21-0
Chapter Twenty One
Leasing
Corporate Finance
Ross  Westerfield  Jaffe
21
Sixth Edition
Sixth Edition
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-1
Chapter Outline
21.1 Types of Leases
21.2 Accounting and Leasing
21.3 Taxes, the IRS, and Leases
21.4 The Cash Flows of Leasing
21.5 A Detour on Discounting and Debt Capacity with
Corporate Taxes
21.6 NPV Analysis of the Lease-versus-Buy Decision
21.7 Debt Displacement and Lease Valuation
21.8 Does Leasing Ever Pay: The Base Case
21.9 Reasons for Leasing
21.10 Some Unanswered Questions
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-2
21.1 Types of Leases
• The Basics
– A lease is a contractual agreement between a lessee and
lessor.
– The lessor owns the asset and for a fee allows the lessee
to use the asset.
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-3
Operating Leases
• Usually not fully amortized.
• Usually require the lessor to maintain and insure the
asset.
• Lessee enjoys a cancellation option.
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-4
Financial Leases
The exact opposite of an operating lease.
1.
2.
3.
4.
Do not provide for maintenance or service by the lessor.
Financial leases are fully amortized.
The lessee usually has a right to renew the lease at expiry.
Generally, financial leases cannot be cancelled.
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-5
Sale and Lease-Back
• A particular type of financial lease.
• Occurs when a company sells an asset it already
owns to another firm and immediately leases it from
them.
• Two sets of cash flows occur:
– The lessee receives cash today from the sale.
– The lessee agrees to make periodic lease payments,
thereby retaining the use of the asset.
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-6
Leveraged Leases
• A leveraged lease is another type of financial lease.
• A three-sided arrangement between the lessee, the
lessor, and lenders.
– The lessor owns the asset and for a fee allows the lessee
to use the asset.
– The lessor borrows to partially finance the asset.
– The lenders typically use a nonrecourse loan. This means
that the lessor is not obligated to the lender in case of a
default by the lessee.
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-7
21.2 Accounting and Leasing
• In the old days, leases led to off-balance-sheet
financing.
• Today, leases are either classified as capital leases or
operating leases.
• Operating leases do not appear on the balance sheet.
• Capital leases appear on the balance sheet—the
present value of the lease payments appears on both
sides.
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-8
Accounting and Leasing
Balance Sheet
Truck is purchased with debt
Truck
$100,000
Land
$100,000
Total Assets
$200,000
Debt
$100,000
Equity
$100,000
Total Debt & Equity $200,000
Operating Lease
Truck
Land
Total Assets
$100,000
$100,000
Debt
Equity
$100,000
Total Debt & Equity $100,000
Capital Lease
Assets leased
Land
Total Assets
$100,000
$100,000
$200,000
Obligations under capital lease
Equity
Total Debt & Equity
McGraw-Hill/Irwin
$100,000
$100,000
$200,000
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-9
Capital Lease
• A lease must be capitalized if any one of the following is
met:
– The present value of the lease payments is at least 90
percent of the fair market value of the asset at the start of
the lease.
– The lease transfers ownership of the property to the
lessee by the end of the term of the lease.
– The lease term is 75 percent or more of the estimated
economic life of the asset.
– The lessee can buy the asset at a bargain price at expiry.
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-10
21.3 Taxes, the IRS, and Leases
• The principal benefit of long-term leasing is tax reduction.
• Leasing allows the transfer of tax benefits from those who
need equipment but cannot take full advantage of the tax
benefits of ownership to a party who can.
• Naturally, the IRS seeks to limit this, especially if the lease
appears to be set up solely to avoid taxes.
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-11
21.3 Taxes, the IRS, and Leases
•
The lessee can deduct lease payments if the lease
is qualified by the IRS.
1. The term must be less than 30 years.
2. There can be no bargain purchase option.
3. The lease should not have a schedule of payments that is
very high at the start of the lease and low thereafter.
4. The lease payments must provide the lessor with a fair
market rate of return.
5. The lease should not limit the lessee’s right to issue debt
or pay dividends.
6. Renewal options must be reasonable and reflect fair
market value of the asset.
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-12
21.4 The Cash Flows of Leasing
Consider a firm, ClumZee Movers, that wishes to
acquire a delivery truck.
