Chapter Twenty-four
Leasing
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
24-1
Chapter Organisation
24.1
24.2
24.3
24.4
24.5
24.6
24.7
24.8
24.9
The Nature of Leases
Types of Leases
A Brief Look at Accounting for Leases
Taxation and Leases
An Evaluation of Leasing
The Role of the Residual Value
Setting Lease Premiums
Alleged Advantages and Disadvantages of
Leasing
Summary and Conclusions
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
24-2
Chapter Objectives
• Understand the characteristics of the different
•
•
•
•
•
types of leases.
Explain how leases are recorded in a firm’s
accounting records.
Identify the tax implications of leases.
Evaluate a lease by calculating the net advantage
of leasing (NAL).
Explain the calculation of lease premiums.
Discuss the advantages and disadvantages of
leases.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
24-3
Leasing versus Buying
Buy
Sass buys asset and uses asset;
financing raised by debt
Manufacturer
of asset
Lease
Sass leases asset from lessor; the
lessor owns the asset
Manufacturer
of asset
Sass arranges
financing and buys
asset from
manufacturer
Sass
1. Uses asset
2. Owns asset
Sass leases asset
from lessor
Lessor
1. Owns asset
2. Does not use asset
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PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
Lessee (Sass)
1. Uses asset
2. Does not own
asset
24-4
Leasing
• What is a lease?
–
A lessee (user) enters an agreement in which they make
lease payments to the lessor (owner) in return for the use
of the leased property/asset.
• Who are the major providers of lease finance in
Australia?
–
Finance companies and banks.
• What assets are leased?
–
Any asset including photocopiers, cars, construction
equipment, computers, shop/office fittings and equipment.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
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Types of Leases
• Operating lease
• Financial lease
–
–
Sale and leaseback agreement
Leveraged lease
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PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
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Operating Leases
• Short-term lease.
• Cancellable prior to the expiry date at little or no
cost.
• Lessor is responsible for maintenance and upkeep
of asset.
• The sum of the lease payments does not provide
for full recovery of the asset’s costs.
• Includes telephones, televisions, computers,
photocopiers, cars.
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PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
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Financial Leases
• Long-term lease.
• Non-cancellable (without penalty) prior to expiry
•
•
•
•
date.
Lessee is responsible for the maintenance and
upkeep of the asset.
Lease period approximates asset’s economic life.
The sum of the lease payments exceeds the
asset’s purchase price.
Includes specialist equipment, heavy industrial
equipment.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
24-8
Residual Value Clause
• Lease continues for its full term
Lessee can purchase the asset for its residual
value, return the asset to the lessor (paying any
shortfall from residual value) or renew the lease.
• Lease is cancelled during its initial term
Lessee must pay outstanding premiums (less
interest component) plus residual value of asset.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
24-9
Types of Financial Leases
• Sale and leaseback agreements
Companies sell an asset to another firm and
immediately lease it back. Enables the company to
receive cash and yet maintain use of the asset.
• Leveraged leases
The lessor arranges for funds to be contributed by
one or more parties—form of risk-sharing and
transferring tax benefits. Often used to finance
large-scale projects.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
24-10
Leasing and the Statement of
Financial Position
A. Statement of Financial Position with Purchase (company finances $100 000 truck with debt)
Truck
Other assets
Total assets
$100 000
100 000
$200 000
Debt
Equity
Debt plus equity
$100 000
100 000
$200 000
B. Statement of Financial Position with Operating Lease (co. finances truck with an operating
lease)
Truck
Other assets
Total assets
$
0
100 000
$100 000
Debt
Equity
Debt plus equity
$
0
100 000
$100 000
C. Statement of Financial Position with Financial Lease (co. finances truck with a financial lease)
Assets under financial
lease
$100 000
Other assets
100 000
Total assets
$200 000
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PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
Obligations under
financial lease
Equity
Debt plus equity
$100 000
100 000
$200 000
24-11
Criteria for a Financial Lease
• AAS17 ‘Accounting for Leases’ states that a
financial lease occurs where substantially all risks
and benefits pass to the lessee.
• A financial lease must be disclosed on the
Statement of Financial Position if at least one of
the following criteria is met:
–
–
the lease term is 75 per cent or more of the estimated
economic life of the asset
the present value of the lease payments is at least 90 per
cent of the fair market value of the asset at the start of the
lease.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
24-12
Leasing and Taxation
• Lease premiums paid under a lease contract are
tax deductible.
• Any payment relating to the ultimate purchase of
the asset is not deductible.
• The residual payment does not qualify as a tax
deduction.
• Any profit made on the asset previously leased is
subject to capital gains tax.
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PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
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Example—Lease versus Buy
Macca Co. has to decide whether to borrow the
$15 000 needed to purchase a new gadget
machine (with a borrowing cost of 10 per cent) or
to lease the machine for $4000 per annum. If
purchased, the asset could be depreciated using
the straight-line method over the three-year life.
The company tax rate is 30 per cent.
