CHAPTER 26
LEASING
SLIDES
26.1
26.2
26.3
26.4
26.5
26.6
26.7
26.8
26.9
26.10
26.11
26.12
26.13
26.14
26.15
Key Concepts and Skills
Chapter Outline
Lease Terminology
Types of Leases
Lease Accounting
Criteria for a Capital Lease
Taxes
Incremental Cash Flows
Example: Lease Cash Flows
Lease or Buy?
Net Advantage to Leasing
Work the Web Example
Good Reasons for Leasing
Dubious Reasons for Leasing
Quick Quiz
CASES
The following case from Cases in Finance by DeMello can be used to help illustrate the
concepts in this chapter.
Lease vs. buy decisions
CHAPTER WEB SITES
Section
Introduction
26.1
26.5
26.7
CHAPTER ORGANIZATION
26.1
Leases and Lease Types
Leasing versus Buying
Operating Leases
Financial Leases
Web Address
www.monitordaily.com
www.bloomberg.com
www.assetcapitallease.com
www.lease-vs-buy.com
www.ilfc.com
A-360 CHAPTER 26
26.2
Accounting and Leasing
26.3
Taxes, the IRS, and Leases
26.4
The Cash Flows from Leasing
The Incremental Cash Flows
A Note on Taxes
26.5
Lease or Buy?
A Preliminary Analysis
Three Potential Pitfalls
NPV Analysis
A Misconception
26.6
A Leasing Paradox
26.7
Reasons for Leasing
Good Reasons for Leasing
Dubious Reasons for Leasing
Other Reasons for Leasing
26.8
Summary and Conclusions
ANNOTATED CHAPTER OUTLINE
Slide 26.1
Slide 26.2
26.1
Key Concepts and Skills
Chapter Outline
Leases and Lease Types
Basic Terminology:
Lease – a contractual agreement between two parties: the lessee
and the lessor
Lessee – the party that has the right to use an asset and makes
period payments to the asset’s owner
Lessor – owner of the asset
Slide 26.3
Lease Terminology
A.
Leasing versus Buying
The decision involves a comparison of the alternative financing
methods employed to secure the use of the asset. In both cases, the
company ends up using the asset.
CHAPTER 26 A-361
B.
Slide 26.4
Operating Leases
Types of Leases
Also called a service lease. Operating leases are often involved
with the leasing of computers and automobiles.
Characteristics:
1. The life of the lease contract is typically less than the asset’s
economic life; therefore, the total cost of the equipment is not
recovered by the lessor over the contract’s life.
2. The lessor typically maintains the asset and assumes
responsibility for paying taxes and insurance.
3. The lessee has a cancellation option prior to the contract’s
expiration date.
C.
Financial Leases
Also called capital leases.
Characteristics:
1. Payments are typically sufficient to cover the lessor’s cost of
purchasing the asset and to provide the lessor a fair return
(therefore, also called a fully amortized lease)
2. The lessee is responsible for insurance, maintenance and taxes
3. There is generally no cancellation clause without sever penalty
The three financial lease types are:
1. Tax-oriented leases – the lessor is the owner for tax purposes
2. Leveraged leases – lessor borrows a substantial portion of the
purchase price on a non-recourse basis
3. Sale and leaseback agreements – lessee sells the asset to the
lessor and leases it back
Real-World Tip, page 875: As described by Professor James
Johnson in his article, “Predatory Leasing: The Curse of the NoExit Lease” (Corporate Finance Review, January/February 1999)
some lessors make it extremely difficult for lessees to escape the
lease at expiration. Typically lessees have the right to purchase the
equipment, extend the lease, or “walk away.” In a “predatory”
lease, the end-of-lease language traps the lessee. Consider the
following end-of-lease language provided in the article:
A-362 CHAPTER 26
“At the expiration of the lease term …or at the
expiration of an extention [sic] term … lessee must (1)
purchase the leased property at a reasonable price; (2)
return the leased property …and lease replacement
property which has a cost at least equal to the original
cost of the returned property; or (3) extend the lease for
an additional year at the lease rate prevailing in the
expiring lease. Regarding options (1) and (2), lessor
and lessee shall agree to terms or not agree to terms in
their sole discretion.”
