Chapter
27
Leasing
27-1
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
•Leases and Lease Types
•Accounting and Leasing
•Taxes, the IRS, and Leases
•The Cash Flows from Leasing
•Lease or Buy Decision
•A Leasing Paradox
•Reason for Leasing
27-2
Chapter Outline
•Leases and Lease Types
•Accounting and Leasing
•Taxes, the IRS, and Leases
•The Cash Flows from Leasing
•Lease or Buy Decision
•A Leasing Paradox
•Reason for Leasing
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Lease Terminology
 Lease – contractual agreement for use of an asset in return


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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
Types of Leases
Operating lease
 Shorter-term lease
 Lessor is responsible for
insurance, taxes, and
maintenance
 Often cancelable
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Types of Leases
Financial lease (capital lease)
 Longer-term lease
 Lessee is responsible for
insurance, taxes, and
maintenance
 Generally not cancelable
 Specific capital leases
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 Tax-oriented
 Leveraged
 Sale and leaseback
Chapter Outline
•Leases and Lease Types
•Accounting and Leasing
•Taxes, the IRS, and Leases
•The Cash Flows from Leasing
•Lease or Buy Decision
•A Leasing Paradox
•Reason for Leasing
27-7
Lease Accounting
 Leases are governed primarily by FASB 13
 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 asset as the
“capitalized value of leased assets”
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Lease Accounting
Operating leases are still “off-balance-sheet” and
do not have any impact on the balance sheet
itself
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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:
1.
2.
3.
4.
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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
Chapter Outline
•Leases and Lease Types
•Accounting and Leasing
•Taxes, the IRS, and Leases
•The Cash Flows from Leasing
•Lease or Buy Decision
•A Leasing Paradox
•Reason for Leasing
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Taxes
Lessee can deduct lease payments for
income tax purposes
 Must be used for business purposes and not
to avoid taxes
 Term of lease is less than 80 percent of the
economic life of the asset
 Should not include an option to acquire the
asset at the end of the lease at a below
market price
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Taxes (continued)
Lessee can deduct lease payments for
income tax purposes
 Lease payments should not start high
and then drop dramatically
 Must survive a profits test – lessor
should earn a fair return
 Renewal options must be reasonable
and consider fair market value at the
time of the renewal
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Chapter Outline
•Leases and Lease Types
•Accounting and Leasing
•Taxes, the IRS, and Leases
•The Cash Flows from Leasing
•Lease or Buy Decision
•A Leasing Paradox
•Reason for Leasing
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Incremental Cash Flows
Cash Flows from the Lessee’s point of
view:
 After-tax lease payment (outflow)
Lease payment*(1 – T)
 Lost depreciation tax shield (outflow)
Depreciation * tax rate for each year
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Incremental Cash Flows
Cash Flows from the Lessee’s point of
view:
 Initial cost of machine (inflow)
Inflow because we save the cost of
purchasing the asset now
 May have incremental maintenance, taxes,
or insurance
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Example: Lease Cash Flows
ABC, Inc. needs some new equipment.
The equipment would cost $100,000 if
purchased and would be depreciated
straight-line over 5 years. No salvage is
expected. Alternatively, the company
can lease the equipment for $25,000 per
year. The marginal tax rate is 40%.
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Example: Lease Cash Flows
What are the incremental cash flows?
After-tax lease payment
= 25,000(1 - .4)
= $15,000 (outflow years 1 - 5)
Lost depreciation tax shield
= (100,000/5)*.4
= $8,000 (outflow years 1 – 5)
Cost of machine
= $100,000 (inflow year 0)
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Chapter Outline
•Leases and Lease Types
•Accounting and Leasing
•Taxes, the IRS, and Leases
•The Cash Flows from Leasing
•Lease or Buy Decision
•A Leasing Paradox
•Reason for Leasing
27-19
Lease or Buy?
 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
 The appropriate discount rate is the
after-tax cost of debt since a lease is essentially the
same risk as a company’s debt
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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
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Net Advantage to Leasing
Consider the previous example.
Assume the firm’s cost of debt is
10%.
After-tax cost of debt
= 10(1 - .4) = 6%
Net Advantage to Leasing (NAL)
= $3,116
Should the firm buy or lease?
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Work the Web
Many people must choose between buying
and leasing a car
Click on the web surfer to go to Kiplinger’s
•Go to Tools & Calculators: Cars
•Do the calculations for a $30,000 car, 5-year loan
at 7% with monthly payments, and a $3,000
down payment. The available lease is for 3 years
and requires a $550 per month payment with a
$1,000 security deposit and $1,000 other upfront
costs.
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Chapter Outline
•Leases and Lease Types
•Accounting and Leasing
•Taxes, the IRS, and Leases
•The Cash Flows from Leasing
•Lease or Buy Decision
•A Leasing Paradox
•Reason for Leasing
27-24
Leasing Paradox
If leasing is good for
one party of the
proposed deal, isn’t it
going to then be a bad
deal for the other
party?
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Leasing Paradox
Are there other
factors (other than
NAL) that might
influence the
attractiveness of a
lease from both
party’s perspectives?
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Chapter Outline
•Leases and Lease Types
•Accounting and Leasing
•Taxes, the IRS, and Leases
•The Cash Flows from Leasing
•Lease or Buy Decision
•A Leasing Paradox
•Reason for Leasing
27-27
Good Reasons for Leasing
 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
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Dubious Reasons for Leasing
1.
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Balance sheet, especially
leverage ratios, may look
better if the lease does not
have to be accounted for on
the balance sheet
Dubious Reasons for Leasing
2. 100% financing – except that leases
normally do require either a downpayment or security deposit
3. Low cost – some may try to compare the
“implied” rate of interest to other
market rates, but this is not directly
comparable
27-30
Ethics Issues
Suppose a manager chooses to lease an asset (operating
lease) rather than buy, simply to keep the asset offbalance sheet and thereby avoid reporting the liability?
 Although this may be legal, is there any ethical
implication?
 Are investors able to effectively monitor and analyze such
activity?
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Quick Quiz
 What is the difference between a lessee and a
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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?
Comprehensive Problem
What is the net advantage to leasing for the following
project, and what decision should be made?
 Equipment would cost $250,000 if purchased
 It would be depreciated straight-line to zero
salvage over 5 years.
 Alternatively, it may be leased for $65,000/yr.
 The firm’s after-tax cost of debt is 6%, and its tax
rate is 40%
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Terminology
Lease
Lessee
Lessor
Direct Lease
Captive finance company
Operating Lease
Financial Lease
Capital Lease
Incremental Cash Flows
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Formulas
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
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Key Concepts and Skills
•Define the basic lease
terminology.
•Describe and compare the
criteria of a capital lease versus an
operating lease.
•Compute the incremental
cash flows to leasing
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Key Concepts and Skills
• Compute the net
Advantage to leasing
(NAL) using a NPV computation.
Differentiate the good and
Dubious reasons for leasing.
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What are the most important
topics of this chapter?
1. A lease versus buy decision is a
specialized case of capital budgeting,
focusing on the incremental cash
flows.
2. The capital budgeting comparison
analysis is called the Net Advantage to
Leasing (NAL).
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What are the most
important topics of this
chapter?
3. There are accounting issues, tax
considerations, and legal
requirements for leases.
4. There are both good and questionable
reasons for leasing versus buying an
asset.
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