26
Leasing
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills
 Understand basic lease terminology
 Understand the criteria for a capital lease
vs. an operating lease
 Understand the typical incremental cash
flows to leasing
 Be able to compute the net advantage to
leasing
 Understand the good reasons for leasing
and the dubious reasons for leasing
26-1
Chapter Outline
 Leases and Lease Types
 Accounting and Leasing
 Taxes, the IRS, and Leases
 The Cash Flows from Leasing
 Lease or Buy?
 A Leasing Paradox
 Reasons for Leasing
26-2
Lease Terminology
 Lease – contractual agreement for use of an
asset in return for a series of payments
 Lessee – user of an asset; makes payments
 Lessor – owner of the asset; receives
payments
 Direct lease – lessor is the manufacturer
 Captive finance company – subsidiaries that
lease products for the manufacturer
26-3
Types of Leases
 Operating lease
 Shorter-term lease
 Lessor is responsible for insurance, taxes, and
maintenance
 Often cancelable
 Financial lease (capital lease)
 Longer-term lease
 Lessee is responsible for insurance, taxes, and
maintenance
 Generally not cancelable
 Specific capital leases



Tax-oriented
Leveraged
Sale and leaseback
26-4
Lease Accounting
 Leases are governed primarily by FASB
13
 Financial leases are essentially treated
as debt financing
 Present value of lease payments must be
included on the balance sheet as a liability
 Same amount shown on the asset as the
“capitalized value of leased assets”
 Operating leases are still “off-balancesheet” and do not have any impact on the
balance sheet itself
26-5
Criteria for a Capital Lease
 If one of the following criteria is met, then
the lease is considered a capital lease
and must be shown on the balance sheet
 Lease transfers ownership by the end of the
lease term
 Lessee can purchase asset at below market
price
 Lease term is for 75 percent or more of the
life of the asset
 Present value of lease payments is at least
90 percent of the fair market value at the
start of the lease
26-6
Taxes
 Lessee can deduct lease payments for income
tax purposes
 Must be used for business purposes and not to avoid
taxes
 Term of lease is less than 80 percent of the
economic life of the asset
 Should not include an option to acquire the asset at
the end of the lease at a below market price
 Lease payments should not start high and then drop
dramatically
 Must survive a profits test – lessor should earn a fair
return
 Renewal options must be reasonable and consider
fair market value at the time of the renewal
26-7
Incremental Cash Flows
 Cash Flows from the Lessee’s point of
view
 After-tax lease payment (outflow)

Lease payment*(1 – T)
 Lost depreciation tax shield (outflow)

Depreciation * tax rate for each year
 Initial cost of machine (inflow)

Inflow because we save the cost of purchasing the asset now
 May have incremental maintenance, taxes,
or insurance
26-8
Example: Lease Cash Flows
 ABC, Inc. needs some new equipment. The
equipment would cost $100,000 if purchased,
and would be depreciated straight-line over 5
years. No salvage is expected. Alternatively,
the company can lease the equipment for
$25,000 per year. The marginal tax rate is
40%.
 What are the incremental cash flows?



After-tax lease payment = 25,000(1 - .4) = 15,000 (outflow years 1
- 5)
Lost depreciation tax shield = (100,000/5)*.4 = 8,000 (outflow years
1 – 5)
Cost of machine = 100,000 (inflow year 0)
26-9
Lease or Buy?
 The company needs to determine
whether it is better off borrowing the
money and buying the asset, or leasing
 Compute the NPV of the incremental
cash flows
 Appropriate discount rate is the after-tax
cost of debt since a lease is essentially
the same risk as a company’s debt
26-10
Net Advantage to Leasing
 The net advantage to leasing (NAL) is the
same thing as the NPV of the incremental
cash flows
 If NAL > 0, the firm should lease
 If NAL < 0, the firm should buy
 Consider the previous example. Assume
the firm’s cost of debt is 10%.
 After-tax cost of debt = 10(1 - .4) = 6%
 NAL = 3,116
 Should the firm buy or lease?
26-11
Work the Web Example
 Many people have to choose between buying
and leasing a car
 Click on the web surfer to go to Kiplinger’s
 Go to Tools: Spending Tools
 Do the calculations for a $30,000 car, 5-year loan at
7% with monthly payments, and a $3,000 down
payment. The available lease is for 3 years and
requires a $550 per month payment with a $1,000
security deposit and $1,000 other upfront costs.
26-12
Good Reasons for Leasing
 Taxes may be reduced
 May reduce some uncertainty
 May have lower transaction costs
 May require fewer restrictive
covenants
 May encumber fewer assets than
secured borrowing
26-13
Dubious Reasons for Leasing
 Balance sheet, especially leverage ratios, may
look better if the lease does not have to be
accounted for on the balance sheet
 100% financing – except that leases normally
do require either a down-payment or security
deposit
 Low cost – some may try to compare the
“implied” rate of interest to other market rates,
but this is not directly comparable
26-14
Quick Quiz
 What is the difference between a lessee and a
lessor?
 What is the difference between an operating
lease and a capital lease?
 What are the requirements for a lease to be tax
deductible?
 What are typical incremental cash flows and
how do you determine the net advantage to
leasing?
 What are some good reasons for leasing?
 What are some dubious reasons for leasing?
26-15
End of Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Comprehensive Problem
 What is the net advantage to leasing for
the following project, and what decision
should be made?
 Equipment would cost $250,000 if purchased
 It would be depreciated straight-line to zero
salvage over 5 years.
 Alternatively, it may be leased for $65,000/yr.
 The firm’s after-tax cost of debt is 6%, and its
tax rate is 40%
26-17