Chapter 15
Leasing and Other
Equipment Finance
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-1
Learning Objectives
• Explain the main features of finance leases
and operating leases.
• Understand the reasons for leveraged leases
and cross-border leases.
• Outline the accounting and tax treatment of
leases in Australia.
• Calculate rentals for a finance lease.
• Evaluate a finance lease from the lessee’s
point of view.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-2
Learning Objectives (cont.)
• Evaluate an operating lease from the lessee’s
viewpoint.
• Critically evaluate the suggested advantages
of leasing.
• Explain the factors that can influence leasing
policy.
• Outline the main features of chattel mortgages
and hire-purchase agreements.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-3
Introduction
• Leasing is distinguished from most other forms of
finance by the fact that the financier (the lessor) is
the legal owner of the leased asset.
• The asset user (the lessee) obtains the right to use
the asset in return for periodic payments (lease
rentals) to the lessor.
• Equipment finance: a general term that
encompasses leasing hire-purchase and chattel
mortgages.
• Recent figures from the Australian Equipment
Lessors Association (2004) estimate that around
20% of all new capital equipment acquired by
Australian businesses is leased.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-4
Finance Leases
• A long-term agreement that generally covers
most of the economic life of the asset.
• Non-cancellable, or cancellable only if the
lessee pays a substantial penalty to the lessor.
• The obligation is essentially the same as a
borrower’s obligation to repay a loan.
• From the lessor's point of view it is, in effect, a
secured loan.
• The risks and benefits of ownership of the asset
are effectively transferred from the lessor to the
lessee.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-5
Operating Leases
• Essentially a rental agreement.
• More attractive to lessors if there is an active secondhand market for the leased asset.
• In Australia, operating leases have been limited mainly
to motor vehicles and multi-purpose industrial
equipment such as forklifts.
• Normally only for a short period, which is considerably
less than the useful life of the leased asset. The assets
are likely to be leased to a series of users.
• Risks of ownership borne by the lessor.
• Maintenance lease: operating lease where the lessor
is responsible for all maintenance and service of the
leased asset.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-6
Sale and Lease-Back
Agreements
• The owner of an asset sells the asset to a financial
institution for an amount usually equal to its current
market value and immediately leases it back from
the institution.
• An alternative to raising cash by borrowing, using
the asset as security.
• Lessor is typically an insurance company, super
fund, bank, or specialist lease company.
• Typical assets include commercial real estate,
railway rolling stock, and vehicle fleets.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-7
Leveraged Leasing
• Form of finance lease.
• A lease in which most of the funds needed to
purchase the leased asset are borrowed by
the lessor.
• Involves at least three parties instead of the
normal two. The additional party is a lender,
normally referred to as a ‘debt participant’.
• Typically involves a non-recourse loan, whereby
the lessor is not responsible for its repayment.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-8
Cross-Border Leasing
• A lease in which the lessee and lessor are located
in different countries.
• Usually leveraged, and motivated by differences
between the tax regulations of different countries.
• Generally structured so that the lessor and lessee
can both claim depreciation deductions on the
same asset.
• Complex tax issues in Australia:
– Difficult for Australian lessor to participate in a CBL
involving an offshore asset.
– Australian lessee can be involved in CBL provided there
is a purchase option.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-9
Accounting for Leases
• In Australia, AASB 117 ‘Leases’ provides that the
accounting treatment of a lease depends on
whether it is classified as an operating or a finance
lease.
• Operating leases are treated in the traditional way
(lease rentals expensed and no recognition of any
assets or liabilities).
• AASB 117 provides that a lease would normally be
classified as a finance lease if:
– Substantially all of the risks and rewards associated with
ownership of the leased asset are effectively transferred to
the lessee.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-10
Accounting for Leases (cont.)
• Where lease is a finance lease, lease asset and
liability equal to fair value of leased property or PV
of lease payments must be recognised on balance
sheet.
• The previous criteria are, however, only guidelines.
• The classification of a lease should depend on the
economic substance of the transaction.
• However, lessors have made efforts to structure
finance leases such that they are recognised as
operating leases to avoid the need to recognise
finance leases as assets or liabilities.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-11
Taxation Treatment of Leases
• If a leased asset is used to generate taxable
income, the lease rentals paid by the lessee are an
allowable tax deduction, provided that the lease is
classified as a ‘genuine lease’ rather than an
‘instalment purchase arrangement’.
• While lease rentals are deductible, the lessee
cannot deduct, for tax purposes, depreciation on
the leased asset.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-12
Setting Lease Rentals
• Four steps:
– Calculate the present value of the cash flows from
ownership of the asset.
– Calculate the required present value of the lease
payments.
– Calculate the minimum after-tax lease payment.
