Tijdschrift voor Economie en Management
Vol. XXXV, 4, 1990
Leasing and the Pie Approach
to Capital Structure
by E. DURINCK, K. JANSEN, E. LAVEREN" and C. VAN HULLE*"
I. INTRODUCTION
In the finance literature there exists a large number of models for the
valuation of financial leases. See for example Herst (1982). Many of
these models approach leasing only from a lessee's point of view. By
analyzing differential cash flows between leasing and alternative methods of financing, and by determining appropriate discount rates for
the various flows, they try to obtain the value of leasing for a lessee.
More complete models do not consider lease payments as given,
but as a result of market forces between lessors and lessees (e.g. Miller
and Upton (1976), Lewellen, Long and MC Connell (1976)). These
equilibrium models often start from a perfect market situation where
leasing adds no value, and subsequently introduce several market imperfections in order to see how they affect the irrelevancy of leasing,
thus obtaining insight in the incentives to lease. Most of the literature
analyzing corporate leasing policy concentrates on the tax-related incentives to lease or buy, but non-tax incentives are considered as well,
and can be very important (see for example Smith and Wakeman
(1985)).
Only a few models try to integrate personal taxes into their approach of financial leasing valuation. Generally leasing is compared
with borrowing. This is because borrowing in a Modigliani and Miller
(MM) world with corporate taxes (M.M. (1963)) is never dominated
by equity. Equity may be cheaper however when the personal tax dis* Departement Bedrijfseconomie, U.F.S.I.A., Antwerpen
* * Departement Toegepaste Economie, K.U.Leuven
advantage of borrowing, where personal taxes on debt income exceed
those on equity income, is larger than the corporate tax advantage
(Miller (1977)). Brealey and Young (1980) analyze leasing in a Miller
world where leasing is compared with equity financing. The same analysis, with inclusion of investment tax credits, can also be found in the
textbook by Franks, Broyles and Carleton (1985).
In this paper we will try to give a more integrated approach of the
leasing phenomenon in perfect but not taxless markets. Our aim is
to see how financial leasing influences the distribution of cash flows,
generated by investment projects, between the government and the
final beneficiaries, i.e. the personal security holders. The foundation
for our analysis is the pie approach of capital structure, and leasing
is just one way to divide the total pie. To include personal taxes in
the analysis without complicating too much our model, we will assume
that personal interest income on debt is taxed at a uniform rate across
investors, while equity income is not taxed at all at the personal level.
This is in fact Miller's assumption in his famous paper of 1977'. It
is however easy to work out the present model under the assumption
that there is a non-zero uniform personal tax rate on equity income.
This will only complicate the formulas a bit, but won't change anything
essential2. Under different assumptions about the relationship between corporate and personal tax rates, we will obtain similar results
as in the classical MM world, but also as in the analysis of Brealey
and Young in Miller's world. The model in this paper will be very simplified, since it is our intention to get an as clear as possible insight
in the mechanism of cash flow distribution. Therefore we purposely
exclude all imperfections but corporate and personal taxes in a simplified form, to the extent that leasing becomes almost indistinguishable from borrowing. This can serve as a starting point for a deeper
understanding of the value of financial leasing when several imperfections are introduced.
11. PERFECT CAPITAL MARKETS AND THE VALUE
ADDITIVITY PRINCIPLE
We start with the assumption that capital markets are perfect, i.e.
there are no transaction costs, information costs or financial distress
costs ; investors and firms have equal access to the market ; they have
homogeneous expectations ; there are no government restrictions
which interfere with capital market transactions ; financial assets are
infinitely divisible ; and markets are competitive. Schall (1972) has
shown that in transaction costless, competitive capital markets the value additivity principle (VAP) holds, i.e. the total equilibrium market
value of any stream Y, received by investors in the market is independent of how it is divided into separate income streams of one or
more firms (Y,, ...,Y,) in being made available to the market:
n
if
Y,
n
1 Yi
i = l
=
then V[Y,]
C V[Yi],
i = l
=
where V[Y] denotes the equilibrium market value of the stream Y.
