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 27-3 Lease Terminology Lease – contractual agreement for use of an asset in return 27-4 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 27-5 Types of Leases Financial lease (capital lease) Longer-term lease Lessee is responsible for insurance, taxes, and maintenance Generally not cancelable Specific capital leases 27-6 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” 27-8 Lease Accounting Operating leases are still “off-balance-sheet” and do not have any impact on the balance sheet itself 27-9 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. 27-10 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 27-11 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 27-12 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 27-13 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 27-14 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 27-15 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 27-16 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%. 27-17 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) 27-18 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 27-20 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 27-21 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? 27-22 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. 27-23 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? 27-25 Leasing Paradox Are there other factors (other than NAL) that might influence the attractiveness of a lease from both party’s perspectives? 27-26 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 27-28 Dubious Reasons for Leasing 1. 27-29 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? 27-31 Quick Quiz What is the difference between a lessee and a 27-32 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% 27-33 Terminology Lease Lessee Lessor Direct Lease Captive finance company Operating Lease Financial Lease Capital Lease Incremental Cash Flows 27-34 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 27-35 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 27-36 Key Concepts and Skills • Compute the net Advantage to leasing (NAL) using a NPV computation. Differentiate the good and Dubious reasons for leasing. 27-37 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). 27-38 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. 27-39 27-40