Under the lease agreement, Macca Co. would be
responsible for maintaining the machine.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
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Example—Lease versus Buy:
Repayment Schedule


Repayment  15 000 / 1 - 1 / 1.10 / 0.10
3
 $6032
Year
Principal
Outstanding
Interest
@ 10%
Total amount
owing
Repayment
1
2
3
15 000
10 468
5 483
1 500
1 047
548
16 500
11 515
6 031
6 032
6 032
6 032
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
Principal
carried
forward
10 468
5 483
nil
24-15
Example—Lease versus Buy:
Tax Subsidises Borrowing
Year
1
2
3
Depreciation
Deduction
5 000
5 000
5 000
Interest
Deduction
1 500
1 047
548
Total
deductions
6 500
6 047
5 548
Total
PV of tax subsidies (30%)
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PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
PV of
Deductions
5 909
4 997
4 168
$15 074
$ 4 522
24-16
Example—Lease versus Buy:
Tax Subsidises Leasing
Year
1
2
3
Lease Premium
4 000
4 000
4 000
Total
PV of tax subsidies (30%)
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PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
Present Value
3 636
3 306
3 005
$9 947
$2 984
24-17
Example—Lease versus Buy:
Net Advantage of Leasing
Opportunit y cost  PV of lease payments - Borrowing cost
 $4 000  2.4869  - $15 000
 ($5 052)
NAL  Net tax savings - Opportunit y cost
 $2 984 - $4 522 - $5 052 
 - $1 538  $5052
 $3 514
The advantage is greater than zero so Macca Co.
should lease.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
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Residual Value
• The residual value is the amount for which the
asset may be purchased by the lessee from the
lessor at the end of the lease term.
• The salvage value is the amount the asset can be
sold for in the market place by the lessee (once
they have acquired the asset).
• In the previous example, assume a residual value
of $2000 and a salvage value of $1500.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
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Example—Lease the Asset with
Residual Value
Salvage value
Residual value
Loss on leasing
Tax savings in year 3
PV of tax savings
Add tax subsidies
Total tax subsidies (A)
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PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
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$1 500
$2 000
($500)
$150
$113
$2 984
$3 097
24-20
Example—Borrow to Purchase the
Asset with Residual Value
Salvage value
Depreciated value
Gain on salvage
Tax payable in year 3
PV of tax payable
Add tax subsidies
Total tax subsidies (B)
Net tax savings (A-B)
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PPTs t/a Fundamentals of Corporate Finance 3e
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$2 000
Nil
$2 000
($600)
($451)
$4 522
$4 071
($974)
24-21
Net Advantage of Leasing
Opp cost  PV lease pay.  PV residual value - Borrowing cost
 $4 000  2.4869  $2 000 / 1.10  - $15 000
3
 ($3 550)
NAL  Net tax savings - Opportunit y cost
 $974  - $3 550 
 $2 576
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
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Setting Lease Premiums
Lease premiums are paid in advance in Australia.
Lease premium in advance 
Asset valu e - PV residual value 
1  PV annuity factor for t - 1 payments
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PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
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Example—Lease Premiums
KAZ Co. has started a four-year lease of a photocopier which
has a $70 000 purchase price. Had the company purchased
the copier, the interest rate quoted on borrowings was 1.5 per
cent per month. KAZ has agreed with the lessor to a residual
value of $10 000 at the end of four years.
What will be the amount of the lease premiums?
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
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Solution—Lease Premiums
Lease premium 
Asset valu e - PV residual value 
1  PV annuity factor for t - 1 payments
70 000 - 10 000 1.015 

1  1 - 1 / 1.015  / 0.015
 48
47
 65 106 / 1  33.5532 
 $1884.22
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
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Slides prepared by Sue Wright
24-25
Advantages of Financial Leases
• No restrictions on future borrowing.
• Can be tailored to suit firm’s needs.
• Eliminates the need to raise extra capital.
• No unnecessary financial outlay.
• May be excluded from the Statement of Financial
Position.
• Facilitates financing capital additions on a
piecemeal basis.
• Is an allowable cost under government contracting.
• Offers tax advantages.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
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Advantages of Operating Leases
• Frees up capital for alternative uses.
• Increases the company’s working capital.
• Provides greater control due to greater certainty in
•
•
•
•
future outlays.
Assures more competent upkeep of asset.
Avoids the risk of obsolescence.
Avoids the equipment disposal problem.
Future outlays cost less in real terms due to
inflation.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
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Slides prepared by Sue Wright
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Disadvantages of Leasing
• Interest cost often higher.
• May not offer the right to the residual value of the
asset.
• Allows the acquisition of assets without submitting
formal capital expenditure procedures.
• May cause distortions in the evaluation of interfirm
and interdivision performance.
• Lacks the prestige associated with ownership.
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PPTs t/a Fundamentals of Corporate Finance 3e
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Slides prepared by Sue Wright
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Good Reasons for Leasing
• Taxes may be reduced by leasing.
• The lease contract may reduce certain types of
uncertainty that might otherwise decrease the
value of the firm.
• Leasing reduces the impact of obsolescence of an
asset on a firm.
• Transaction costs may be lower for a lease
contract than for buying the asset.
• Leasing may require fewer (if any) restrictive
covenants than secured borrowing.
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PPTs t/a Fundamentals of Corporate Finance 3e
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Bad Reasons for Leasing
• The perception of 100 per cent financing.
• The apparent low cost.
• Using leasing to artificially enhance accounting
income.
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
24-30