We assume that there are only two types of security holders : bondholders entitled to promised payments and equityholders receiving residual payments3. The VAP also holds with corporate taxes, and since
we assumed uniform personal taxation on debt income, also if there
are personal taxes. In the last situation, investors value streams in the
form they really receive them, i.e. after personal taxes. The assumption of uniform personal taxation has the advantage that we are able
to follow the distribution of cash flows up to the point they are received by individuals. This gives us a better idea of how cash flows
are divided between investors and the government.
111. THE PIE APPROACH T O CAPITAL STRUCTURE
The capital structure of a firm is the pattern of the firm's liabilities
that in total represent the claims against the future cash flows of the
firm. These future cash flows are generated by the firm's operations
(investments). The manner in which these operations are financed determines the distribution of the total claim against these cash flows,
the total pie, between various parties : stockholders, bondholders, the
government (taxes), lawyers (bank-ruptcy costs), etc.. As we will see
in the next paragraph, also leasing is no-thing more than a particular
way to cut the total pie into pieces. No matter how the pie is divided,
and no matter who gets the parts, they must still add up to the total
cash flow, and the value is unaltered by the capital structure. This is
in fact the essence of the Modigliani-Miller theory (M.M. (1958)).
However as Ross and Westerfield (1988) notice there is an important difference between claims such as those of stockholders and
bondholders, which are marketed claims, and those of the government
which are nonmarketed. Marketed claims for instance can be bought
and sold in financial markets, while nonmarketed claims cannot. By
the value of a firm one generally means the value of the marketed
claims. But this value can change with changes in the capital structure.
So, the financing decisions in general have an influence on the value
V of the firm. By the pie theory however, any increase in V must imply
an identical decrease in the value of the nonmarketed claims. Hence,
a firm trying to maximize its value equally can try to minimize the value of the nonmarketed claims.
We further assume that the value of the claims from the existing
debtholders does not change by the undertaking of a new investment
project4 (see for example Haley and Schall (1981)). S'ince any new security holders (who finance the project) will pay the market value of
the claims they receive, the net present value of the project V - I (with
V the value of the marketed claims generated by the project, and I
the investment outlay necessary to finance the project) precisely
equals the value to the existing shareholders from undertaking the investment. Hence, under this assumptions firm value maximization is
equivalent to the maximization of the existing shareholders' wealth.
IV. FINANCIAL LEASING IN PERFECT CAPITAL MARKETS WITH TAXES
In a financial lease agreement, the lessor purchases an asset and then
immediately grants the lessee exclusive use of the asset for most of
its economic life in return for periodic lease payments. The contract
is not cancellable, the failure to meet lease payments can force the
lessee into bankruptcy (or reorganization) and the lease is fully amortized (that is, the lessor receives lease payments which repay the full
.~
the lessor is the legal owner of
cost of the leased a s ~ e t )Although
the asset, the contract is otherwise closely analogous to a loan secured
by the asset.
We assume that capital markets are perfect, but for the existence
of corporate taxes, and personal taxes on debt income. Financial leasing is considered to be completely equivalent to debt financing, i.e.
they are perfect substitutes and have exactly the same risk. This is naturally the case in a perfect market. One dollar of a lease obligation
has the same value as one dollar of a debt obligation unless there are
imperfections causing lease payments to be less (or more) certain than
debt payments.
Consider a firm having the opportunity to invest in an asset that
generates a future operating cash flow X in perpetuity. This investment requires an initial outlay I. We assume that the project is completely isolated from other projects, so that no transfer of taxable losses between projects is possible. For the same reason, we suppose that
taxable losses cannot be carried forward (or backward). The firm has
the choice between buying the asset and financing the purchase price
with a mixture of debt and equity, or leasing the asset from a lessor.
Suppose also that capital good markets are perfect so that the invest. ~ look at the distribution
ment cost I is the same for any i n v e ~ t o rLet's
of the total pie X under the two alternatives. All cash flows are considered to be perpetuities ; in particular payments to bondholders will
be all interest, and there is no salvage value to the invested asset.
A. Purchase alternative
where
DP = (dividend) payments to equityholders of the purchaser;
RP
= payments to bondholders of the purchaser before personal
taxes ;
FP
= RP(1-TB) = payments to bondholders after personal taxes
(TB is the tax rate on interest income);
TcP
=
corporate taxes paid by the purchaser ;
TaxP = total taxes paid by the purchaser and its security holders.