The truck is expected to reduce costs by $4,500 per
year.
The truck costs $25,000 and has a useful life of 5 years.
If the firm buys the truck, they will depreciate it
straight-line to zero.
They can lease it for 5 years from Tiger Leasing with an
annual lease payment of $6,250.
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-13
21.4 The Cash Flows of Leasing
• Cash Flows: Buy
Cost of truck
After-tax savings
Depreciation Tax Shield
Year 0
–$25,000
Years 1-5
4,500×(1-.34) =
5,000×(.34) =
–$25,000
$2,970
$1,700
$4,670
• Cash Flows: Lease
Year 0
Lease Payments
After-tax savings
Years 1-5
–6,250×(1-.34) =
4,500×(1-.34) =
–$4,125
$2,970
–$1,155
• Cash Flows: Leasing Instead of Buying
Year 0
$25,000
McGraw-Hill/Irwin
Years 1-5
–$1,155 – $4,670 = –$5,825
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-14
21.4 The Cash Flows of Leasing
• Cash Flows: Leasing Instead of Buying
Year 0
$25,000
Years 1-5
–$1,155 – $4,670 = –$5,825
• Cash Flows: Buying Instead of Leasing
Year 0
–$25,000
Years 1-5
$4,670 –$1,155 = $5,825
• However we wish to conceptualize this, we need to
have an interest rate at which to discount the future
cash flows.
• That rate is the after-tax rate on the firm’s secured
debt.
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-15
21.5 A Detour on Discounting and Debt
Capacity with Corporate Taxes
• Present Value of Riskless Cash Flows
– In a world with corporate taxes, firms should discount
riskless cash flows at the after-tax riskless rate of interest.
• Optimal Debt Level and Riskless Cash Flows
– In a world with corporate taxes, one determines the
increase in the firm’s optimal debt level by discounting a
future guaranteed after-tax inflow at the after-tax riskless
interest rate.
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-16
21.6 NPV Analysis of the Lease-vs.-Buy
Decision
• A lease payment is like the debt service on a secured
bond issued by the lessee.
• In the real world, many companies discount both the
depreciation tax shields and the lease payments at
the after-tax interest rate on secured debt issued by
the lessee.
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-17
NPV Analysis of the Lease-vs.-Buy Decision
• There is a simple method for evaluating leases: discount
all cash flows at the after-tax interest rate on secured debt
issued by the lessee. Suppose that rate is 5 percent.
NPV Leasing Instead of Buying
Year 0
$25,000
Years 1-5
–$1,155 – $4,670 = -$5,825
5
$5,825
 $219.20
t
t 1 (1.05)
NPV  $25,000  
NPV Buying Instead of Leasing
Year 0
Years 1-5
-$25,000
$4,670 – $1,155 = $5,825
5
$5,825
 $219.20
t
t 1 (1.05)
NPV  $25,000  
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-18
21.7 Debt Displacement and Lease Valuation
• Considering the issues of debt displacement allows
for a more intuitive understanding of the lease
versus buy decision.
• Leases displace debt—this is a hidden cost of
leasing. If a firm leases, it will not use as much
regular debt as it would otherwise.
– The interest tax shield will be lost.
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-19
21.7 Debt Displacement and Lease Valuation
• The debt displaced by leasing results in forgone
interest tax shields on the debt that ClumZee movers
didn’t go into when they leased instead of bought
the truck.
• Suppose ClumZee agrees to a lease payment of
$6,250 before tax. This payment would support a
loan of $25,219.20 (see the next slide)
• In exchange for this, they get the use of a truck
worth $25,000.
• Clearly the NPV is a negative $219.20, which
agrees with our earlier calculations.
