Leasing Definition: Leasing is an alternative to owning the asset through 100 % debt financing wherein the lessor grants the use of a fixed asset for a specific amount of time in exchange for payment usually in the form of rent from the lessee. Analysis: Lessor’s point of view From the point of view of the lessor, the lease is just another project and it must have a 0 or positive net present value. Consider the following example: What is the minimum lease payment that would make purchasing a truck and writing a 6year lease contract on it acceptable? The price of the truck is $150,000, it is a five-year asset for depreciation purposes, it has a residual value of $20,000, it requires $500 maintenance per year, the cost of capital is 9%, and the corporate tax rate is 40%. The cash flows associated with this project are as follows: At time 0, we have a $150,000 purchase price. At the end of the 6 years we will have the after tax residual value. Since the truck will have a book value of 0, the entire salvage value is a tax gain. Therefore, the after tax flow from the residual value is: Residual value = $20,000 – (20,000 x 0.4) = $12,000. The cash flows for the 6 year period are as follows: Year 0 1 Price -150,000 Depreciation -30,000 Tax saving 12,000 on dep. Add dep. 30,000 back Residual value Net cash -150,000 12,000 flows NPV at 9% WACC is -95,335.70 2 3 4 5 6 -48,000 19,200 -28,500 11,400 -18,000 7,200 -16,500 6,600 -9,000 3,600 48,000 28,500 18,000 16,500 9,000 12,000 19,200 11,400 7,200 6,600 15,600 For this to be an acceptable project, the net present value of the lease payments must be $95,335.70. Since lease payments are an annuity due, the minimum annual lease payment is: $19,497.44 This is how you get the lease payment: The PV of the lease payments is an annuity due because lease payments are made at the beginning of the period, not at the end. For example, people pay rent at the beginning of the month. Therefore: PV annuity due (lease payments) = PV regular annuity (lease payments)*(1 + WACC) $95,335.70 = PV regular annuity (lease payments)*(1 + 0.9) Divide both sides by 1.09 87,463.94 = PV (lease payments) Using the financial calculator: Set P/Y = 1 because the lease payments are annual in this example N = 6 because the contract is for 6 years I/Y = 9 because WACC is 9% PV = 87463.94 because the PV of the lease payments is converted to a regular annuity FV = 0 Compute payment, [CPT] [PMT] you get 19,497.44 Lessee’s point of view The lessee may not include costs such as insurance and maintenance on the truck because the expenses would be incurred regardless of the structure of the financial contract, borrow and purchase versus lease. Assume that the cost of debt for the lessee is 8% and the corporate tax rate is 40%. From the point of view of the lessee the cash flows look as follows: Buying the truck: Year loan to buy Buy truck Depreciation Tax saving on dep. Add dep. back Residual value Interest of loan 0 150,000 -150,000 1 2 3 4 5 6 -30,000 12,000 -48,000 19,200 -28,500 11,400 -18,000 7,200 -16,500 6,600 -9,000 3,600 30,000 48,000 28,500 18,000 16,500 9,000 12,000 4.8% of 150,000 = -7,200 -7,200 Net cash 0 4,800 12,000 flows After tax cost of debt is 8% x (1 – 0.4) = 4.8% PV at 4.8% is -88,199.38 -7,200 -7,200 -7,200 4,200 0 -600 -150,000 - 7,200 = -157,200 -141,600 Therefore, the PV of buying the truck is -$88,199.38 Now the potential lessee has to compare the cost of buying with the cost of leasing and choose the lower cost alternative. So, let us look at the cost of leasing. Year 0 1 2 3 4 5 Lease -19,497.44 -19,497.44 -19,497.44 payment Tax 7,798.98 7,798.98 7,798.98 savings Net cash -11,698.46 -11,698.46 -11,698.46 flows PV at 4.8% after tax cost of debt is -62,627.91 -19,497.44 -19,497.44 -19,497.44 7,798.98 7,798.98 7,798.98 -11,698.46 -11,698.46 -11,698.46 Therefore, the PV of leasing the truck is -$62,627.91 The Net Advantage of Leasing (NAL) is the present value of leasing minus the present value of borrowing and buying. This = -$62,627.91 – (-$88,199.38) = $25,571.47 Since the NAL is positive, the lessee is better off leasing the truck.