The next figure shows this distribution of the total pie X, i.e. the
distribution of the total operating cash flow X between the security
holders and the government.
FIGURE 1
total operating cash flow
1
PaYy-n'.
equityholders
PaYpts
bondholders
1
TanP
payments
to the
government
The net present value V of the project equals
V = V[DP]
+ V[FP] -
value of the marketed claims
I = V[X] - V[TaxP] - I
investment
outlay
value of the
value of the
investment
total pie nonmarketed claims
outlay
(2)
B. Lease alternative
where
D"
= (dividend) payments to equityholders of the lessee ;
L
= payments to the lessor ;
Taxe = total taxes paid by the lessee and its security holders.
It is assumed that except for the lease claims, the lessee is all equity
financed. Possibly the project might support more debt than the lease
obligations, so that the lessee could take additional debt, hence increasing the value of the project to its security holders7. Our aim however is to compare the lease and purchase alternatives. In order to
make leasing and purchasing comparable we assume, following Myers
et al. (1976) and Franks and Hodges (1978), that the purchaser takes
as much debt as to equate his debt associated cash flows with those
of the lessee.' Since these flows are of the same risk, as we assumed,
we have two comparable alternatives. Stated differently, the amount
of debt is chosen in such a way that the yearly after tax flows received
by equityholders are identical under both alternatives (i.e. under leasing and under purchasing). Any additional debt might increase the
value of the project, but it won't change the difference in value between the purchase and the lease alternative^.^
The value V" to the lessee equals
L however is received by the lessor and divided into payments to its
debt- and equityholders by its financing decision :
where
D'
=
(dividend) payments to equityholders of the lessor;
R'
= payments to bondholders of the lessor before personal taxes ;
F'
=
Rr(l-TB) = payments to bondholders after personal taxes ;
Tcr = corporate taxes paid by the lessor;
Taxr = total taxes paid by the lessor and its security holders.
The value V' to the lessor equals
From (3) and (5) we get the distribution of the total pie X under the
lease alternative :
The value to the lessee and the lessor together equals
V"
+V
= V[De]
+ V[Dr] + V[Fr]
value of the marketed claims
= V[X] - (V[Taxe]
value of the total pie
- I
investment outlay
+ V[Taxr])
valuz of the nonmarketed claims
- I
investment outlay
(8)
C. The net advantage of leasing
The net advantage of leasing is the value of the cash flows to the security holders of lessee and lessor together, compared with the value
of the cash flows to a purchaser, i.e. the difference between the value
of the marketed claims associated with the two alternatives. But this
is also equal to the difference in value of the nonmarketed claims,
i.e. the difference between the taxes corresponding to the purchase
and the lease alternatives. Consequently, we obtain for the net advantage of leasing (NAL) (see also the appendix):
NAL
= V[TaxP] - V[Taxe] - V[Taxr]
(9)
So leasing has a net advantage whenever the tax leaks associated
with the purchaser exceed those of the lessee and lessor together.
The net advantage of leasing to the lessee is equal to the value of the
cash flows to the security holders of the lessee, compared with the
value of the cash flows to a purchaser. Under the leasing alternative,
the security holders of the investing firm (the lessee) do not have to
supply the investment outlay and neither do they have the tax obligations associated with the purchase alternative. They do however
have their own tax obligations and they have to pay lease rentals to
the lessor. It follows that the net advantage of leasing to the lessee
(NALe) is given by (see also the appendix)
Finally, the lessor supplies the investment outlay and pays his taxes,
while he receives lease rentals as income. The net advantage of leasing
to the lessor (NALr), which equals the value of the project to the lessor in this case, is thus given by (see also the appendix)
If lessor and lessee are in a bargaining position, they could agree
on maximizing their combined value, the net advantage of leasing, and
sharing the profit following a certain sharing rule (see for example
Hull (1982)). This can be done by appropriately choosing L (notice
that taxes depend on L). More likely, L will be determined as an equilibrium in the leasing market, and no lessor and lessee will come to
an agreement unless leasing has a positive value for both of them (i.e.
