CHAPTER 22
LEASING
Learning Objectives
LO1
LO2
LO3
LO4
LO5
LO6
The basics of a lease and the different types of leases.
How accounting rules and tax laws define financial leases.
The cash flows from leasing.
How to conduct a lease versus buy analysis.
How lessee and lessor can both benefit from leasing.
The difference between good and bad reasons for leasing.
Answers to Concepts Review and Critical Thinking Questions
1.
(LO1) Some key differences are: (1) Lease payments are fully tax-deductible, but only the interest
portion of the loan is; (2) Lessee does not own the asset and cannot depreciate it for tax purposes; (3) In
the event of a default, lessor cannot force bankruptcy; and (4) Lessee does not obtain title to the asset at
the end of the lease (absent some additional arrangement).
2.
(LO2) The less profitable one because leasing provides, among other things, a mechanism for
transferring tax benefits from entities that value them less to entities that value them more.
3.
(LO4) Potential problems include: (1) Care must taken in interpreting the IRR (a high or low IRR is
preferred depending on the setup of the analysis); and (2) Care must be taken to ensure the IRR under
examination is not the implicit interest rate just based on the lease payments.
4.
(LO5)
a.
Leasing is a form of secured borrowing. It reduces a firm’s cost of capital only if it is cheaper than
other forms of secured borrowing. The reduction of uncertainty is not particularly relevant; what
matters is the NAL.
b.
The statement is not always true. For example, a lease often requires an advance lease payment or
security deposit and may be implicitly secured by other assets of the firm.
c.
Leasing would probably not disappear, since it does reduce the uncertainty about salvage value
and the transactions costs of transferring ownership. However, the use of leasing would be greatly
reduced.
5.
(LO2) A lease must be disclosed on the balance sheet if one of the following criteria is met:
1.
The lease transfers ownership of the asset by the end of the lease. In this case, the firm essentially
owns the asset and will have access to its residual value.
2.
The lessee can purchase the asset at a price below its fair market value (bargain purchase option)
when the lease ends. The firm essentially owns the asset, and will have access to most of its
residual value.
3.
The lease term is for 75% or more of the estimated economic life of the asset. The firm basically
has access to the majority of the benefits of the asset, without any responsibility for the
consequences of its disposal.
4.
The present value of the lease payments is 90% or more of the fair market value of the asset at the
start of the lease. The firm is essentially purchasing the asset on an installment basis.
6.
(LO2) In order for the CRA to count a lease as valid, it must be for business purposes, not for tax
avoidance. If there is any clause which involves the lessee acquiring title to the property, then the CRA
does not consider it a lease and no tax advantages are given. Specifically, a lease will be disallowed if:
1.
The lessee automatically acquires title to the property after payment of a specified amount in the
form of rentals.
2.
The lessee is required to buy the property from the lessor during or at the termination of the lease.
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3.
The lease should not contain a bargain purchase option, which the CRA interprets as an equity
interest in the asset.
7.
(LO2) As the term implies, off-balance sheet financing involves financing arrangements that are not
required to be reported on the firm’s balance sheet. Such activities, if reported at all, appear only in the
footnotes to the statements. Operating leases provide off-balance sheet financing. For accounting
purposes, total assets will be lower and some financial ratios may be artificially high. Financial analysts
are generally not fooled by such practices. There are no economic consequences, since the cash flows of
the firm are not affected by how the lease is treated for accounting purposes.
8.
(LO1, 6) The lessee may not be able to take advantage of the depreciation tax shield and may not be
able to obtain favorable lease arrangements for “passing on” the tax shield benefits. The lessee might
also need the cash flow from the sale to meet immediate needs, but will be able to meet the lease
obligation from cash flows in the future.
9.
(LO4) Since the relevant cash flows are all after-tax, the after-tax discount rate is appropriate.
10. (LO4) There is the tax motive, but, beyond this, the leasing company knows that, in the event of a
default, Air Canada would relinquish the planes which would then be re-leased. Tangible assets, such as
planes, which can be readily reclaimed and redeployed are good candidates for leasing.
11. (LO4) They will be re-leased to Air Canada or another air transportation firm, or they will simply be
sold. There is an active market for used aircraft.
