Leasing and Other
Asset-Based
Financing
21
Corporate Financial Management 3e
Emery Finnerty Stowe
Modified for course use by Arnold R. Cowan
Lease Financing
A lease is a rental agreement that extends for one
year or longer.
The owner of the asset (the lessor) grants
exclusive use of the asset to the lessee for a fixed
period of time.

In return, the lessee makes fixed periodic payments to
the lessor.
At termination, the lessee may have the option to
either renew the lease or purchase the asset.
1
Types of Leases
Full-service lease

Lessor responsible for maintenance, insurance,
and property taxes.
Net lease

Lessee responsible for maintenance, insurance,
and property taxes.
2
Types of Leases
Operating lease
short-term
 may be cancelable

Financial lease
long-term
 similar to a loan agreement

3
Types of Lease Financing
Direct leases
Sale-and-lease-back agreements
Leveraged leases
4
Direct Lease
Lessee
Manufacturer
/ Lessor
Lease
or
Lessee
Lease
Lessor
Sale of Asset
Manufacturer
/ Lessor
5
Sale-and-Lease-Back
Sale of Asset
Lessor
Lessee
Lease
6
Leveraged Lease
Manufacturer
Sale of Asset
Lessee
Lease
Single
Purpose
Leasing
Company
Lien
Lender
Loan
Equity
Equity
Investor
7
Synthetic Leases
Firms have used synthetic leases to get the
use of assets but keep debt off their balance
sheets.
An unrelated financial institution invests
some equity and sets up a special-purposeentity that buys the assets and leases it to
the firm under an operating lease.
Since the Enron bankruptcy, firms have
been reluctant to use synthetic leases.
8
Enron’s Murky Deals
Enron provided some or
all of the 3%.
Enron used outside
partnerships to move assets
off its balance sheet and
monetize assets. But the
company was deeply
involved with funding
those partnerships.
Enron
3
1
Enron sells assets, gets
debt off the balance
sheet and recognizes a
gain on the sale.
5
Enron guarantees the loan.
Sometimes with nowworthless Enron shares.
2
Partnership
or Special
Purpose
Entity
4
Outside investors inject
at least 3% of the
funding so that Enron
doesn’t have to claim it
as a subsidiary.
Equity
Investor
Banks provided the
other 97% of the
financing.
Lending
Group
9
Enron’s Partnerships
Reasons for setting up SPEs:
 By
setting up partnerships, partly owned by
the company, Enron could draw in capital
from outside investors.
 If structured properly (the tax code requires
that at least 3% of the partnership equity be
obtained from outside investors), the
partnerships could also be kept separate from
Enron.
10
Enron’s Partnerships
As a result, any debt incurred by the
partnership could be kept off the company's
balance sheet.
As an added bonus, Enron often recognized
a gain on the sale of the assets.
11
Why did Enron want debt off their
balance sheet?
The simple answer is that Enron feared that
too much debt would damage its credit
rating.
12
Why did Enron want debt off their
balance sheet?
A more complex answer lies with agency costs.
Enron executives headed and partly owned
some of the partnerships, which provided a huge
source of outside income for those involved.

Enron’s former CFO, Andrew Fastow, made more
than $30 million from two partnerships that he ran.
If you were a shareholder in a SPE buying an
asset from your employer, where would your
loyalties lie?
13
How Widespread Was This at Enron?
There were hundreds, and perhaps even
thousands, of these partnerships.
The exact number isn't known.
In all, Enron had about 3,500 subsidiaries
and affiliates, many of them limited
partnerships and limited-liability
companies, which are a sort of hybrid
between corporations and partnerships.
14
How Did They Get Away With It?
The company and its board of directors
claimed that allowing executives to be
involved with the outside partnerships gave
it the advantage of speed.
Enron claimed that it set up safeguards to
protect itself, but in retrospect they were
clearly inadequate.
15
Advantages of Leases
Efficient use of tax deductions and tax credits of
ownership
Reduced risk
Reduced cost of borrowing
Bankruptcy considerations
Tapping new sources of funds
Circumventing restrictions


debt covenants
off-balance sheet financing
16
Disadvantages of Leasing
Lessee forfeits tax deductions associated
with asset ownership.
Lessee usually forgoes residual asset value.
17
Valuing Financial Leases
Basic approach is similar to debt refunding.
Lease displaces debt.
Missed lease payments can result in the lessor



claiming the asset.
filing lawsuits.
forcing firm into bankruptcy.
Risk of a firm’s lease payments are similar to
those of its interest and principal payments.
18
Equivalent Ways to Analyze
Net Advantage to Leasing (NAL) approach:

