in the decision to lease Panel A Factors in the decision to lease oth land & uildings and other assets L&B rank Question asked (areviated) Please indicate the relative importance of the following factors in your company s decision to leases land and uildings and other asset Mean 1,2 (Standard deviation) Land & Build 1 Avoiding large capital outlay 3.68 (1.12) 2 Conservation of cash flow 3.51 (1.13) 3 Rate of interest implicit in lease 3.42 (1.06) 4 Positive outcome of quantitative analysis 3.14 (1.21) 5 Incentives to lease given y lessor 3.04 (1.18) 6 Lease rentals are tax deductile ut capital allowances 2.92 not availale on asset purchased (1.13) 7 Leasing can e otained on any scale 2.82 (1.24) 8 Leasing permits the total financing of an asset (apart 2.70 from advanced rental deposit) (1.19) 9 Lease covenants generally less restrictive 2.59 (1.11) 10 Operating leases are not accounted for on the alance 2.58 sheet and have no impact on financial accounting ratios (1.26) 11 Leasing has the aility to offer a complete package 2.55 (1.17) 12 Expanding overall det-type capacity 2.40 (1.13) 13 Leasing has minimal impact on measures used in 2.36 current det covenants (1.04) 14 Leasing can reduce/eliminate risk of ownership 2.31 (1.02) 15 Lease agreements flexile, sharing asset risk and 2.30 economic enefit etween parties as required (1.06) 16 Leasing is conveniently offered at point of sale 2.19 (1.20) 17 Leasing is easier from an administrative point of view 2.18 (1.01) 18 Higher disposal value of leased property 2.13 (0.98) 19 Legal consequences of default less severe for leasing 2.07 (1.02) 20 Contingent lease rentals can reduce company exposure 2.05 to economic or usiness downturns (1.01) 21 Flexile repayment low lease rentals early on 1.95 (0.94) 22 Operating leases avoid capital expenditure controls 1.57 (0.78) Other Assets 3.39 (1.11) 3.57 (1.00) 3.60 (0.96) 3.18 (1.24) 2.27 (1.15) 2.83 (1.10) 3.08 (1.19) 2.97 (1.15) 2.47 (1.16) 2.64 (1.23) 3.11 (1.20) 2.42 (1.13) 2.34 (1.02) 2.51 (1.02) 2.51 (1.07) 2.42 (1.24) 2.47 (1.14) 2.27 (1.01) 2.11 (0.99) 2.01 (0.93) 2.12 (1.05) 1.64 (0.89) Other Assets rank 3 Diff 4 3 0.29 2 ns 1 ns 4 ns 20 0.77 9 ns 6 ns 8 ns 14 ns 10 ns 5-0.56 16 ns 18 ns 11 ns 12 ns 17 ns 13-0.29 21 ns 23 ns 24 ns 22 ns 25 ns 27

Panel B Factors specific to the decision to lease other assets Question asked (areviated) Please indicate the relative importance of the following factors in your company s decision to lease other assets Mean 1,2 (Standard deviation) Other Assets Other Assets rank 3 1 Transfer of capital tax allowances to leasing company reflected in lower lease rental cost 2 Expenditure under finance leasing, qualifying for capital tax allowances is time apportioned in first year 3 Expenditure on long-life assets qualifying for capital tax allowances is restricted to a WDA of 6% 3.08 (1.05) 2.47 (1.01) 2.29 (0.93) 7 15 19 Notes: 1. Response categories are: 1 = not important at all, 2 = of little importance, 3 = fairly important, 4 = important, 5 = very important 2. All mean responses significantly different from not important at all (i.e.1) at 1% level (one-tailed test) 3. Ranked y mean responses for land and uildings; Other assets rank = rank of mean responses for other assets 4. P-Value from a Wilcoxon-Mann-Whitney test for significant difference etween medians: significant differences of 5% and aove are reported (2-tail test); ns = not significant 28

