Chapter Twenty-Two Leasing Prepared by Anne Inglis, Ryerson University © 2003 The McGraw-Hill Companies, Inc. All rights reserved. 22.1 Key Concepts and Skills • Understand the basic lease terminology • Understand the criteria for a capital lease vs. an operating lease • Understand the typical incremental cash flows to leasing • Be able to compute the net advantage to leasing • Understand the good reasons for leasing and the dubious reasons for leasing Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 22.2 Chapter Outline • Leases and Lease Types • Accounting and Leasing • Taxes, Canada Customs and Revenue Agency (CCRA), and Leases • The Cash Flows from Leasing • Lease or Buy? • A Leasing Paradox • Reasons for Leasing Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 22.3 Lease Terminology 22.1 • Lease – contractual agreement for use of an asset in return for a series of payments • Lessee – user of an asset; makes payments • Lessor – owner of the asset; receives payments • Direct lease – lessor is the manufacturer • Captive finance company – subsidiaries that lease products for the manufacturer Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 22.4 Figure 22.1 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 22.5 Types of Leases • Operating lease – Shorter-term lease – Lessor is responsible for insurance, taxes and maintenance – Often cancelable • Financial lease (capital lease) – – – – Longer-term lease Lessee is responsible for insurance, taxes and maintenance Generally not cancelable Specific capital leases • Tax-oriented • Leveraged • Sale and leaseback Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 22.6 Lease Accounting 22.2 • Leases are governed by CICA 3065 • Financial leases are essentially treated as debt financing – Present value of lease payments must be included on the balance sheet as a liability – Same amount shown on the left side of the balance sheet • Operating leases are still “off-balance-sheet” and do not have any impact on the balance sheet itself Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 22.7 Criteria for a Capital Lease • If one of the following criteria is met, then the lease is considered a capital lease and must be shown on the balance sheet – Lease transfers ownership by the end of the lease term – Lessee can purchase asset at below market price – Lease term is for 75 percent or more of the life of the asset – Present value of lease payments is at least 90 percent of the fair market value at the start of the lease Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 22.8 Taxes 22.3 • Lessee can deduct lease payments for income tax purposes under specific circumstances – Lease must be primarily for business purposes and not just to avoid taxes – Does not apply to conditional sales agreements – Lessee cannot automatically acquire title of the property after payment of a specified amount in the form of rentals – Lessee cannot be required to buy the property during or at the termination of the lease – Lessee cannot have the right during or at the expiration of the lease to acquire the property at a price less than fair market value Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 22.9 Incremental Cash Flows 22.4 • After-tax lease payment (outflow) – Lease payment*(1 – T) • Lost depreciation tax shield (outflow) – Depreciation * tax rate for each year • Initial cost of machine (inflow) – Inflow because we save the cost of purchasing the asset now • May have incremental maintenance, taxes or insurance depending on the type of lease and whether the leased asset is replacing one currently owned Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 22.10 Example: Lease Cash Flows • ABC, Inc. needs new cars. The equipment cars would cost $10,000 each if purchased and would be depreciated at a CCA rate of 40%. They would help the sales force generate $6,000 in additional sales per year for 5 years. No salvage is expected after the 5 years. Alternatively, the company can lease the cars for $2,500 per year and payments are due at the beginning of the year. The marginal tax rate is 40%. What are the incremental cash flows? Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 22.11 Example: Lease Cash Flows continued – What are the incremental cash flows? • After-tax lease payment = 2,500(1 - .4) = 1,500 (outflow years 1 - 5) • Cost of the car = 100,000 (inflow year 0) • Lost depreciation tax shield – Table 22.2: Tax shield on CCA for car Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 22.12 Lease or Buy? 22.5 • The company needs to determine whether it is better off borrowing the money and buying the asset or leasing • Compute the NPV of the incremental cash flows • Appropriate discount rate is the after-tax cost of debt since a lease is essentially the same risk as a company’s debt Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 22.13 Net Advantage to Leasing • The net advantage to leasing (NAL) is the same thing as the NPV of the incremental cash flows – If NAL > 0, the firm should lease – If NAL < 0, the firm should buy • Consider the previous example. Assume the firm’s cost of debt is 11%. – After-tax cost of debt = 10(1 - .4) = 6.6% – NAL = -119 • Should the firm buy or lease? Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 22.14 A Leasing Paradox 22.6 • If the lessor and lessee have the same effective tax rate, then leasing is a zero sum game • When their tax rates differ, then leasing has benefits for both parties – The company in the higher tax bracket can benefit from being a lessor, because they can use the CCA tax shields – The CCA tax shields are worth less to the lessee because the lessee faces a lower tax rate or may not have enough taxable income to absorb the accelerated tax shields in the early years Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 22.15 Good Reasons for Leasing 22.7 • • • • • Taxes may be reduced May reduce some uncertainty May have lower transaction costs May require fewer restrictive covenants May encumber fewer assets than secured borrowing Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 22.16 Dubious Reasons for Leasing • Balance sheet, especially leverage ratios, may look better if the lease does not have to be accounted for on the balance sheet • 100% financing – leases normally do not require either a down-payment or a security deposit • Other reasons for leasing – circumvent capital expenditure control systems set up by bureaucratic firms Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 22.17 Quick Quiz • What is the difference between a lessee and a lessor? • What is the difference between an operating lease and a capital lease? • What are the requirements for a lease to be tax deductible? • What are typical incremental cash flows and how do you determine the net advantage to leasing? • What are some good reasons for leasing? • What are some dubious reasons for leasing? Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 22.18 Summary 22.8 • There are two types of leases: financial and operating • There are accounting and tax consequences for both types of leases • An NPV analysis is used to determine whether borrowing or leasing is most advantageous. The appropriate discount rate is the after-tax borrowing rate • Differential tax rates can make leasing an attractive proposition to all parties Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.