CHAPTER 22: Leasing
Topics:
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•
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22.1 Types of Leases
22.2 Accounting and leasing
22.4 The Cash Flows of Operating Leasing
22.6 NPV Analysis of the Lease-versus-Buy Decision
22.8 Does Leasing Ever Pay: The Base Case
22.9 Reasons for Leasing
(This illustration contains a minor correction of your text. Section
22.4 should be operating lease rather than financial lease.)
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22.1 Types of Leases
• The Basics
– A lease is a contractual agreement between a lessee and lessor.
– The agreement establishes that the lessee has the right to use
an asset and in return must make periodic payments to the
lessor.
– The lessor is either the asset’s manufacturer or an independent
leasing company.
• Two types:
– Operating lease
– Financial lease
• Sale and lease-back
• Leverage lease
2
Buying versus Leasing
Buy
Lease
Firm U buys asset and uses asset;
financed by debt and equity.
Lessor buys asset, Firm U leases it.
Manufacturer
of asset
Manufacturer
of asset
Firm U
1.
2.
Lessor
Uses asset
Owns asset
Equity
shareholders
Creditors
1.
Owns asset
2. Does not use asset
Equity
shareholders
Lessee (Firm U)
1.
Uses asset
2. Does not own asset
Creditors
3
Operating Leases
• Usually not fully amortized. This means that the
payments required under the terms of the lease are
not enough to recover the full cost of the asset for
the lessor.
• Usually require the lessor to maintain and insure the
asset.
• Lessee usually enjoys a cancellation option. This
option gives the lessee the right to cancel the lease
contract before the expiration date.
4
Financial Leases
•
•
Most commonly referred to as “Capital lease”
The opposite of an operating lease.
1.
2.
3.
4.
Do not provide for maintenance or service by the lessor.
Generally fully amortized
The lessee usually has a right to renew the lease at expiry.
Generally, financial leases cannot be cancelled, i.e., the
lessee must make all payments or face the risk of
bankruptcy.
5
Sale and Lease-Back (Read by your own)
• A particular type of financial lease.
• Occurs when a company sells an asset it already
owns to another firm and immediately leases it from
them.
• Two sets of cash flows occur:
– The lessee receives cash today from the sale.
– The lessee agrees to make periodic lease payments, thereby
retaining the use of the asset.
• Example: Sell you IT assets to HP Financial Services and
lease them back.
– You can easily adapt to future needs down the road.
6
Leveraged Leases
• A leveraged lease is another type of financial lease.
• A three-sided arrangement between the lessee, the
lessor, and lenders.
– The lessor owns the asset and for a fee allows the lessee to use
the asset.
– The lessor borrows to partially finance the asset.
– The lenders typically use a nonrecourse loan. This means that
the lessor is not obligated to the lender in case of a default by
the lessee.
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Leveraged Leases
Lessor buys asset, Firm U leases it.
Manufacturer
of asset
Lessor
1.
Owns asset
2. Does not use asset
Equity
shareholders
Lessee (Firm U)
1.
Uses asset
2. Does not own asset
Creditors
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22.2 Accounting: Financial (Capital) Lease
• The accounting treatment of leasing follows CICA 3065
• A lease must be capitalized (balance sheet disclosure) if any one of the
following four criteria is met (CICA or GAAP):
– The present value of the lease payments is at least 90-percent of the fair
market value of the asset at the start of the lease.
– The lease transfers ownership of the property to the lessee by the end of the
term of the lease.
– The lease term is 75-percent or more of the estimated economic life of the
asset.
– The lessee can buy the asset at a bargain price at expiry.
• Both CRA and IRS will treat a capitalized lease as sales for tax
purposes.
– Lessor records leasing as installment sales;
– Lessee records leasing on balance sheet and take depreciation on assets.
– Please refer to the attached CRA or IRS regulations for further illustration.
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22.4 The Cash Flows of (Operating) Leasing
• Capital leasing is (generally) no different from sales.
– Same budgeting process as sales
– Lessor: asset sale
– Lessee: asset on balance sheet, dep. tax shield
• Operating leasing
– Lessor: asset on balance-sheet
• takes depreciation and enjoys tax-deduction of
depreciation
– Lessee: Off-balance-sheet
• lease payment tax-deductible
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Incremental cashflow approach to lease:
An example
Zee Movers needs to acquire 50 more cars. Each car will
generate $12,000 per year in added sales for the next five
years. The firm has a corporate tax rate of 40%. The car
would qualify for a CCA (cost of capital allowance) rate of
40% (rental car). There is no residual value of the car after
five years. Assume that this is an operating lease.