Notice that: the first option does not say “fair market value” –
thus, the lessor can insist on an exorbitant price, effectively taking
this option off the table. The second option does not specify the
terms of the subsequent lease, which allows the lessor to specify
exorbitant terms, taking the second option off the table. And, the
third option results in the lessee paying the same lease rate for
equipment that is worth a fraction of its original value. As
Professor Johnson points out, the “reasonable exit – simply
returning the equipment when the lease ends – has been ruled out”
by the wording of the document.
Real-World Tip, page 876: Traditionally, sale and leaseback
arrangements have involved expensive assets (e.g. buildings,
airliners, railroad cars); however, according to a piece in The
Wall Street Journal, the number of employees hired out by
“employee leasing” has grown from almost none to over 1.5
million between 1984 and 1993. Unlike traditional “temps,” these
people are employed by the lessor, provided with health and other
benefits, and then leased to a client firm. The development of this
industry is perhaps a natural outgrowth of the downsizing and
outsourcing of the 1990s; it remains to be seen whether the
anticipated cost savings materialize.
26.2
Accounting and Leasing
Slide 26.5
Lease Accounting
Statement of Financial Accounting Standards No. 13, “Accounting
for Leases.”
Financial leases – capitalized and reported on the balance sheet (a
debit to the asset for the present value of the lease payments and a
credit recognizing the financial obligation of the lease).
CHAPTER 26 A-363
Operating leases – not disclosed on the balance sheet, but
discussed in the footnotes.
Slide 26.6
Criteria for a Capital Lease
A lease is declared a capital lease if one or more of the following
criteria is met:
1. Property ownership is transferred to the lessee by the end of the
lease term
2. Lessee can purchase the asset for below market value at the
lease’s expiration
3. Lease term is 75 percent of the asset’s economic life
4. Present value of payments is at least 90 percent of the market
value of the asset at inception
Note: Often it is an arbitrary distinction between financial and
operating leases. An advantage of operating lease classification is
that the balance sheet may appear stronger (such as a lower total
debt to total asset ratio).
26.3
Taxes, the IRS and Leases
Slide 26.7
Taxes
A valid lease from the IRS’s perspective will meet these standards:
1. Lease term is less than 80 percent of the asset’s economic life
2. The contract should not have an option to buy at a price below
fair market value when the lease contract expires
3. The lease contract should not have a payment schedule that is
initially very high and lower thereafter, it suggests that tax
avoidance is the motive for the lease
4. The lease payment plan should provide the lessor a fair rate of
return
5. Renewal options must be reasonable, reflecting market value
26.4
The Cash Flows From Leasing
A.
Slide 26.8
The Incremental Cash Flows
Incremental Cash Flows
A-364 CHAPTER 26
Three important cash flow differences between leasing and buying:
1. The lessee’s lease payments are fully tax deductible. The aftertax lease payment is equal to the pre-tax payment times (1 – tax
rate).
2. The lessee does not own and may not depreciate the asset. The
lost depreciation tax shield is depreciation expense times tax rate.
3. The lessee does not have the upfront cost of purchasing the
asset.
Slide 26.9
Example: Lease Cash Flows
B.
A Note on Taxes
The size of the lease advantage is often a question of who can best
utilize the tax shelters associated with the lease arrangement.
26.5
Lease or Buy?
A.
A Preliminary Analysis
Leasing is advantageous if the implied after-tax interest rate on the
lease is less than the company’s after-tax cost of borrowing.
Lecture Tip, page 887: Here is another example of the lease
versus buy decision. A florist can purchase a delivery truck from
her local GM dealer for $25,000. The GM dealer will also lease
the truck for $6,100 per year over five years. The truck has an
expected life of seven years. The van is expected to be worth
$2,500 in five years and the florist has the option to buy it at fair
market value at that time. If the florist wants to purchase the truck,
she must borrow the money from Boone National Bank at a current
rate of 10%. Which financing option is better?
First, ignoring taxes the implied interest rate of these
payments is (assuming lease payments are end of year) 9.5%. This
implies that the GM dealer is willing to loan money to the florist at
9.5% instead of the conventional 10% loan being offered by the
bank. The decision appears clear – lease the truck.
