Contemporary Financial Management Chapter 19: Leasing © 2004 by Nelson, a division of Thomson Canada Limited Introduction This chapter explores the reasons a firm might choose to lease rather than borrow and buy some of their assets. It examines the type of analysis that should go into a lease versus borrow-and-purchase decision to maximize shareholder wealth. It examines the costs and benefits to leasing companies offering this type of financing. 2 © 2004 by Nelson, a division of Thomson Canada Limited Concept of a Lease A lease is a contractual arrangement between two parties: The Lessor – the owner of the asset, who agrees to allow the lessee to use the asset for a period of time, in return for a fixed payment The Lessee – the user of the asset, who agrees to pay the Lessor for the use of the asset 3 © 2004 by Nelson, a division of Thomson Canada Limited Concept of a Lease Leases are most effective when done between a high marginal tax lessor and a low marginal tax lessee. The lessee passes to the lessor tax deductions that the lessee cannot use. In return, the lessor passes some of the benefit back to the lessee in the form of lower lease payments. 4 © 2004 by Nelson, a division of Thomson Canada Limited Lease Contract Leases An alternative to term financing A mechanism to transfer tax benefits Lessee Obtains use of an asset For a specific period of time In return for a series of payments to the lessor 5 © 2004 by Nelson, a division of Thomson Canada Limited Types of Leases Operating Lease Sometimes called service or maintenance leases Term of the lease is less than the economic life of the asset Usually cancelable by the lessee Lessor maintains and services the asset Lessor pays any tax and insurance 6 © 2004 by Nelson, a division of Thomson Canada Limited Types of Leases Financial Lease Sometimes called a capital lease Initial term usually equal to the expected economic life of the asset Not cancelable by the lessee Lessee responsible for maintenance, insurance and property taxes May originate as a: • Direct lease • Sale and leaseback 7 © 2004 by Nelson, a division of Thomson Canada Limited Direct Lease The lessee acquires the use of an asset it does not own. The lessor may be the manufacturer or a financial institution. If the lessor is a financial institution (F.I.), the lessee provides all specifications to the F.I., which then purchases the asset and leases it to the lessee. 8 © 2004 by Nelson, a division of Thomson Canada Limited Sale and Leaseback A firm sells an asset to a lessor and immediately enters into an agreement to lease it back. Benefits to the lessee include: Cash from the sale can be invested in other assets. The lessee continues to use the asset, even though it is now owned by somebody else. May be able to record a “gain on sale” if the asset is sold at greater than its book value. 9 © 2004 by Nelson, a division of Thomson Canada Limited Types of Leases Leveraged Lease Three-party lease involving a lessee, a lessor and a financial institution (F.I.) or lender. The lessor and the F.I. jointly provide the funds required to purchase the asset. All other terms are similar to a financial lease. 10 © 2004 by Nelson, a division of Thomson Canada Limited Advantages to Leasing Flexible – fewer restrictive covenants Convenient Source of financing to the risky firm (since ownership remains with the lessor) May avoid some risk of obsolescence Smoother earnings and earnings per share 100% financing (but lease payments usually occur at the beginning of the period) Enhance liquidity (sale & leaseback) 11 © 2004 by Nelson, a division of Thomson Canada Limited Disadvantages to Leasing May be more expensive than borrowing Lessor retains the salvage value May be difficult to obtain approval for modifications Often subject to a cancellation penalty 12 © 2004 by Nelson, a division of Thomson Canada Limited Tax Considerations Annual lease payments are tax deductible for the lessee if the CRA (Canada Revenue Agency) agrees that the contract is truly a lease and not just an installment loan called a lease. Reasons why CRA might disallow a lease Lessee has the right to acquire the asset at less than fair market value Lessee required to buy the asset at the end of the lease Lessee automatically obtains ownership at the end of the lease 13 © 2004 by Nelson, a division of Thomson Canada Limited Leases and Accounting Practices Canadian accounting standards are contained in the CICA handbook. Firms are normally required to capitalize financial leases. The capitalized value of a lease is equal to: Present value of the lease payments Discounted at the firm’s borrowing rate for a secured loan with similar maturity Details must be disclosed in the Notes. 