Two options:
(1) Each car can be purchased at a wholesale price of 20,000.
(2) Each car can be leased through an operating leasing with Tiger
Leasing at a payment of $5,000 each year for five years (payable
at the beginning of each year). Suppose that all the conditions for
operating lease are met.
Buy or lease?
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Example cont’d: Tax shield on CCA for car
Year
UCC
CCA1
Tax Shield4
0
1
$1,600
2
2,560
3
9,600
3,840
1,536
4
5,760
2,304
922
5
3,456
1,382
553
Residual at yr 5
2,074
829.6
12
Cont’d: Incremental cashflows of leasing compared with
buying
•
If the cars are leased, then:
1.
•
Lease payment of 5,000 each year. Tax-deductible expenses.
• Lease payment shield = lease payment * tax rate
If buy, then:
1.
2.
3.
Ownership—Depreciate for tax purposes.
Cash outlay of 20,000 at time 0.
Tax deduction due to residual value loss.
Note: The added sales of 12,000 each car apply to both leasing and buying,
so the incremental cashflow of added sales for leasing is zero.
•
Timing of cashflow: (a bit different from the text)
–
–
Lease rental payment happens in advance
Depreciation happens in arrears
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Cont’d: Incremental Cashflows: Lease minus buy
Year
0
1
2
3
4
-3000
-3000
-3000
-3000
2560
1536
921.6
5
After-tax cash flows from leasing
(1) AT lease payment
-3000
After-tax cashflows from buying the asset
Asset cost
-20,000
Dep. tax shield
1600
Residual tax shield
(2) Net cash from buying
552.8
829.6
-20,000
1600
2560
1536
921.6
1,382
-4600
-5560
-4536
-3922
-1382
Differential cashflow
(3) Lease minus buy
17,000
Note: (3) = (1) – (2)
14
Cont’d: Incremental cashflows—Textbook method
• Same cashflow, but view things from the aggregate of (leasebuy):
– Lease: Lease payment (outflow) + lease payment tax shield
(inflow)
– Effects of “Minus Buy”: Save on initial purchase price
(inflow), but bypass depreciation tax shields (outflow).
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22.6 NPV Analysis of the Lease-vs.-Buy Decision
•
•
•
Lease payment is like interest payment!—Cashflows are
deterministic once the lease contract is entered into.
A lease payment is like the debt service on a secured bond
issued by the lessee. A lessee incurs a liability equal to the
present value of all future lease payments. (Lease displaces
debt—“Debt displacement”)
In practice, many companies discount both the depreciation
tax shields and the lease payments at the after-tax interest
rate on secured debt issued by the lessee.
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Example cont’d: NPV of leasing
Assume that Zee can either borrow or lend at 11% interest rate.
What is the NPV of the lease?
AT discount rate =
NPV = 17,000– 4,600/1.066 – 5,560 /1.0662 – 4,536 /1.0663 3,922/1.0664-1382/1.0665
= 6.21
• Lease or buy?
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What if there is economic residual value left?
• To make it compatible with laws, the lease needs to be an
operating lease. One way is to specify sufficiently high residual
value. Let’s suppose 5 years later, the cars are returned to Tiger
Leasing with a residual guarantee value of 15%, which is also the
residual economic value. Everything else remains the same.
What’s your answer now?
– CF to lease won’t change.
– Changes in CF to buy:
• If you buy, 5 years later you dispose of (sell) the asset for 15%
of purchase price.
• You realize some proceeds;
• You pay (deduct) taxes if there is capital gains (loss) in asset
disposal. (Depreciation Recapture when terminating the pool.)
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Cont’d: Add residual guarantee to valuation
Year
0
Depreciation schedule
1
2
3
4
5
4000
6400
3840
2304
1382
Residual book
2074
Residual guarantee (1)
After-tax cashflows from buying the asset
Asset cost
-20,000
Depreciation tax shield
1600
2560
1536
921.6
552.8
1,600
2,560
1,536
922
3,182
AT Residual cashflow (2)
Net cash from buying
-20,000
Notes: (1) Residual guarantee =
(2) AT Residual cashflow =
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Cont’d: Solution
After-tax rental payment
-3000
-3000
-3000
-3000
-3000
Net cash from buying
-20000
1600
2560
1536
922
3182
Lease minus buy
17000
-4600
-5560
-4536
-3922
-3182
NPV
-1301
IRR
9.60%
Decision?
