LEASING
A rental agreement lasting one year or more
Periodic (e.g., monthly, quarterly, etc)payments
Payments usually level, but could change over
life of lease
Substitute for asset ownership
What are the benefits of ownership?
When would you be willing to give these up?
LEASE TYPES
Operating leases
short-term
cancelable at option of lessee prior to end of
lease term
Financial leases
long-term (typically covers most of asset’s
useful life)
typically non-cancelable
POSSIBLE LEASING ADVANTAGES
More efficient use of tax advantages of
ownership
e.g., an owner with no taxable income can’t
use depreciation tax shields
Risk shifting
more applicable to operating leases
Lower-cost financing
Creditors have a better claim on the asset
POSSIBLE DISADVANTAGES
Loss of tax deductions associated with
ownership
Loss of residual asset value
If the advantages to some potential lessees
are disadvantages to others, who should
lease asset?
LESSEE CASH FLOWS
Benefits
Purchase price of
machine (opportunity
cost benefit)
Maintenance or other
costs paid by lessor
Note that business
revenues and
expenses are same
whether we lease or
buy
Costs
Stream of after-tax
lease payments
Stream of
depreciation tax
shields (forgone opportunity cost)
Future after-tax
salvage value
(forgone opportunity cost)
EXAMPLE
Machinery cost: 40 mil
Lease payment: 12 mil per year, payable at
end of year for next four years
Depreciation: 10 mil per year for four years
Tax rate = .40
Salvage value = 2 mil
rD= 8%; WACC = 12%
EXAMPLE CASH FLOWS
Year
0
1
2
3
4
Initial Outlay
+40
A.T. Lease Pmts
-7.2
-7.2
-7.2
-7.2
Dep. Tax Shields
-4
-4
-4
-4
A.T. Salvage
Net Cash Flow
-1.2
+40
-11.2
-11.2
-11.2
-12.4
DISCOUNT RATE
After-tax lease
payments and
depreciation tax
shields: These are safe
and would support
100% of value in debt
- discount at after-tax
cost of debt
After-tax salvage
value: This is riskier
and more like other
company activities discount at WACC
NET ADVANTAGE TO LEASING
P.V. of four-year annuity of -11.2 per year
@ 8(1-.4) = 4.8% = -39.9 mil
P.V. of -1.2 mil 4 years from now at 12% =
-1.2/(1.12)4 = -.763 mil
NPV = +40 - 39.9 - .763 = -.662 mil
Buying better than leasing in this case
ADDITIONAL POINTS
Buying may be better than leasing, or vice
versa, but make sure that one of them is
worthwhile
To compute break-even lease payment, set
NPV = 0 and solve for payment
If company is not in a tax-paying position,
use pre-tax cash flows and pre-tax discount
rate
PROJECT FINANCING
Separate a project from the rest of the
company and finance it separately
Example: Problem 3, Problem Set #2
(RCI’s new project)
Rationale: project financing controls the
underinvestment problem
Other examples: coal mines, oil fields, oil
and gas pipelines
FEATURES SOMETIMES FOUND
IN PROJECT FINANCING
Completion undertaking
guarantee project completion or minimum
performance by a certain date or repay debt
helps control asset substitution
Purchase or throughput agreements
guarantee that project output will be purchased
or at least put through pipeline
partial lender control over project cash flows
COMMON THREADS
IN PROJECT FINANCING
Large-scale project with identifiable assets
and cash flows
Protect project from other creditors
Project cash flows are predictable, or can
be protected against certain risks
Higher debt ratio as a result of guarantees
or improved lender oversight
LIMITED PARTNERSHIP FINANCING
Project is again separated from rest of
company
Example: Genzyme’s RDLP
Gain: Proceeds from selling partnership
shares plus savings in taxes
Cost: Portion of cash flows plus portion of
salvage value allocated to limited partners