Lease if
NAL > 0.
The Internal Rate of Return (IRR) approach:

Lease if
IRR of leasing < after-tax cost of debt
financing.
19
Leases Analysis Example
The Emerson Co. needs the use of a special
purpose stamping machine for the next 10
years.
The machine costs $6 million, has a life of
10 years, and a salvage value of $300,000.
Emerson can lease this machine from the
General Supply Co. for 10 years, with annual
year-end lease payments of $1.05 million.
Emerson’s tax rate is 40%.
20
Leases Analysis Example
If Emerson were to buy the machine, it
would finance 80% of the purchase price with
a 11.5% secured installment loan, with the
remainder being borrowed as unsecured
installment debt at 14% interest.
The after-tax required return on the asset is
15%.
Evaluate this leasing opportunity.
21
Leasing Displaces Borrowing
Suppose initially that the Emerson Co. has net
assets worth $50 million, and a debt ratio of
50%. Compute the debt ratio if Emerson uses:


Conventional financing for the stamping
machine.
Leases the stamping machine. How
would the target debt ratio be restored?
22
Leasing Displaces Borrowing
Conventional Debt
Financial Lease
Obligation
Total Debt
Equity
Total
Debt Ratio
Initial
Capitalization
$ 25 M
$0M
$25 M
$25 M
$50 M
50%
23
Leasing Displaces Borrowing
Conventional Debt
Financial Lease
Obligation
Total Debt
Equity
Total
Debt Ratio
Conventional
Financing
$ 28 M
$0M
$25 M
$28 M
$56 M
50%
24
Leasing Displaces Borrowing
Conventional Debt
Financial Lease
Obligation
Total Debt
Equity
Total
Debt Ratio
Lease
Financing
$ 25 M
$6M
$ 31 M
$25 M
$56 M
5 5.36%
25
Leasing Displaces Borrowing
Conventional Debt
Financial Lease
Obligation
Total Debt
Equity
Total
Debt Ratio
Debt Ratio
Restored
$ 22 M
$6M
$28 M
$28 M
$56 M
50%
26
Analyzing Leases
The Net Advantage to Leasing (NAL)
equals the purchase price (P) minus the
present value of the incremental after-tax
cash flows (CFAT) associated with the
lease.
NAL = P – PV(CFATs)
27
Analyzing Leases - the Discount
Rate
The discount rate should be the lessee’s after-tax
cost of similarly secured debt.
Since the lease obligation is not overcollateralized,
the secured debt rate should reflect this.
Fully secured means the asset is worth more than
25% of the loan.

$80M loan on $100M asset: $20/$80 = 25%
Use weighted average of secured and unsecured
debt rates if necessary.
28
Analyzing Leases - the Cash Flows
Cost of asset (saving)
Lease payments (cost)
Incremental differences in operating and
other expenses (cost or savings)
Depreciation tax shelter (foregone benefit)
Expected net residual value (foregone
benefit)
Investment tax credits (foregone benefit)
29
Net Advantage to Leasing
Dt = year t depreciation deduction
DEt = year t cash expense savings from leasing
ITC = investment tax credit, if available
CFt = lease payment in year t
N = life of lease (in years)
P = purchase price of asset
r = asset’s after-tax required return
r′ = cost of debt (secured & unsecured)
Salvage = net salvage value
T = lessee’s marginal income tax rate
(1  T )(CFt  DEt )  TDt Salvage
NAL  P  ITC  

' t
(1  (1  T )r )
(1  r ) N
t 1
N
Net Advantage to Leasing
(1  T )(CFt  DEt )  TDt Salvage
NAL  P  ITC  

' t
N
(1  (1  T )r )
(1  r )
t 1
N
We save paying the purchase price P.
We lose the ITC and salvage value.
We pay the lease payment CF; this may be partly
offset by savings on operating and other cash
expenses (E) and by tax deductibility.
We lose the depreciation tax shield TD.
Discount main cash flows at the after-tax cost of
debt.
Net Advantage to Leasing
For the Emerson Co.,
P = $6 million
 CFt = $1.05 million per year for 10 years
 Dt = ($6,000,000 - $300,000) / 10 = $570,000
per year for 10 years