– Calculate the minimum before-tax payment, given
the tax rate tc.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-13
Evaluation of Finance Leases
• Should we compare:
– Leasing with borrowing, or leasing with buying?
• Myers, Dill and Bautista (1976) (MDB) suggested
analysing a finance lease in the context of its effect
on the lessee’s capital structure.
• MDB emphasised that entering into a finance lease
uses some of the lessee’s debt capacity.
– Therefore, it follows that a finance lease should be
analysed by comparing it with debt.
• MDB method:
– Leasing will be economically advantageous to a lessee if
the finance provided by leasing is greater than the liability
incurred by leasing.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-14
Leasing Decisions and
Investment Decisions
• In practice, the investment decision would normally
be considered first and, if the project were profitable,
the alternative of leasing the required assets would
be evaluated.
• However, a project revealing a negative NPV should
not necessarily be discarded, as the NPV of a lease
can be large enough to ‘rescue’ an otherwise
marginally unprofitable project.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-15
The Value of Leasing in
Competitive Capital Markets
• Suppose that all financiers and asset users
operate in a perfect capital market where the
following conditions apply:
– Leasing involves no transactions costs.
– Information is costless and freely available.
– All parties are subject to the same tax laws and
tax rates.
• Under these conditions, the cost of leasing an
asset should be the same as the cost of buying
it. The lease or buy decision should be a matter
of indifference.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-16
The Value of Leasing in
Competitive Capital Markets
(cont.)
• The popularity of leasing has varied over time.
It is particularly popular for some types of
assets.
• This suggests that there are cases where
asset users have a systematic preference for
leasing or buying.
• For this to be so, there must be tax differences
or imperfections that can make leasing
advantageous in some cases.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-17
Establishing an Advantage
for Leasing
• To make leasing attractive to the user of an asset
without simultaneously making leasing unattractive
to the lessor requires some departure from the
perfect-market conditions.
• The symmetry between the positions of the two
parties needs to be broken:
– Quantity discounts available to specialty lessors.
– Differences in tax positions of the parties.
Copyright  2009 McGraw-Hill Australia Pty Ltd
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-18
Taxes and the Size of Leasing
Gains
•
The NPV of a lease to the lessee (NPVLES ) can be
expressed as:
NPVLES  C  PV L   PV Dep 
where:
C  cost of the leased asset
PV ( L)  present value of the lease rentals
PV ( Dep)  present value of depreciation tax savings
•
Similarly, the NPV to the lessor (NPVLOR ) will be:
NPVLOR   C  PV L *  PV Dep *
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-19
Taxes and the Size of Leasing
Gains (cont.)
• A lease can affect the present value of the
government’s tax receipts in two ways:
– The government gains, in that it can tax the lease
rentals received by the lessor.
– The government loses, in that the lessor is able to
claim deductions for depreciation on the leased
asset.
• The net result is that the government can lose
through deferral of tax receipts — this net loss
by the government is why the lease is
advantageous to the parties to the lease.
Copyright  2009 McGraw-Hill Australia Pty Ltd
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-20
Taxes and the Size of Leasing
Gains (cont.)
• Other things being equal, the government’s net
loss will be larger in present value terms if:
– Lessor’s tax rate is much greater than the
lessee’s.
– Depreciation tax savings are received early.
– The term of the lease is long and the lease rentals
are paid late.
– Interest rate is high.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-21
Leasing and the Imputation
Tax System
• Under the imputation tax system, any advantage
associated with deferring a company’s tax
payments is likely to be small.
– This is because company tax is, from the point of view
of resident shareholders, only a withholding tax
(effective rate of company income tax is low).
– Hence, any tax advantage from leasing must also
be small.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-22
Evaluation of Operating Leases
• Short-term lease that allows lessee to obtain the
services provided by an asset, without directly
bearing the risks of asset ownership.
• Operating leases are more complex than finance
leases.
• Equivalent annual cost model can be used to
evaluate operating leases where projects have
different economic lives.
• The principle involved explains that — an operating
lease is attractive to the lessee if the annual rental is
less than the equivalent annual cost of buying and
operating the asset.
• Care must be taken in applying this principle to
ensure that the lease and buy alternatives are
treated consistently.
Copyright  2009 McGraw-Hill Australia Pty Ltd
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-23
Evaluation of Operating
Leases (Cont.)
• Operating lease is more costly than buying an
asset that is needed for extended period.
• However, operating leases can be less costly than
buying an asset in the following circumstances:
– Operating lease can be cheaper if lessors can take
advantage of cost savings that are not available to the
lessee.
– Operating leases provide options that are valuable to the
lessee and, in some cases, the option to cancel a lease
can be the most effective way of obtaining a benefit, such
as the risk that an asset is no longer needed due to
decline in demand.