Tale 4: Relative importance of factors in the decision not to lease Question asked (areviated) Please indicate the relative importance of the following factors in your company s decision not to lease land and uildings and other assets 1 Leasing is more expensive than other sources of finance Mean 1,2 (Standard deviation) Land & Build 3.36 (1.27) 2 Company preference for legal ownership 2.98 (1.37) 3 Control over and hence the aility to use leased 2.77 property is limited to duration of lease agreement with (1.20) extension at lessor s discretion 4 Loss of grants / taxation allowances if an asset is leased 2.32 (1.08) 5 Company assets are highly specialised or company 2.11 specific, making it expensive for a lessor to ear the (1.18) risk of osolescence and the costs of purchase and disposal 6 Assets acquired under lease agreement can e repossessed if company defaults 1.87 (0.92) 7 Some key company executives are opposed to leasing 1.71 (0.97) 8 Leasing does not provide 100% finance due to the 1.70 requirement of advance rentals (0.76) 9 Leasing indicates a source of financial weakness 1.58 (0.73) Other Assets 3.68 (1.10) 2.77 (1.29) 2.58 (1.14) 2.43 (1.09) 2.37 (1.29) 1.89 (0.90) 1.80 (1.05) 1.68 (0.72) 1.62 (0.77) Diff 4-0.32 ns ns ns ns ns ns ns ns Notes: See Tale 3 29

Tale 5: Lease agreement features Panel A: The use of contingent rentals Question asked (areviated) To what extent does your company enter lease agreements in which rentals vary with: Mean 1,2 (Standard deviation) Land & Build Other Assets 1 Prices (upward-only rent reviews) 2.44 (1.42) 2 Revenue / profits derived from use of leased asset 1.26 (0.65) 3 Usage 1.13 (0.43) 1.39 (0.84) 1.21 (0.62) 1.66 (1.08) Panel B: Lessee interest in residual value Question asked (areviated) To what extent does your company enter lease agreements in which: Mean 1,2 (Standard deviation) Land & Build Other Assets 1 Ownership is transferred to lessee at the end of the agreement 2 All or a share of the proceeds is received y lessee on the sale of the leased asset 3 A surplus is received y lessee if the residual value is aove a certain amount 4 A guarantee is given y lessee to pay compensation if the residual value is elow a certain amount 1.58 (1.14) 1.44 (0.95) 1.36 (0.78) 1.26 (0.67) 2.71 (1.26) 2.13 (1.23) 1.96 (1.07) 1.74 (0.98) Notes: 1. Response categories are: 1 = never, 2 = seldom, 3 = sometimes, 4 = usually, 5 = always 2. All mean responses significantly different from never (i.e., 1) at 1% level (one-tailed test) 30

Tale 6: Summary of survey evidence on factors influencing the leasing decision Panel A: Accounting treatment Importance of factors influencing the leasing decision Strength of Evidence 1 Land and Buildings Other Assets SU U N S SS SU U N S SS Operating leases are not on the alance sheet and have no impact on financial accounting ratios Panel B: Tax saving reasons Importance of factors influencing the leasing decision Land and Buildings Other Assets SU U N S SS SU U N S SS Lease rentals tax deductile ut capital allowances not allowances not availale on assets purchased Loss of grants / tax allowances if asset is leased Transfer of capital allowances to lessor reflected in lower lease rental cost Time apportionment of qualifying expenditure under finance leases in first year N/A Restriction to 6% WDA on qualifying expenditure on longlife assets 31

Panel C: Borrowing capacity Importance of factors influencing the leasing decision Land and Buildings Other Assets SU U N S SS SU U N S SS Expanding overall det-type capacity Lease covenants generally less restrictive Leasing has minimal impact on measures used in current det covenants Panel D: Repayment Importance of factors influencing the leasing decision Land and Buildings Other Assets SU U N S SS SU U N S SS Avoiding large capital outlay Leasing provides total finance for an asset Leasing does not provide 100% finance Conservation of cash flow Flexiility of lease repayments 32

Panel E: Risk sharing reasons Importance of factors influencing the leasing decision Land and Buildings Other Assets SU U N S SS SU U N S SS Leasing can reduce / eliminate risk of significant cost of transferring ownership at end of a contract Higher disposal value of leased property lessor has etter access to / knowledge of markets Lease rentals contingent on sales / profits can reduce exposure to economic / usiness downturns Lease agreements are flexile drawn up to share asset risk and economic enefits etween parties Company assets specialised / specific making it expensive for lessor to ear risks of osolescence and costs of purchase / disposal Use of lease agreements with rentals that vary with: Usage Revenue / Profits Prices Use of lease agreements with residual interest: ownership transferred when contract ends Lessee guarantees residual value, lessee enefits from high residual value, all or share of sales proceeds received y lessee 33