Unfortunately, lease versus buy decisions are not this
simple. Taxes are very important. In this lease, the entire lease
payment is tax deductible since the lease term is less than 80
percent of the asset’s life and the option to purchase at the end is
for fair market value. If she purchases the truck, the purchase
price is deductible only through depreciation. Lease contracts also
often included maintenance, insurance, etc. Consider the following
after-tax cash flows when making the decision.
CHAPTER 26 A-365
The florist’s tax rate is 34% and for simplicity assume
straight-line depreciation.
Year
0
Purchase Savings
25,000
After-tax lease payment
6100(1-.34)
Lost depreciation tax shield
(25,000/5)(.34)
Purchase truck
Incremental Cash Flows
25,000
1
2
3
4
5
-4,026 -4,026 -4,026 -4,026 -4,026
-1,700 -1,700 -1,700 -1,700 -1,700
-2,500
-5,726 -5,726 -5,726 -5,726 -8,226
After-tax discount rate = 10%(1-.34) = 6.6%
NPV = -547.50, she should purchase now instead of leasing. The
savings of 25,000 today is not supported by the future after-tax
costs.
The after-tax loan rate (compute the IRR) would have to be 7.37%
to be indifferent between the two options. This corresponds to a
pre-tax loan rate of 11.16%.
Slide 26.10 Lease or Buy?
B.
Three Potential Pitfalls
Potential pitfalls to using the implied rate of interest on the lease
instead of the NPV:
1. Since the cash flows are positive, then negative, you have to
adjust the interpretation of the IRR rule. The IRR represents the
rate paid in this instance and you should choose the lower number.
2. Normally, you determine the advantage to leasing over
borrowing – as was done above – so you lease if the IRR is lower
than the after-tax cost of borrowing. If you determine the
advantage of borrowing over leasing (reverse all the signs), then
you are back to “conventional cash flows,” and you would lease if
the IRR is higher than the after-tax cost of borrowing.
3. The implied rate is based on the net cash flows of leasing instead
of borrowing – you have to use incremental cash flows.
C.
NPV Analysis
The net advantage to leasing can be determined by discounting the
cash flows back at the lessee’s after-tax cost of borrowing. This is
the same as the NPV computed in the example above.
A-366 CHAPTER 26
Slide 26.11 Net Advantage to Leasing
D.
A Misconception
The present value of the loan payments, if we borrow and buy, is
the cost of the equipment regardless of the loan repayment
schedule. So, it doesn’t really matter if we pay cash to purchase the
asset or we borrow and buy the asset; the initial cost is the same
either way.
Slide 26.12 Work the Web Example
26.6
A Leasing Paradox
It is important to recognize that the cash flows to the lessee are
exactly the opposite of the cash flows to the lessor when they have
the same tax rate and cost of debt. As a result, a lease arrangement
is often a zero-sum game. Since, in this situation, either one party
wins and one party loses, or both parties break even, why would
leasing take place?
26.7
Reasons For Leasing
A.
Good Reasons for Leasing
1. Taxes may be reduced by leasing. A potential tax shield that
cannot be used effectively by one firm can be transferred to
another firm through a leasing arrangement. The firm in the higher
tax bracket would act as the lessor and the utilize the majority of
the tax shields. (The loser is the IRS.)
2. Leasing may reduce uncertainty regarding the asset’s residual
value. This uncertainty may reduce firm value.
3. Transaction costs may be lower for leasing than buying.
4. Leasing may require fewer restrictive covenants than borrowing.
5. Leasing may encumber fewer assets than secured borrowing.
Slide 26.13 Good Reasons for Leasing
B.
Dubious Reasons for Leasing
1. The balance sheet may appear stronger when operating leases
are used (since they are considered off-balance sheet financing).
2. A firm may secure a lease arrangement when additional debt
would violate existing loan agreements.
3. Basing the lease decision on the interest rate implied by the
lease payments and not on the incremental after-tax cash flows.
CHAPTER 26 A-367
Slide 26.14 Dubious Reasons for Leasing
C.
26.8
Other Reasons for Leasing
Summary and Conclusions
Slide 26.15 Quick Quiz