NALe > 0 and NALr > 0). For example, if there is perfect competition between lessors, they will compete until V = 0, and all the benefits go to the lessee (e.g. Lewellen et al. (1976), Hull (1982)). We
shall assume that a lease agreement is only possible if
> 0.
NALe > 0 and NALr Moreover, the project must have a positive net present value to the
purchaser or to the lessee. Since we want to concentrate on the value
and the possible advantage of leasing, we will assume however that
this condition is fulfilled and that the project is acceptable in one way
or another.
V. FINANCIAL LEASING WITHOUT NON-CASH TAX
DEDUCTIONS
Taxes are determined by cash payments such as interest and lease payments, which are tax deductible to the payer and taxable to the receiver, but also by non-cash tax deductions such as depreciation. Leasing causes a transfer of cash andlor non-cash tax deductions from
lessee to lessorlO, and hence changes the taxable earnings of both
firms. A second important point, considering personal taxes, is the influence of leasing on the distribution of cash flows between interest
and dividend income.
In this paper we assume the absence of any non-cash tax deductions
such as depreciation and investment tax credit. Suppose that the marginal corporate tax rates of lessor and lessee (purchaser) are TICand
T, respectively. Let TBbe the personal tax rate on debt income, while
equity income is not taxed. Let's calculate the taxable earnings of our
different firms.
The taxable earnings of a purchaser equal
Hence,
If TB < T, there is an advantage of debt financing to equity financing, since part of the total pie X is transferred from a tax regime T,
into a tax regime TB,which causes a decrease in total taxes, and hence
an increase in the marketed streams. If there are no restrictions on
the amount of debt a firm can take and if there are no imperfections
such as bankruptcy or agency costs, the firm will only use debt financing, hence reducing its corporate tax bill to zero.''
If TB = T, debt financing causes no increase in value.
If TB > T, equity financing is the best option.
The taxable earnings of lessee and lessor equal1'
Hence,
and
Formula (18) clearly shows how the pie distribution has its influence on the taxes. The first term of this formula indicates a taxation of
the total pie at the tax rate of the investing firm (the lessee). Part of
the pie (the lease rental L) however is transferred to the lessor and
falls into another tax regime. This correction is affected by the second
term. Finally, the last term expresses the influence of the lessor's interest payments which are free of corporate taxes but fall under the
personal tax regime of interest income.
Without the non-cash tax deductions, leasing is exactly the same
as a corporate borrowing arrangement between the lessor and the lessee. So if leasing is the best alternative, it means that the optimal choice for the investing firm is to borrow from the lessor.13
Using the tax formulas derived in this section it is possible to obtain
explicit expressions for the net advantage of leasing under different
assumptions about the tax rates (see also the appendix). Hence, let
us consider now some different situations for the relation between the
corporate tax rates of lessee and lessor, and the personal tax rate on
bond income.
In particular, when TB = 0, we obtain the classical Modigliani-Miller
case. As we already noticed, the purchaser will prefer 100% debt financing. But to be comparable with the leasing alternative we assume
that he takes as much debt as to equate his debt associated cash flows
to those of the lessee. By debt associated cash flows we mean the difference between the cash flows to the stockholders of the firm and
those of an all equity financed firm. As we show in the appendix the
equivalent loan must satisfy RP = L, i.e. to have the same debt obligations as the lessee the purchaser borrows as much as to make his
interest payments equal to the lease rentals. Hence it follows from
(12) and (14) that the taxable earnings of the purchaser EP are equal
to those of the lessee E".
It is clear that the lessor cannot borrow more than the amount that
makes interest payments equal to L. Without other imperfections the
lessor will be all debt financed. This means R' = L and Er = 0.
For the net advantage of leasing we obtain now (see Appendix):
NAL
= 0,
Under this tax scenario, leasing has no advantage and there exists
a unique value for the lease payments which makes lessee and lessor
indifferent to leasing, i.e. NALe = NALr = 0.
This value is given by
If the interest rate on debt is equal to r, the discount rate for cash
flows of the same risk applie by investors in the market equals r(l-TB).