Panel F: Other reasons Importance of factors influencing the leasing decision Land and Buildings Other Assets SU U N S SS SU U N S SS Leasing is easier to arrange on an administrative asis Leasing has the aility to offer a complete package (including service and maintenance agreements) Leasing is conveniently offered at asset point of sale Rate of interest in lease compared to orrowing Incentives to lease given y lessor Leasing is more expensive in decision not to lease Leasing avoids capital expenditure controls Leasing provides finance on any scale Notes: 1 Strength of evidence ased on percentage of respondents who indicated they took a particular action, indicated something was fairly to very important, or agreed or strongly agreed with something, classified as follows:- 0-20% = SU (strongly unsupported), 21-40% = U (unsupported), 41-60% = N (neutral), 61-80% = S (supported), 81-100% = SS (strongly supported). 34

Appendix 1: Descriptive statistics: Company size, gearing and industry Panel A: Company size Size y assets ( m) Size y sales ( m) Mean Stan Dev Min Max Mean Stan Dev Min Max Total sample (n = 198) 871.7 2426.9 701 17288 840. 2384.8 0.00 17158 Small (n=66) 10.8 7.9 701 27.6 9.3 7.8 0.00 27.7 Large (n=66) 2532.1 3694.3 14227 17288 2422.5 3663.1 204.8 17158 Panel B: Gearing Total Gearing 2 Long-term Gearing 2 Mean Stan Dev Min Max Mean Stan Dev Min Max Total sample (n = 196) 0.43 0.71 0.00 6.19 0.24 0.37 0.00 2.56 High gearing firms (n=65) 1.07 0.92 0.41 6.19 0.60 0.47 0.24 2.56 Low gearing firms (n=66) 0.03 0.03 0.00 0.08 0.01 0.01 0.00 0.02 Panel C: Industry classification BI 1 CCG 1 CS 1 GI 1 IT 1 NCCG 1 NCS 1 R 1 U 1 (n = 19) (n = 15) (n = 72) (n = 18) (n = 18) (n = 32) (n = 6) (n = 13) (n = 5) 9.60% 7.58% 36.36% 9.09% 9.09% 16.16% 3.03% 6.57% 2.53% Notes: 1 Datastream level 3 industry classifications: BI = Basic Industries; CCG = Cyclical Consumer Goods; CS = Cyclical services; GI = General Industries; IT = Information Technology; NCCG = Non-Cyclical Consumer Goods; NCS = Non-Cyclical Services; R = Resources; and U = Utilities. 2 Total Gearing = (total loan capital + orrowings repayale in less than one year) / market value of equity; Long-term Gearing = total loan capital / market value of equity 35

Appendix 2: Significant differences in the leasing decision ased on size and gearing Panel A Relative importance of factors in decision to lease land and uildings and other assets Size y sales 1 Total Gearing 1 Land and Buildings Other Assets Land and Buildings Other Assets Large 1 Avoiding large capital outlay 3.32 4.09-0.77 3.08 3.70-0.62 2 Positive outcome to quantitative analysis 3 Leasing is easier to arrange from an administrative point of view Small Diff 2 Large Small Diff 2 High Low Diff 2 High Low Diff 2 3.35 2.79 0.56 1.88 2.35-0.46 2.04 2.77-0.73 4 Leasing permits total financing 2.39 3.16-0.77 2.62 3.36-0.75 2.4 2.90 -.050 2.79 3.26-0.46 5 Operating leases avoid capital expenditure controls 1.34 1.68-0.34 1.36 1.80-0.44 6 Conservation of cash flow 2.98 3.84-0.87 2.92 3.87-0.96 7 Legal consequences of default less severe for leasing 1.80 2.29-0.49 1.88 2.38-0.50 8 Leasing can e otained on any scale 2.48 3.05-0.57 2.79 3.40-0.61 9 Rate of interest implicit in lease compared to cost of orrowing to purchase 10 Leasing can reduce/eliminate risk of significant cost of transferring ownership 3.84 3.38 0.46 2.22 2.71-0.49 11 Leasing is conveniently offered at asset point of sale 2.37 2.80-0.53 12 Leasing has minimal impact on measures used in current det covenants 13 Higher disposal value of leased asset 2.53 2.03 0.50 2.55 2.00 0.55 2.14 2.57 -.043 36