Solutions to Questions and Problems
Basic
1.
(LO4) Tax shields are assumed to be claimed at the beginning of the year.
Year
Investment
Lease payment
Payment shield
Forgone tax shield
Total cash flow
0
$24,000
-9,000
3,600
-1,440
$17,160
1
2
3
-9,000
3,600
-2,448
-$7,848
-9,000
3,600
-1,714
-$7,114
-3,998
-$3,998
NAL6% = $67.99
Intermediate
2.
(LO4) Assuming end of year lease payments:
I=$6,300,000, SV4=0, L=$1,875,000/yr., d = 30%, T = 37%, and r = 7.5%
The after-tax cost of debt is 7.5(1–.37) = 4.725%
PV of CCATS = 6,300,000(.3)(.37) x (1 + .5(.04725)) = $1,968,392.90
.04725 + .30
1 + .04725
NAL = 6,300,000 – 1,875,000(1–.37) x PVIFA (4.725%, 4) – 1,968,392.90 = $116,056.90
Therefore, the firm should lease the equipment.
22-2
3.
(LO4) A gain for the lessee means a loss for the lessor = –$116,056.90
4.
(LO4) NAL = 0 = $6,300,000 – X(PVIFA4.725%,4) – 1,968,392.90
X = $1,213,770.60 is the break-even after-tax lease payment.
Before tax lease payment = $1,213,770.60 /0.63 = $1,926,620
5.
(LO3) If the tax rate is zero, there is no depreciation tax shield foregone, the after-tax lease payment
is the same as the pretax payment, and the after-tax cost of debt is the same as the pretax cost.
cost of debt = .075 annual cost of leasing = leasing payment = $1,875,000
NAL = $6,300,000 – $1,875,000(PVIFA7.5%,4) = $20,013.24
6.
(LO5) The lessor breaks even with a payment of $1,926,620 (from problem 4).
Lessee: breakeven payment — NAL = 0 = $6,300,000 – PMT(PVIFA7.5%,4)
PMT = $1,765,338.96
L < $1,765,338.96, NPV > 0 (Lessee)
L > $1,926,620, NPV > 0 (Lessor)
A lease is not feasible because lessee <= $1,765,338.96, lessor >= $1,926,620, so there is no range
over which a lease is beneficial for both.
7.
(LO4) Scanner cost=$6,300,000, SV4=0, Lease payment=$1,875,000/yr., d=50%, T=37%, and
r=7.5%
The after-tax cost of debt is 7.5(1–.37) = 4.725%
PV of CCATS = 6,300,000(.5)(.37) x (1 + .5(.04725)) = $2,081,694.63
.04725 + .5
1 + .04725
NAL = 6,300,000 – 1,875,000(1– .37) x PVIFA (4.725%, 4) – 2,081,694.63= $2,755.17
With the larger CCA tax shield the firm has a greater incentive to buy than before. But the NAL is
still positive, and therefore the firm should still lease the equipment.
8.
(LO4) The forgone salvage value is a cost to the lease decision and the lost tax shield on the resale
represents a gain to the lease decision. Also, the salvage value is not really a debt-like cash flow,
since there is uncertainty associated with it at year 0. Nevertheless, although a higher discount rate
may be appropriate, we’ll use the after tax cost of debt to discount the residual value as is common
in practice. We will also assume beginning of year payments.
After-tax cost of debt = .09(1 – .36) = .0576
PV of CCATS = 9,400,000(.25)(.36) x (1 + .5(.0576) – 975,000(.25)(.36) x
1
. 0576 + .25
1 + .0576
. 0576 + .25
(1 + .0576)5
= 2,459,827.31
After-tax lease payment = $2,150,000(1 – .36) = $1,376,000.00
NAL = $9.4M – $1,376,000(1.0480)(PVIFA5.76%, 5) – 2,459,827.31– 975,000 (PVIF5.76%, 5) = $32,985
22-3
The equipment should NOT be purchased.
Maximum payment:
NAL = 0 = $9.4M – $X(1.0576)(PVIFA5.76%, 5) – 2,459,827.31– 975,000 (PVIF5.76%, 5)
X = $1,383,355.97
Maximum pretax lease payment = $1,383,355.97/ (1 – .36) = $2,161,493.70
9.
