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
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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.