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-20
21.7 Debt Displacement and Lease Valuation
Suppose ClumZee agrees to a lease payment of $6,250 before
tax. This payment would support a loan of $25,219.20
Outstanding Balance of the Loan
Interest
Tax Deduction on interest
After-tax Interest Expense
Extra Cash that purchasing
firm genereates over leasing firm
0
1
2
3
$25,219.20 $20,655.16 $15,862.92 $10,831.07
$1,910.55 $1,564.78 $1,201.74
$649.59
$532.03
$408.59
$1,260.96 $1,032.76
$793.15
$ 5,825.00
$ 5,825.00
$ 5,825.00
4
$5,547.62
$820.54
$278.98
$541.55
5
$0.00
$420.27
$142.89
$277.38
$ 5,825.00
$ 5,825.00
$1,260.96  $25,219.20  0.05
$20,655.16  $25,219.20  $5,825.  $1,260.96
After-Tax Lease Payments
Forgone Depreciation Tax Shield
–6,250×(1-.34) =
– 5,000×(.34) =
–$4,125
–$1,700
-$5,825
Calculate the increase in debt capacity by discounting the
difference between the cash flows of the purchase and the cash
flows of the lease by the after-tax interest rate.
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-21
21.8 Does Leasing Ever Pay: The Base Case
• In the above example, ClumZee Movers chose to buy,
because the NPV of leasing was a negative $219.20
• Note that this is the opposite of the NPV that Tiger Leasing
would have:
• Cash Flows: Tiger Leasing
Year 0
Years 1-5
–$25,000
Cost of truck
Depreciation Tax Shield
5,000×(.34) =
Lease Payments
6,250×(1-.34) = $4,125
–$25,000
5
$5,825
$5,825
 $219.20
t
t 1 (1.05)
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
NPV  $25,000  
McGraw-Hill/Irwin
$1,700
21-22
21.9 Reasons for Leasing
• Good Reasons
– Taxes may be reduced by leasing.
– The lease contract may reduce certain types of
uncertainty.
– Transactions costs can be higher for buying an asset and
financing it with debt or equity than for leasing the asset.
• Bad Reasons
– Accounting
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-23
A Tax Arbitrage
• Suppose ClumZee movers is actually in the 25% tax bracket and Tiger
Leasing is in the 34% tax bracket. If Tiger reduces the lease payment to
$6,200, can both firms have a positive NPV?
• Cash Flows: Tiger Leasing
Cost of truck
Depreciation Tax Shield
Lease Payments
Year 0
–$25,000
Years 1-5
5,000×(.34) =
6,200×(1 –.34) =
–$25,000
$1,700
$4,092
$5,792
NPV = 76.33
• Cash Flows ClumZee Movers: Leasing Instead of Buying
Cost of truck we didn’t buy
Lost Depreciation Tax Shield
After-Tax Lease Payments
Year 0
$25,000
Years 1-5
5,000×(.25) =
6,200×(1 –.25) =
$25,000
–$1,250
–$4,650
–$5,900
NPV = -$543.91
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-24
Reservations and Negotiations
• What is the smallest lease payment that Tiger Leasing will
accept? Set their NPV to zero and solve for $Lmin:
• Cash Flows: Tiger Leasing
Year 0
-$25,000
Cost of truck
Depreciation Tax Shield
Lease Payments
Years 1-5
5,000×(.34) =
$1,700
$Lmin ×(1 –.34) =
$Lmin × .66
$1,700 + $Lmin × .66
-$25,000
.66  Lmin  $1,700
(1.05)t
t 1
5
NPV  0  $25,000  
5
$25,000  .66  Lmin 
t 1
5
5
Lmin 
$1
$1,700


(1.05)t t 1 (1.05)t
$1,700
t
t 1 (1.05)
5
$1
.66  
t
t 1 (1.05)
$25,000  
Lmin  $6,173.29
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-25
Reservations and Negotiations
• What is the highest lease payment that ClumZee Movers can
pay? Set their NPV to zero and solve for $Lmax:
• Cash Flows ClumZee Movers: Leasing Instead of Buying
Cost of truck we didn’t buy
Lost Depreciation Tax Shield
After-Tax Lease Payments
Year 0
$25,000
Years 1-5
5,000×(.25) =
– $1,250
– $Lmax×( 1 –.25) = .75× Lmax
– 1,250 – .75× Lmax
$25,000
.75  Lmax  $1,250
NPV  0  $25,000  
(1.05)t
t 1
5
5
.75  Lmax
$1,250


t
t
t 1 (1.05)
t 1 (1.05)
5
$25,000  
5
No lease is possible: Lmin > Lmax
McGraw-Hill/Irwin
Lmax 
$25,000  
t 1
$1,250
(1.05)t
5
.75

t
t 1 (1.05)
Lmax  $6,032.49
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-26
21.10 Some Unanswered Questions
• Are the Uses of Leases and of Debt
Complementary?