14 © 2004 by Nelson, a division of Thomson Canada Limited Notes to the Financial Statements For Financial Leases, the Notes must contain, as of the date of the Balance Sheet: Gross amount of assets leased by asset class Amount of accumulated lease amortization Future minimum lease payments in total for each of the next five fiscal years 15 © 2004 by Nelson, a division of Thomson Canada Limited Small Firms Reasons for leasing Less cash required upfront Better protection against obsolescence Quicker approvals Fewer restrictive covenants Expensive reasons High interest cost Loss of tax benefits 16 © 2004 by Nelson, a division of Thomson Canada Limited Lease Versus Buy Analysis Compare the incremental cost or benefit of leasing versus borrowing and buying the asset. The Net Advantage to Leasing (NAL) compares: Present Value Cost of Leasing 17 against © 2004 by Nelson, a division of Thomson Canada Limited Present Value Cost of Owning Net Advantage to Leasing Calculation 1. Installed cost of the asset Less 2. Present value of lease payments Plus 3. Present value of tax shield from lease payments Less 4. Present value of tax shield due to CCA Plus 5. Present value of operating costs incurred due to ownership Less 6. Present value of salvage Plus 7. Present value of the tax shield due to CCA that is lost due to salvage 8. Net advantage to leasing 18 © 2004 by Nelson, a division of Thomson Canada Limited Lease Versus Buy Example A company is deciding whether to lease or buy a new truck. The truck can be purchased for $50,000 or leased for a 6-year period for $10,000/year (due at the beginning of each year). The firm can borrow at 10%. If purchased, the firm will incur insurance and maintenance costs of $750 per year. The truck has a CCA rate of 30%. Salvage value in six years is expected to be $2,000. The firm’s marginal tax rate is 40% and its after-tax cost of capital is 15%. 19 © 2004 by Nelson, a division of Thomson Canada Limited Lease Versus Buy: Solution Calculate the firm’s after-tax cost of debt, which will be used as the discount rate. k Debt After-tax k Debt PreTax 1 T 0.10 1 0.4 6% 20 © 2004 by Nelson, a division of Thomson Canada Limited Lease Versus Buy: Solution Step 1: Determined installed cost of the asset Given as $50,000 Step 2: Calculation present value of lease payments 1 - 1 + k -n 1 + k PVLease = C k Payments 1 1.06 6 1.06 $52,123.64 10, 000 0.06 21 © 2004 by Nelson, a division of Thomson Canada Limited Lease Versus Buy: Solution Step 3: Determine present value of tax shield due to lease payments 1 - 1 + k -n PVTax Shield = C T k Due to Lease Payments 1 1.06 6 10, 000 0.40 0.06 $19, 669.29 22 © 2004 by Nelson, a division of Thomson Canada Limited Lease Versus Buy: Solution Step 4: Determine present value of tax shield due to CCA PVTax Shield Due to CCA dT 1 + 0.5k = UCC d + k 1 + k 0.30 0.40 1.03 50, 000 0.30 0.06 1.06 $16,194.97 23 © 2004 by Nelson, a division of Thomson Canada Limited Lease Versus Buy: Solution Step 5: Determine present value of operating costs PVOperating Costs 24 1 - 1 + k -n = Annual Cost 1 - T k 1 1.06 6 750 1 0.4 .06 $2,212.80 © 2004 by Nelson, a division of Thomson Canada Limited Lease Versus Buy: Solution Step 6: Determine present value of salvage PVSalvage = Salvage 1 + k n 2, 000 1.06 6 $1, 409.92 25 © 2004 by Nelson, a division of Thomson Canada Limited Lease Versus Buy: Solution Step 7: Determine present value of CCA tax shield lost due to salvage dT = Salvage Tax d + k Shield Lost Due to Salvage PVCCA 0.30 0.40 2, 000 0.30 0.06 $470 26 © 2004 by Nelson, a division of Thomson Canada Limited Lease Versus Buy: Solution Step 8: Calculate net advantage to leasing 27 Step Step Step Step Step Step Step 1: 2: 3: 4: 5: 6: 7: $50,000.00 ($52,123.64) $19,660.29 ($16,194.97) $2,212.80 ($1,409.92) $470.00 $2,623.56 © 2004 by Nelson, a division of Thomson Canada Limited The net advantage to leasing is $2,623.56, based on the set of assumptions provided. This would change if any of assumptions are changed. Major Points Leasing is an alternative to borrowing and purchasing an asset. Leasing is most effective when the lessor has a high marginal tax rate and the lessee has a low marginal tax rate. Leasing may also be advantageous for small, riskier firms that would otherwise have a hard time acquiring the assets they need. Leasing is not cost free and it should only be done after a complete analysis of the costs and benefits. 28 © 2004 by Nelson, a division of Thomson Canada Limited