(LO4)
PV of CCATS = 9,400,000(.25)(.36) x (1 + .5(.0576)) = 2,675,429.71
.0576 + .25
1 + .0576
NAL = 0 = $9.4M – $X(1.0576)(PVIFA5.76%, 5) – 2,655,873.76
X = $1,499,602,96
Maximum pretax lease payment = $1,499,602,96/ (1 – .36) = $2,343,129.62
10.
(LO4) The security deposit of $750,000 reduces the initial benefit of leasing (not having to pay $9M
upfront for the system) and reduces the foregone benefit of the salvage value by the same amount
when it is returned at the end of the fifth year.
NAL = $8.65M – $1,376,000(1.0576)(PVIFA5.76%, 5) – 2,459,827.31 – 225,000 (PVIF5.76%, 5)
= -$150,182.52
With the security deposit, the firm should buy the equipment since the NAL is negative.
Challenge
.
11.
(LO4) loan amount = $6,300,000 = PMT(PVIFA8%,4) ; PMT = $1,902,101.07
PV after-tax payment = PV(payment – interest tax shield):
year 1: PV($1,902,101.07 – ($6,300,000.00)(.08)(.37)) = $1,715,621.07/1.0504
year 2: PV($1,902,101.07 – ($4,901,898.93)(.08)(.37)) = $1,757,004.86/1.05042
year 3: PV($1,902,101.07– ($3,391,949.77)(.08)(.37)) = $1,801,699.36/1.05043
year 4: PV($1,902,101.07– ($1,761,204.68)(.08)(.37)) = $1,849,969.41/1.05044
PV(loan) = PV1 + PV2 + PV3 + PV4 = $6,300,000.00
Where the interest tax shield is calculated on the balance remaining on the loan (i.e. the present
value of the remaining loan payments) for each year.
NAL = PV(loan) – 1,875,000(1 – .37) x PVIFA (5.04%, 4) – 1,968,392.90
= $6,300,000 – 1,875,000(1 – .37) x PVIFA (5.04%, 4) – 1,405,994.93 = $146,842.08
The NAL is the same because the present value of the after tax loan payments, discounted at the
after tax cost of capital (which is the after tax cost of debt) equals $6,300,000.
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12. (LO4) Rework the problem using the net value of the investment in the tax shield section of the
equation:
2
NAL = $24,000 – ∑ $9,000(1– 0.40) – $24,000 x 0.4 x 0.3 x 1.03 + $800 x 0.4 x 0.3 x 1 –
t=0
(1.06)t
0.06 + 0.30
1.06
0.06 + 0.30
(1.06)3
$800
(1.06)3
NAL = $479.21
13. (LO4, 5) Assuming payments are made at the end of the year:
a.
PV of CCATS = 675,000(.25)(.35) x (1 + .5(.065)) – 50,000(.25)(.35) x
1
.065 + .25
1 + .065
.065 + .25
(1 + .065)2
= $163,985.68
NAL = 0 = 675,000 – L x (PVIFA6.5%,2) – $162,985.68
Therefore, L = $280,680.49 after-tax.
Before tax payment = $280,680.49 / 0.65=$431,816.14
b.
TLessor=TLessee
c.
Lessee pays no taxes, so the PVCCATS is not used but the lost salvage value must be accounted
for , and the interest rate is now 10%:
NPV = 0 = $675,000 – L x ( PVIFA10%,2) – 50,000 x ( PVIF10%,2)
Therefore, L = $365,119.05 is the indifference lease payment for the lessee with no tax.
Lessor pay a 35% tax rate:
NPV = 0 = -$675,000 + L x ( PVIFA6.5%,2) + 163,985.68
L = $154.21 is the after-tax indifference lease payment for the lessor.
Therefore, L = $280,680.49 / 0.65 = $431,816.14 pre-tax.
L < $365,119.05 , NPV > 0 (Lessee)
L > $431,816.14, NPV > 0 (Lessor)
A lease is not feasible because lessee <= $365,119.05, lessor >= $431,816.14, so there is no range
over which a lease is beneficial for both.
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