Please refer to the spreadsheet in the course webpage.
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22.8 Does Leasing Ever Pay: The Base Case
• Cashflow to Tiger Leasing (the lessor) is just the opposite of that to
Zee Movers (the lessee) in the leasing:
• Lease minus sell (for the case of no residual value)
Year
Negative of Asset sale
AT lease income
0
1
2
3
4
3000
3000
3000
3000
1600
2560
1536
921.6 552.8
-20,000
3000
Dep. tax shield
Residual tax shield
Net CF
5
829.6
-17,000
4600
5560
4536
3922
1382
NPV: Same tax rate and same discount rate: -6.21!
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A zero-sum game for lessee and lessor if
• Both are at the same corporate tax bracket
• Both borrow and lend at the same rate
• No transaction costs
 No leasing would ever occur!
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22.9 Reasons for Leasing
• Taxes may be reduced by leasing in operating leasing.
– The principal benefit of long-term leasing is tax reduction.
– Leasing allows the transfer of tax benefits from those (lessee)
who need equipment but cannot take full advantage of the tax
benefits of ownership to a party (lessor) who can.
• The lease contract may reduce certain types of uncertainty
(the residual value risk at the end of the contract is borne by
the lessor, and it may be in a better position to bear this risk)
• Transactions costs can be higher for buying an asset and
financing it with debt or equity than for leasing the asset.
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An Illustration of Benefit of Tax Reduction: Tax Arbitrage
Back to the example where there’s no economic residual.
Suppose Zee (the LESSEE) is still in the 40% tax bracket, but Tiger
Leasing (the LESSOR) is in the 30% tax bracket instead. Can
leasing happen in this case? (i.e., Can both firms have a positive
NPV?)
• What’s changed?
– For Lessee, nothing is changed: same tax rate, same interest rate,
same payment Same incremental cashflow in Lease vs. buy
decision. + NPV.
– For Lessor’s Lease vs. sell decision, after-tax cashflow is now
changed
• AT lease income
• Depreciation and residual tax shield
• AT discount rate as well!
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Tax arb. cont’d: Lease vs. sell (no residual guarantee)
Year
0
Depreciation
1
2
3
4
5
4000
6400
3840
2304
1,382
Residual
2,074
After-tax cash flows from leasing
After-tax rental income
3500
Depreciation tax shield
3500
3500
3500
3500
1200
1920
1152
691
Residual tax shield
622
Net cash from leasing
3,500
Selling Asset proceeds
20,000
Diff: Lease minus sell
-16,500
NPV
415
4,700
5,420
4,652
4,191
1,037
4,700
5,420
4,652
4,191
1,037
$91.16
Notes: 1. Depreciation tax shield and lease payment is now
calculated at tax rate of 30%.
2. Discount rate for NPV is:
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Tax arb. cont’d: Reservations and Negotiations
• What is the smallest lease payment that Lessor (Tiger Leasing)
will accept? Set their NPV to zero (break-even) and solve for the
payment.
• What is the highest lease payment that Lessee (Zee Movers) can
pay? Set their NPV to zero (break-even) and solve for the
payment.
• As long as the highest payment from the lessee is larger than the
smallest payment for the lessor, it is feasible to lease.
– Feasible lease payment: [lessor’s smallest lease payment, lessee’s
largest lease payment]
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Derivation of reservation payment: Lessee
Three components:
• PV of Depreciation (and residual loss) Tax Shield
• PV of AT lease payment—Annuity (in advance)
• Equipment cost at time 0
Set 3 – 2 – 1 = 0. (Answer: $5002)
For Zee Movers:
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Cont’d
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Derivation of reservation payment: Lessor
Three components:
1. PV of Depreciation (and, if any, residual loss) Tax Shield
2. PV of AT lease payment—Annuity (in advance)
3. Equipment proceeds at time 0
Set 1+2 -3 = 0.
•
Repeat the same exercise for Tiger Leasing.
–
–
–
Note that tax rate, and hence AT discount rate, are different.
Answer: $4970.
Lease will happen with a lease payment in [4970, 5002].
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Review Questions
• How would you evaluate a capital lease through incremental
cashflow approach? Give the incremental cashflow from the
perspective of lease vs. buy.
• Assigned problems: #22. 1, 2-6, 8, 11 (Assume operating
leasing for incremental cashflow analysis.)
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