On Leasing
Adapted from Fundamentals of Corporate Finance RWJR, Fourth Canadian Edition
Definition
A lease is a contractual agreement between two parties:
Lesee: the user of an asset, makes payments to the lessor
Lessor: the owner of the asset, receives payments from lessee
Operating vs. Financial lease
Operating lease
Relatively short-term
Partially amortized
Lessor responsible for insurance,
taxes, and maintenance
Cancelable on short notice
Operating vs. Financial lease
Operating lease
Financial lease
Relatively short-term
Partially amortized
Lessor responsible for insurance,
taxes, and maintenance
Relatively long-term
Fully amortized
Lessee responsible for
insurance, taxes, and
maintenance
Cancelable with hefty penalty
Cancelable on short notice
Sale and Leaseback Agreements
When a company sells an asset it owns to another firm and
immediately leases it back:
• The lessee receives cash from the sale of the asset
• The lessee continues to use the asset.
Ex: In January 1989 Air Canada arranged a sale and leaseback of
four Boeing 767 airplanes with a Canadian financial institution.
Leveraged leases
Tax oriented lease involving a lessee, a lessor, and a lender.
When the lessee cannot fully take advantage of its CCA deductions
associated with owning the asset, the lessee will find someone willing to
buy
The lessee selects the asset, uses the asset, and makes the periodic
lease payments.
The lessor (owner of the asset) makes a down payment (20-30%)
towards the purchase of the asset, borrows from a lender the balance,
has the title of the asset, and receives the lease payments.
The lender supplies the financing and receives interest payments.
Accounting and Leasing
The Canadian Institute for Chartered Accountants requires that all
financial leases must be capitalized:
Exemplification:
Bearskin Airlines contemplates adding another airplane to its fleet.
The candidate it's a Swedish made Saab, which cost $350,000.
The company has to decide whether to buy or lease the airplane:
Borrow and buy the airplane
Assets
Liabilities
Saab turbo-prop
$350,000
Debt
$350,000
Other airplanes
$4,500,000
Equity
$4,500,000
Total
$4,850,000
Total
$4,850,000
Operating lease
Assets
Liabilities
Saab turbo-prop
0
Debt
0
Other airplanes
$4,500,000
Equity
$4,500,000
Total
$4,500,000
Total
$4,500,000
Financial lease
Assets
Liabilities
Saab turbo-prop
(Assets under capital lease)
$350,000
Long-term obligations under
lease agreements
$350,000
Other airplanes
$4,500,000
Equity
$4,500,000
Total
$4,850,000
Total
$4,850,000
Clarification
For accounting purposes, a lease is declared to be a financial lease,
and must be disclosed, if at least one of the following criteria is
met:
• the lease transfers ownership of the property to the lessee by the
end of the lease term
• The lessee has an option to purchase the asset at a price below
fair market value (bargain purchase price option) when the lease
expires.
• The lease term is 75% or more the estimated economic life of the
asset
• The present value of the lease payments is at least 90% of the fair
market value of the asset at the start of the lease.
Why do managers want to disguise financial leases
as operating leases?
• Under an operating lease, the lessee can deduct lease
payments for income tax purposes.
• Under a financial lease, the lessee is allowed to amortize the
asset over a period that might be longer than the lease, and only
the interest portion of the lease is deductible for tax purposes.
• Not showing a financial lease can disguise a firm’s long-term
financial commitments
Leasing: A NPV analysis
TransCanada Distributors runs a fleet of company cars for its sales staff.
Business has been expanding and the firm needs an 50 additional cars to
provide basic transportation. Each car can be purchased wholesale for
$10,000 and will generate an additional $6,000/year in added sales for the
next five years.
TransCanada has a corporate tax rate of 40%. The CCA rate is also 40%,
over an estimated life span of five years. After that the residual value of
each car would be zero.
Financial Lease Co. has offered to lease for $2,500/year for each car, over
a five-year period. Lease payments are made at the beginning of the year.
Trans Canada would be responsible for maintenance, insurance, and
operating expense.