Hence
and consequently
Purchase or leasing are equivalent alternatives and the cost of leasing and debt financing is the same.
The taxable earnings of the purchaser are identical to those of the
lessee, while personal taxable earnings are transferred from debtholders of the purchaser to debtholders of the lessor. As a result total
taxes and consequently total marketed streams remain the same.
For the purchaser equity financing will be the alternative to leasing.
The lessor however still wants to have 100% debt in its capital structure, i.e. RP = 0 and R' = L. For the taxable earnings we now have :
Leasing causes a decrease in taxable earnings, and consequently
in corporate taxes. However, personal taxes increase by TBRr = TBL.
Hence,
NAL
= (T,-T,)V[L]
<0.
Transferring a stream L in a tax regime T, to a tax regime TB, with
TB > T,, can never be advantageous.
Now the purchaser prefers debt financing, but the lessor will be all
equity financed : RP = L, Rr = 0.
The taxable earnings are given by
Leasing causes an increase in taxable earnings and consequently
in corporate taxes. However, personal taxes decrease by T,RP = T,L.
Hence,
NAL
= (TB-T,,)V[L]
>O
Transferring a stream L in a tax regime TB to a tax regime T,,, with
T,, < TB, is always advantageous.
Leasing, which is just a corporate borrowing arrangement under our
present assumptions, is the cheapest form of financing since the lessor
has a lower corporate tax rate than the lessee and than individual debtholders.
As we noticed before however, lessor and lessee will only come to
an agreement if leasing has a positive value for both of them. So,
the feasible values of L must satisfy the equations NALr 10 and
NALc 2 0.
It follows that acceptable values of L are bounded by an upper and
lower bound as in the next relation (see appendix)
and using the discount rate r(1-TB) to value L, we get
The upper bound is the maximal acceptable value of L, which leaves the lessee with a zero net advantage, while the lower bound is the
minimal acceptable value leaving the lessor in a neutral situation.
D. TB > T , TB > T,,
Now both purchaser and lessor prefer equity financing : RP = R' = 0.
Hence,
There is no change in taxable earnings and there are no personal
taxes. Under this assumptions, leasing just causes a transfer of taxable
earnings L from a tax regime T, to a tax regime T,,.
Consequently,
NAL
= (T,-T,,)V[L] .
The relation between T,, and T, now becomes relevant. If T,, >
TIT, leasing has a negative present value, but if T,, < T, leasing is advantageous.
If TIT,, < T, the possible values of L are given by (see Appendix)
And if debt with the same risk as L requires a before tax return r,
we have
VH. CONCLUSION
In this paper we investigated how the way of financing, in particular
financial leasing, influences the distribution of cash flows, generated
by investment projects, between the government and the final beneficiaries, i.e. the personal security holders. In order to obtain a fundamental insight, we excluded all imperfections, but corporate and
personal taxes in a simplified form (uniform personal taxation on debt
income and tax free equity income). We even disregarded depreciation and other non-cash tax deductions, and only looked at separated
projects with no salability of tax losses and no possibility to carry them
forward (or backward). The basic (logical) result is that the best way
to finance an investment project is the one which directs the generated
cash flows to the most favourable tax regime. If the tax rate on personal income is smaller than the corporate tax rates, leasing has no
value since both lessee and lessor will take as much debt as possible
so that the final tax rate at which the cash flows are taxed is the personal one. If for some reason the lessor could not be fully debt financed, leasing will not be the most favourable form of financing. If
the personal tax rate on debt income is larger than the corporate tax
rate of some firm, debt financing will not be the best choice for this
firm. Leasing can only have value then, when the corporate tax rate
of the lessor is smaller than that of the lessee. Firms with small tax
rates should lend, which is equivalent to lease, to firms with larger
tax rates in this situation.
Under our perfect assumptions, financial leasing has the same risk
as debt financing. Consequently, in the absence of non-cash tax deductions, a lease agreement or a corporate debt agreement with a certain lessor are completely equivalent from an economic point of view.