• Why are Leases offered by Both Manufacturers and
Third Party Lessors?
• Why are Some Assets Leased More than Others?
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-27
21.11 Summary and Conclusions
• There are three ways to value a lease.
1. Use the real-world convention of discounting the
incremental after-tax cash flows at the lessors after-tax
rate on secured debt.
2. Calculate the increase in debt capacity by discounting
the difference between the cash flows of the purchase
and the cash flows of the lease by the after-tax interest
rate. The increase in debt capacity from a purchase is
compared to the extra outflow at year 0 from a
purchase.
3. Use APV (presented in the appendix to this chapter).
• They all yield the same answer.
• The easiest way is the least intuitive.
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-28
Appendix 21A: APV Approach to Leasing
APV = All-Equity Value + Financing NPV
Calculations shown on the following slides will show
that for the latest Clumzee Movers example (tax rate
is 25%)
APV = $591.38 – $1,135.30
APV = –$543.91
Which is the same value as the easier NPV analysis.
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-29
Appendix 21A: APV Approach to Leasing
APV = All-Equity Value + Financing NPV
• To find the all-equity value, discount the cash flows at the
pre-tax interest rate. The after tax rate was 5% which implies
a pretax rate of
6.66% = 5%/(1-.25).
Cash Flows ClumZee Movers: Leasing Instead of Buying
Year 0
Years 1-5
Cost of truck we didn’t buy $25,000
Lost Depreciation Tax Shield
5,000×(.25) =
–$1,250
After-Tax Lease Payments
6,200×(1 –.25) =
–$4,650
–$5,900
$25,000
5
All - equity val ue  $25,000  
t 1
McGraw-Hill/Irwin
$5,900
 $591.38
t
(1.06667)
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-30
Appendix 21A: APV Approach to Leasing
APV = All-Equity Value + Financing NPV
• The NPV of the financing is the forgone interest tax shields
on the debt that ClumZee movers didn’t go into when they
leased instead of bought the truck.
• ClumZee agreed to a lease payment of $5,900.
• This payment would support a loan of $25,543.91
5
$5,900
Increased debt capacity  $25,543.91  
t
(
1
.
05
)
t 1
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-31
Appendix 21A: APV Approach to Leasing
The lost interest tax shield associated with this additional debt
capacity of $25,543.91 has a present value of $1,135.30
0
1
2
3
4
5
Outstanding Balance of the Loan $25,543.91 $20,921.11 $16,067.16 $10,970.52 $5,619.05
$0.00
Interest
$1,702.93 $1,394.74 $1,071.14 $731.37 $374.60
Tax Deduction on interest
$425.73
$348.69
$267.79 $182.84 $93.65
After-tax Interest Expense
$1,277.20 $1,046.06
$803.36 $548.53 $280.95
 $1,135.30 
$425.73
$348.69
$267.79
$182.84
$93.65




(1.06667) (1.06667) 2 (1.06667)3 (1.06667) 4 (1.06667)5
APV  $591.38  $1,135.30  $543.91
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-32
21.7 Debt Displacement and Lease Valuation
The lost interest tax shield associated with this additional debt
capacity of $25,219.20 has a present value of $
Outstanding Balance of the Loan
Interest
Tax Deduction on interest
After-tax Interest Expense
Extra Cash that purchasing
firm genereates over leasing firm
 $1,135.30 
0
1
2
3
$25,219.20 $20,655.16 $15,862.92 $10,831.07
$1,910.55 $1,564.78 $1,201.74
$649.59
$532.03
$408.59
$1,260.96 $1,032.76
$793.15
$ 5,825.00
$ 5,825.00
$ 5,825.00
4
$5,547.62
$820.54
$278.98
$541.55
5
$0.00
$420.27
$142.89
$277.38
$ 5,825.00
$ 5,825.00
$425.73
$348.69
$267.79
$182.84
$93.65




(1.06667) (1.06667) 2 (1.06667)3 (1.06667) 4 (1.06667)5
APV  $591.38  $1,135.30  $543.91
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.