TransCanada: Tax shield if buying
(assuming the asset pool is closed after 5 years)
Year
UCC
CCA
Tax shield
0
1
2
3
4
5
$5,000
$8,000
$4,800
$2,880
$1,728
$1,037
$2,000
$3,200
$1,920
$1,152
$691
-
$800
$1,280
$768
$461
$276
$415
TransCanada: Annual tax shield if leasing
$2,500(0.4) = $1,000
TransCanada: Incremental cash flow analysis
Year
Investment
Payment shield
Lease
Forgone tax shield
Total
0
1
2
3
4
5
TransCanada: Incremental cash flow analysis
Year
0
Investment
$10,000
1
2
3
4
5
TransCanada: Incremental cash flow analysis
Year
0
Investment
$10,000
Payment shield
$1,000
1
2
3
4
$1,000
$1,000
$1,000
$1,000
5
TransCanada: Incremental cash flow analysis
Year
0
1
2
3
4
Investment
$10,000
Payment shield
$1,000
$1,000
$1,000
$1,000
$1,000
Lease
-$2,500
-2,500
-$2,500
-$2,500
-$2,500
5
TransCanada: Incremental cash flow analysis
Year
0
1
2
3
4
Investment
$10,000
Payment shield
$1,000
$1,000
$1,000
$1,000
$1,000
Lease
-$2,500
-2,500
-$2,500
-$2,500
-$2,500
Forgone tax shield
-$800
-1,280
-$768
-$461
-$276
5
-$415
TransCanada: Incremental cash flow analysis
Year
0
1
2
3
4
Investment
$10,000
Payment shield
5
$1,000
$1,000
$1,000
$1,000
$1,000
Lease
-$2,500
-2,500
-$2,500
-$2,500
-$2,500
Forgone tax shield
-$800
-1,280
-$768
-$461
-$276
-$415
Total
$7,700
-2,780
-$2,268
-$1,961
-$1776
-$415
TransCanada: Analysis
If TransCanada can borrow at 11% from the bank, then its after-tax cost of
borrowing is 11(1-0.4) = 6.6%.
NPV of the lease =
Investment - PV(after-tax lease payments) - PV(CCA tax shield)
NPV = $7,700 - $2,780/(1.066) - $2,268/(1.066)2 - $1,961/(1.066)3 $1776/(1.066)4 - $415/(1.066)5 = -$199
Here, buying is preferred over leasing.
TransCanada: Analysis (2)
If the asset pool is not closed after five years,
PV (CCA) = Investment(T)(d)(1+k/2)/(k+d)(1+k)
PV (CCA) = 10,000 (0.4)(0.4)(1.033) /(0.466)(1.066) = $3,327
NPV = $10,000 - $6,627 -$3,327 = $46
In this case, leasing is better than buying.
The Lessor: Financial Lease Co.
(decision: buy and lease versus do nothing)
Assumptions:
• Asset pool is closed after five years
• CCA rate = 40%
• Corporate tax rate = 40%
Cash flow to the lessor: Financial Lease Co.
Year
0
1
2
3
4
5
Investment
Tax
Lease
Tax shield
Total
-$10,000
-$1,000
$2,500
$800
$7,700
-$1,000
$2,500
$1,280
-$2,780
-$1,000
$2,500
$768
-$2,268
-$1,000
$2,500
$461
-$1,961
-$1,000
$2,500
$276
$415
-$1776 -$415
Financial Lease Co.: Analysis
If the after-tax cost of borrowing is also 6%, NPV = $199
Note:
NPV to TransCanada =$-199
NPV to the lessor = $199.
Obviously TransCanada will not agree to the lease contract.
Special Case
Assume TransCanada pays no taxes, and is able to negotiate an
annual lease payment of $2,437
Cash flow to the lessee (TransCanada)
Year
0
1
2
3
4
5
Investment
Lease pmt.
Total
$10,000
-$2,437
$7,563
-$2,437
-$2,437
-$2,437
-$2,437
-$2,437
-$2,437
-$2,437
-$2,437
0
0
NPV = $7, 563 - $2,437 PVA*(r = 11%, t = 5) = $2.34
In this case, leasing is better than buying.
Cash flow to the lessor
Year
0
1
2
3
4
5
Investment
Lease
Tax
Tax shield
Total
-$10,000
$2,437
-$974
$800
$7,738
$2,437
-$974
$1,280
-$2,742
$2,437
-$974
$768
-$2,230
$2,437
-$974
$461
-$1,923
$2,437
-$974
$276
-$1739
$415
-$415
NPV to the lessor = $32
IMPLICATION
LEASE CONTRACTS ARE USUALLY BENEFICIAL FOR BOTH
PARTIES WHEN THE LESSE IS IN A LOWER TAX BRACKET
THAN THE LESSOR.
THE LESSOR CAN PASS ON SOME OF THE TAX SAVINGS TO
THE LESSEE IN THE FORM OF LOWER LEASE PAYMENTS.