In spite of this equivalence, we still represented leasing in a way as
if there was a difference between the two forms of financing. This is
not the case under our present assumptions, but this manner of representation gives one the opportunity to introduce imperfections
into the model (causing leasing to be a really special form of financing) and to study the consequences for the value of leasing. It shows
that essentially financial leasing is nothing more than another form
of debt financing, which obtains its characteristic features from a
number of imperfections. In the present paper we only tried to create
the basic view and understanding, which can serve as a starting point
for further investigations.
APPENDIX
In this appendix we derive some formulas for the net advantage of leasing under different
assumptions about the tax rates. As defined in the text, the net advantage of leasing (NAL)
is equal to the value of the cash flows to the security holders of lessee and lessor together,
compared with the value of the cash flows to a purchaser:
NAL = V"
+
= V[De]
V'
-
VP
+ VID1] +
= V[TaxP]
-
V[TaxC]
V[Fr]
-
V[DP]
-
V[FP]
VITaxl]
-
Using (2).(4) and (6) we find that the net advantage of leasing to the lessee is equal to
NAL"
=
V" - VP = V[De]
= I - V[L]
and to the lessor
-
+ V[TaxP]
V[DP] - V[FP]
-
V[TaxL],
+I
From (13), (16) and (17) it follows that the net advantage of leasing is given by:
NAL
=
V[TaxP]
=
T,V[EP-E']
V[TaxC] - V[Taxr]
-
- T,,VIE1] + TBV[RP-R'].
+ V[Tax" - V[TaxL]
+ T,V[EP-E"] + TBV[RP],
NAL" = I
-
V[L]
=
I
-
V[L]
=
V[L]
=
V[L] - I - T,,V[Er] - TBV[Rr]
NAL'
I - VITaxl]
-
Let us now discuss as in the text the different cases for the relation between the corporate
tax rates of lessee and lessor, and the personal tax rate on bond income.
Case l : TB < T,, TB < T,,
We first apply the equivalent loan principle, i.e. we equate the debt associated cash flows
of the purchaser with those of the lessee. As mentioned in the text we mean by debt associated cash flows, the difference between the cash flows to the stocltholders of the firm
and those of an all equity financed firm. For the purchaser this gives :
and foi- the lessee
Hence the equivalent loan must satisfy RP = L and it follows from (12) and (14) that EP
= E". As already noticed in the text, we also have
R' = L and E' = 0. For the net advantage of leasing we can then use (19),(20) and (21)
to obtain
NAL
= 0.
+ TBV[L] = I - (1-T,)V[L],
NALe = I - V[L]
-
I
5 T, <
T,,
NAL' = V[L]
Case 2 : T,
-
T,V[L] = (l-T,)V[L]
- 1.
As we explained above RP = 0 and R' = L. Using (12), (14) and (15) we see then that
the taxable earnings are given by:
E"=X,EC=X
-
L,E1=O.
Hence we have by (19) (20) and (21)
NAL
NAL"
T,V[L] - TBV[L] = (T,-T,)V[L],
I - V[L] + T,V[L] = I - (1-T,)V[L],
NAL' = V[L] - I - TBV[L] = (1-T,)V[L] - I.
=
=
Case 3 : T,,
5 TB < T,
We now have that RP = L, Rr
=
0. Hence
Again we obtain from (19), (20) and (21)
= -T,,V[L] + TBV[L] = (TB-T,,)V[L],
NAL" = I - V[L]
TBV[L] = I - (1-TB)V[L],
NAL' = V[L] - I - T,,V[L] = (l-T,,)V[L] - I.
NAL
+
Requiring that leasing has a positive value for both the lessor and the lessee, i.e. NAL'
> 0 and NAL" 1 0 , it follows that
Using the discount rate r(1-TB) to value L; we get for the net advantage of leasing
NAL = (TB-T,,)L l (l-TB)] ,
= I - L!r ,
NAL'
NALr = (l-T,,)L / (l-T,)r
-
I.
Case 4 : TB > T,, TB > T,,
Since in this case
R' = 0 it follows that
RP =
Consequently, it follows for the net advantage of leasing
NAL = T,V[L]
NALC = I
NALr
=
-
V[L]
-
V[L]
-
I
T,,V[L] = (T,-T,,)V[L],
+ T,V[L]
-
= I - (1-T,)V[L],
T,,V[L] = (1-T,,)V[L]
-
1.