Appendix 2: Significant differences in the leasing decision ased on size and gearing Panel B Relative importance of factors in decision not to lease land and uildings and other assets 1 Leasing is more expensive than other sources of finance Size y sales 1 Total Gearing 1 Land and Buildings Other Assets Land and Buildings Other Assets Large Small Diff 2 Large Small Diff 2 High Low Diff 2 High Low Diff 2 3.83 2.90 0.93 2 Company preference for legal ownership 3.19 2.50 0.69 3.31 2.65 0.66 3 Some key executives are opposed to leasing 1.94 1.42 0.52 1.96 1.40 0.56 4 Loss of grants / taxation allowances if asset is leased 2.65 2.06 0.59 5 Assets acquired under lease agreements can e repossessed if company defaults 6 Control over and hence aility to use leased property is limited with extension at lessor s discretion 1.60 2.08-0.47 1.63 2.17-0.54 3.00 2.44 0.57 Notes: Mean responses reported 1 Similar differences estalished using total assets as proxy for company size and long-term gearing measures 2 Differences are significant at 5% level 2-tailed test (Mann-Whitney confidence interval and test Minita) 37

Appendix 3: Significant differences in the leasing decision ased on industry classification Panel A Relative importance of factors in decision to lease land and uildings 1 Avoiding large capital outlay 2.73 (1.27) 2 Rate of interest implicit in lease compared to cost of orrowing to purchase BI 1 CCG 1 CS 1 GI 1 IT 1 NCCG 1 NCS 1 R 1 U 1 Kruskal- Wallis Test 2 4.09 (0.70) 3.50 (1.23) 3.80 (1.30) 3.84 (1.16) 3.09 (1.01) 3.80 (0.86) 3.40 (0.99) 3.81 (0.54) 3.13 (1.13) 3.91 (0.97) 3.68 (0.89) 2.20 (0.84) 4.00 (1.73) 3.60 (1.67) 3.80 (1.10) 4.00 (1.00) 4.33 (0.58) H = 17.98 p = 0.012** H= 18.68 p = 0.009*** Panel B Relative importance of factors in decision not to lease land and uildings 1 Control over & hence aility to use leased property is limited with extension at lessor s discretion 2 Loss of grants / taxation allowances if asset is leased BI 1 CCG 1 CS 1 GI 1 IT 1 NCCG 1 NCS 1 R 1 U 1 Kruskal- Wallis Test 2 2.46 (1.13) 3.07 (0.96) 3.70 (1.34) 2.56 (1.01) 2.58 (1.18) 2.21 (1.11) 3.13 (1.09) 2.29 (0.83) 2.29 (1.14) 2.00 (1.10) 2.78 (1.05) 2.32 (1.11) 3.83 (1.47) 1.50 (0.84) 3.00 (1.12) 2.38 (0.92) 1.67 (0.58) 3.00 (1.73) H = 16.59 p = 0.020** H = 14.36 p = 0.045** Panel C Relative importance of factors in decision not to lease other assets 1 Company assets are highly specialised/specific, making it expensive for a lessor to ear the risk of osolescence & costs of purchase & disposal BI 1 CCG 1 CS 1 GI 1 IT 1 NCCG 1 NCS 1 R 1 U 1 Kruskal- Wallis Test 2 3.08 (1.44) 1.83 (0.94) 1.95 (1.11) Notes: 1 Datastream level 3 industry classifications: BI = Basic Industries; CS = Cyclical services; GI = General Industries; IT = Information Technology; NCCG = Non- Cyclical Consumer Goods; OTHERS = Non-Cyclical Services, Resources, Utilities & Cyclical Consumer Goods. 2 *** = significant at 1%, ** = significant at 5% 2.80 (1.21) 2.29 (1.33) 2.41 (1.28) 2.00 (1.10) 4.22 (0.97) 2.67 (0.58) H = 27.31 p =0.000*** 38