 DEt
= 0, ITC = 0
 r = 15%
 r′ = 80%(11.5%) + 20%(14%) = 12.0%
32
Net Advantage to Leasing
(1  T )(CFt  DEt )  TDt Salvage
NAL  P  ITC  

' t
N
(1

(1

T
)
r
)
(1

r
)
t 1
N
(1  .40)($1.05m)  0.4  $570,000 $300,000
NAL  $6m  

t
10
(
1

(
1

0
.
40
)

0
.
12
)
(
1
.
15
)
t 1
10
NAL  $45,068
33
The IRR Approach
For Emerson’s leasing opportunity, the IRR
is 7.58%.
The after-tax cost of debt financing is
12%×(1– 0.40) = 7.20%.
Since the IRR (the cost of lease financing)
is greater than the after-tax cost of debt
financing, Emerson should not lease the
machine.
34
Break-Even Lease Payments
The break-even lease payments can be
computed by setting the NAL to zero.
In the case of Emerson’s lease, the annual
break-even payments are $1,039,206.

Since the lease contract calls for payments of
$1,050,000; the leasing alternative is not
preferred.
35
NPV of Lease to the Lessor
In a perfect market with no tax, leasing is a
zero-sum game.

The NPV of the lease to the lessor will be
- (NAL to the lessee).
If lessee and lessor have the same marginal
income tax rates, leasing is still a zero sum
game in an otherwise perfect market.
36
NPV of Lease to the Lessor
(1  T ' )(CFt  DEt )  T ' Dt Salvage
  P  ITC  

'
' t
N
(1

(1

T
)
r
)
(1

r
)
t 1
N
NALLessor
where T′ = lessor’s marginal income tax rate.
37
NPV of Lease to the Lessor
(1  T ' )(CFt  DEt )  T ' Dt Salvage
  P  ITC  

'
' t
N
(1

(1

T
)
r
)
(1

r
)
t 1
N
NALLessor
(1  .40)($1.05m)  0.4  $570,000 $300,000
NALLessor  $6m  

t
10
(
1

(
1

0
.
40
)

0
.
12
)
(
1
.
15
)
t 1
10
NALLessor  $45,068
38
Effect of Tax Asymmetries
Suppose lessee’s (Emerson’s) tax rate is
zero. Also assume that the before-tax
required return on the asset for the lessee is
17.50%.
The NAL to Emerson is then $7,460.
The NPV to the lessor is still $45,068.
Thus, both parties gain from the leasing
arrangement.
39
Tax Treatment of Financial Leases
IRS has guidelines for distinguishing
between true leases and
installment sales agreements.
 secured loans.

If lessor meets these guidelines:
lessor can claim tax deductions and credits of
asset ownership.
 lessee can deduct full amount of lease payment
for tax purposes.

40
IRS Guidelines for Financial
Leases
Term of lease < 80% of asset’s useful life.
Lessor must maintain an equity investment of
at least 10% of asset’s original cost.
Exercise price of the purchase option must
equal the asset’s fair market value at the time
the option is exercised.
Lessee does not pay any portion of the asset’s
purchase price.
Lessor must hold title to the property.
41
Accounting Treatment of Financial
Leases
SFAS 13 requires lessees to capitalize all leases
that meet any one of the following:
Lease transfers ownership of asset to lessee before
the lease expires.
 Lessee has option to purchase asset at a bargain
price.
 Term of lease is greater than or equal to 75% of
assets useful economic life.
 PV of lease payments is ≥ 90% of asset value.

42
Project Financing
Desirable when
Project can stand alone as an economic unit.
 Project will generate enough revenue (net of
operating costs) to service project debt.

Examples:
Mines & mineral processing facilities
 Pipelines
 Oil refineries
 Paper mills

43
Project Financing Arrangements
Completion undertaking
Purchase, throughput, or tolling agreements
Cash deficiency agreements
44
Advantages and Disadvantages of
Project Financing
Advantages
Risk sharing
 Expanded debt capacity
 Lower cost of debt

Disadvantages
Significant transaction costs and legal fees
 Complex contractual agreements
 Lenders require a higher yield premium

45
Limited Partnership Financing
Another form of tax-oriented financing.
Allows the firm to “sell” the tax deductions
and credits associated with asset ownership
to the limited partners.
Income (or loss) for tax purposes flows
through to the partners.
Limited partners are passive investors.
General partner operates the limited
partnership and has unlimited liability.
46