If T,, < T, the feasible values of L making leasing acceptable to both the lessor and the
lessee are thus given by
NOTES
1. There is much controversy about this assumption however, certainly in Belgium where
the withholding tax on dividends vastly exceeds the taxon interest income at the moment.
2. If this tax rate on equity income exceeds the tax rate on debt income, clearly debt financing will be preferred above equity financingand a result similar to case one of the
present paper will be obtained.
3. Dividends can be considered as residual, since dividend policy is irrelevant in perfect
markets (see for example FIaley and Schall (1981)).
4. This happens for instance when the existing debt is risk free.
5. We assume away the complications of purchase option and salvage value in this paper.
6. Imperfections of the capital good markets, such as specialization and market power
can of course be an important justification for the existence of leasing. A differepce
in investment cost between purchaser (investor) and lessor could readily be built in
into our model. In this paper however we concentrate on the basic tax aspects. For
more details on non-tax incentives to lease see for instance Smith and Wakeman (1985).
7. See for example Haley and Schall (1981).
S. By debt associated cash flows we mean the difference between the cash flows to the
stockholders of the firm (purchaser or lessee) and those of an all equity financed firm.
9. This "equivalent loan" principle to determine the value of a lease agreement can only
be applied however, when there are no restrictions on the amount of debt a lessee or
purchasel- can take, other than those caused by the debt associated cash flows themselves. For example; if the debt claims increase, agency costs and financial distress costs
will increase as well (in an imperfect world). This process will limit the debt capacity,
but has the same influence to purchaser or lessee, and comparison by an equivalent
loan is still possible. If there are other limitations on debt capacity, having a different
effect for purchaser or lessee, the equivalent loan principle cannot be applied and a
direct comparison with absolute debt amounts is necessary. In this case one has to include an interest term R e in equation (3).
10. The depreciation deduction is only transferred from lessee to lessor in the American
leasing system. In a number of countries, for example in Belgium, the lessee is considered to be the fiscal ownel- of the asset and he has the right to keep the depreciation
deduction.
11. As explained before, we assume that if the conditions for the equivalent loan principle
are fulfilled, the lessee does not take additional debt and the purchaser uses as much
debt as to equate his debt associated cash flows to those of the lessee.
12. We deduct the whole lease payment L as an expense from the operating cash flow X,
while L is treated as a gain to the lessor. This is the American system of leasing, which
silnultaneously gives the lessor the right to deduct depreciation from its income for tax
purposes. The lessor is the fiscal owner of the asset. In Belgium, the lessee is the owner
from a fiscal point of view. H e can not deduct the whole L as an expense however,
but only a part of L which is considered to be the interest part of the implicit loan.
The implicit interest rate or the (before tax) cost of leasing is equal to the internal rate
of return, equating the present value of the lease payments to the initial investment
outlay. For our perpetuity model we get:
But this means that the whole L can be considered as interest, and the two different
systems are equivalent except for the transfer of the depreciation in the American system. Since in this paper we are ignoring depreciation, the two systems are equal.
13. In our analysis we compare leasing with personal debt and equity financing. Although
NAL
0, it is possible that there are other corporate financing methods which are
still more valuable. In fact under our perfect markets assumption and without depreciation deductions, leasing is just a particular corporate borrowing arrangement. Other
corporate financing methods can b e analyzed in the same way however as we do for
leasing, i.e. we follow the distribution of cash flows until they reach their final destination (the personal security holders). For the role financial intermediaries can play
in the valuation of firms and the distribution of cash flows and taxes, when these intermediaries provide equity financing, see for example Franks and Pringle (1982).
Because of the resemblance between financial leasing and borrowing, one can ask what
remains under our perfect markets assumptions of the essential features of leasing. Typical for lelrsing is what is generally called 100% financing. The lessor always finances
the investment for an amount equal to the investment outlay I, since he buys the asset
instead of the lessee. Even if a project supports more debt than I, this additional debt
can only be obtained by borrowing arrangements other than leasing. So, this 100% value
I is also an upper bound on the amount of lease financing (if lease payments are due
in advance there is of course less than 100% financing).
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