Leasing
Leasing is the process by which a firm can obtain the
use of certain fixed assets for which it must make a
series of contractual, periodic, tax-deductible
payments.
The lessee is the receiver of the services of the
assets under a lease contract.
The lessor is the owner of assets that are being
leased.
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Leasing: Types of Leases
An operating lease is a cancelable contractual
arrangement whereby the lessee agrees to make
periodic payments to the lessor, often for 5 or fewer
years, to obtain an asset’s services; generally, the
total payments over the term of the lease are less
than the lessor’s initial cost of the leased asset.
A financial (or capital) lease is a longer-term lease
than an operating lease that is noncancelable and
obligates the lessee to make payments for the use of
an asset over a predefined period of time; the total
payments over the term of the lease are greater than
the lessor’s initial cost of the leased asset.
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Leasing: Types of Leases (cont.)
Technically, under FASB (Financial Accounting
Standards Board) Statement No. 13, “Accounting for
Leases,” a financial (or capital) lease is defined as one
that has any of the following elements:
1. The lease transfers ownership of the property to the
lessee by the end of the lease term.
2. The lease contains an option to purchase the property at
a “bargain price.” Such an option must be exercisable at
“fair market value.”
3. The lease term is equal to 75 percent or more of the
estimated economic life of the property (exceptions exist
for property leased toward the end of its usable economic
life).
4. At the beginning of the lease, the present value of the
lease payments is equal to 90 percent or more of the fair
market value of the leased property.
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Focus on Practice
Leases to Airlines End on a Sour Note
– Using a structure known as a leveraged lease, cash-rich
Disney purchased airplanes in the early 1990s and leased
them out to air carriers.
– Under a typical leveraged lease, Disney put up 20 percent
of the purchase price. The rest was borrowed under a loan
using the plane as collateral.
– During the 1990s, leveraged leases were attractive
investments. However, the events of 9/11 crippled air
travel and put U.S. air carriers under tremendous financial
pressure.
– Disney had to write off entirely the $114 million book value
assigned to its investment in two Boeing 747s and two
767s leased to United and $68 million for leases to Delta.
Were the Disney leases of aircraft to United Airlines operating
leases or financial leases?
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Leasing: Leasing Arrangements
A direct lease is a lease under which a lessor owns
or acquires the assets that are leased to a given
lessee.
A sale–leaseback arrangement is a lease under
which the lessee sells an asset to a prospective lessor
and then leases back the same asset, making fixed
periodic payments for its use.
A leveraged lease is a lease under which the lessor
acts as an equity participant, supplying only about 20
percent of the cost of the asset, while a lender
supplies the balance.
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Leasing: Leasing Arrangements (cont.)
Maintenance clauses are provisions normally
included in an operating lease that require the lessor
to maintain the assets and to make insurance and tax
payments.
Renewal options are provisions especially common
in operating leases that grant the lessee the right to
re-lease assets at the expiration of the lease.
Purchase options are provisions frequently included
in both operating and financial leases that allow the
lessee to purchase the leased asset at maturity,
typically for a prespecified price.
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Leasing: Lease-versus-Purchase Decision
The lease-versus-purchase (or lease-versusbuy) decision is the decision facing firms needing to
acquire new fixed assets: whether to lease the assets
or to purchase them, using borrowed funds or
available liquid resources.
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Leasing: Lease-versus-Purchase Decision
The lease-versus-purchase decision involves
application of the capital budgeting methods
presented in Chapters 11 through 12. First, we
determine the relevant cash flows and then apply
present value techniques. The following steps are
involved in the analysis:
Step 1
Find the after-tax cash outflows for each year under
the lease alternative. This step generally involves a
fairly simple tax adjustment of the annual lease
payments. In addition, the cost of exercising a
purchase option in the final year of the lease term
must frequently be included.
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Leasing: Lease-versus-Purchase Decision
(cont.)
Step 2
Find the after-tax cash outflows for each year under
the purchase alternative. This step involves adjusting
the sum of the scheduled loan payment and
maintenance cost outlay for the tax shields resulting
from the tax deductions attributable to maintenance,
depreciation, and interest.
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Leasing: Lease-versus-Purchase Decision
(cont.)
Step 3
Calculate the present value of the cash outflows
associated with the lease (from Step 1) and purchase
(from Step 2) alternatives using the after-tax cost of
debt as the discount rate. The after-tax cost of debt is
used to evaluate the lease-versus-purchase decision
be-cause the decision itself involves the choice
between two financing techniques—leasing and
borrowing—that have very low risk.
Step 4
Choose the alternative with the lower present value of
cash outflows from Step 3. It will be the least-cost
financing alternative.
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Leasing: Lease-versus-Purchase Decision
(cont.)
Roberts Company, a small machine shop, is
contemplating acquiring a new machine that costs
$24,000. Arrangements can be made to lease or
purchase the machine. The firm is in the 40% tax
bracket.
Lease The firm would obtain a 5-year lease requiring
annual end-of-year lease payments of $6,000. All
maintenance costs would be paid by the lessor, and
insurance and other costs would be borne by the
lessee. The lessee would exercise its option to
purchase the machine for $1,200 at termination of
the lease.
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Leasing: Lease-versus-Purchase Decision
(cont.)
Purchase The firm would finance the purchase of the
machine with a 9%, 5-year loan requiring end-of-year
installment payments of $6,170. The machine would
be depreciated under MACRS using a 5-year recovery
period. The firm would pay $1,500 per year for a
service contract that covers all maintenance costs;
insurance and other costs would be borne by the firm.
The firm plans to keep the machine and use it beyond
its 5-year recovery period.
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Leasing: Lease-versus-Purchase Decision
(cont.)
Step 1
The after-tax cash outflow from the lease payments can
be found by multiplying the be-fore-tax payment of
$6,000 by 1 minus the tax rate, T, of 40%.
After-tax cash outflow from lease = $6,000  (1 – T)
= $6,000  (1 – 0.40) = $3,600
Therefore, the lease alternative results in annual cash
outflows over the 5-year lease of $3,600. In the final
year, the $1,200 cost of the purchase option would be
added to the $3,600 lease outflow to get a total cash
outflow in year 5 of $4,800 ($3,600 + $1,200).
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Leasing: Lease-versus-Purchase Decision
(cont.)
Step 2
To calculate the after-tax cash flow, begin by
calculating the interest portion of each payment, as
only interest is deductible for taxes.
Table 17.1 Determining the Interest and Principal Components
of the Roberts Company Loan Payments
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Leasing: Lease-versus-Purchase Decision
(cont.)
Calculate the cash outflows associated with borrowing
to purchase the new machine.
Table 17.2 After-Tax Cash Outflows Associated with
Purchasing for Roberts Company
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Leasing: Lease-versus-Purchase Decision
(cont.)
Step 3
Calculate the present value of the cash outflows
associated with the lease and purchase alternatives.
Table 17.3 Comparison of Cash Outflows Associated with
Leasing versus Purchasing for Roberts Company
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Leasing: Lease-versus-Purchase Decision
(cont.)
Step 4
Because the present value of cash outflows for leasing
($16,062) is lower than that for purchasing
($19,541), the leasing alternative is preferred.
Leasing results in an incremental savings of $3,479
($19,541 – $16,062) and is therefore the less costly
alternative.
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Table 17.4 Advantages and
Disadvantages of Leasing
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Table 17.4 Advantages and
Disadvantages of Leasing (cont.)
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