Copyright  2009 McGraw-Hill Australia Pty Ltd
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-24
Possible Advantages of
Leasing
• Company taxation:
– Advantages may arise from the deferral of taxes.
– Firms with lower marginal tax rates use leasing more than
firms with high marginal tax rates, found by Graham,
Lemmon and Schallheim (1998) for US.
– Cross-border leases take advantage of the differences
between the tax environments in different countries.
– Possible advantages where lessors are able to choose
between different accounting methods to calculate their
taxable income.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-25
Possible Advantages of
Leasing (cont.)
• Conservation of capital:
– By leasing, a company can conserve its capital for
investment elsewhere.
– However, there are problems with this argument.
• ‘Off-balance sheet’ finance:
– Because in the past lessees have not been required to
report their lease obligation on the balance sheet, they
can use leasing to increase their access to debt.
– However, AASB 117 now requires the capitalisation of
finance lease obligations, which means that any potential
‘off-balance sheet’ advantage for leasing should no
longer be available.
Copyright  2009 McGraw-Hill Australia Pty Ltd
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-26
Possible Advantages of
Leasing (cont.)
• Cost of capital:
– If the lessor’s cost of capital is lower (higher) than that
of the potential lessee, the existence of competitive
capital markets will result in leasing (buying) being
preferred to buying (leasing).
– The circumstances when the cost of capital of the lessor
and lessee will differ depending on the risks associated
with using the asset.
– Miller and Upton (1976) — cost of capital for leasing
and buying should be the same, otherwise one would
dominate the other in marketplace.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-27
Possible Advantages of
Leasing (cont.)
• Transaction cost:
– If a lessee defaults, the lessor, as owner of the asset, can
immediately repossess it.
– However, a secured lender is likely to face considerable
delay and greater costs because it may be necessary for the
defaulting borrower to be liquidated.
Copyright  2009 McGraw-Hill Australia Pty Ltd
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-28
Possible Advantages of
Leasing (cont.)
• Agency costs:
– Leasing and debt are not perfect substitutes as they
can differ in terms of incentive effects and control of
agency costs.
– Remuneration packages can create incentive to lease
rather than purchase — impact on ROI, to which pay
packages may be linked — Smith and Wakeman (1985).
– If manager has large equity stake in company, he/she
may prefer to lease assets to reduce personal exposure
to specific asset risk — Mehran, Taggart and Yermack
(1999).
Copyright  2009 McGraw-Hill Australia Pty Ltd
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-29
Leasing Policy
• Why does a business lease some assets while
purchasing other similar assets?
• Sensitivity to use and maintenance decisions:
– A lessee does not have a right to the salvage value of an
asset at the end of the lease.
– Therefore, there is less incentive to care for and maintain
assets that are leased rather than owned.
– Therefore, lessors set lease rentals on the basis of
expected levels of abuse.
– Consequently, assets that are sensitive to use and
maintenance decisions will tend to be purchased.
Copyright  2009 McGraw-Hill Australia Pty Ltd
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-30
Leasing Policy (cont.)
• Specialised assets:
– There is an incentive to buy, rather than lease, specialised
(or company-specific) assets.
– The residual value of such assets tends to be disputed
between lessor and lessee, i.e. lessor places lower
residual value on asset than lessee.
– This leads to unacceptably high lease payments, making
outright purchase relatively more attractive to potential
lessee.
• Flexibility and transaction costs:
– An operating lease is likely to involve lower costs than
purchasing an asset and then selling it.
– Leasing may also involve lower search costs and costs of
assessing quality.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-31
Leasing Policy (cont.)
• Comparative advantage in asset disposal:
– Three potential sources of comparative advantage
in asset disposal by a lessor:
 Lower search, information and transaction costs
associated with the lessor providing a specialised
market for used assets.
 Reduced repair and maintenance costs for current
machines from reusing components of previously
leased machines.
 Reduced production costs resulting from reusing
components of previously leased machines in the
production of new machines.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-32
Chattel Mortgages and Hire
Purchase
• Chattel mortgages and hire purchase
agreements are similar to finance leases.
• Chattel mortgage (CM)
– User purchases goods and financier registers charge
over goods as security.
– Loan secured over movable property rather than real
estate.
• Hire purchase (HP)
– Financier purchases asset and hires it to user for
agreed period.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
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Chattel Mortgages and Hire
Purchase (cont.)
• In the case of a CM or HP agreement, user will be
required to make a series of payments or
instalments to the financier for an agreed period.
• An HP agreement will either commit the user to
buy the asset or give the user an option to buy it.
• In the case of HP, the user, rather than the
financier, will be entitled to claim deductions for
depreciation.
• During 2005–06, CM and HP agreements made up
65% of the Australian equipment finance market.
Copyright  2009 McGraw-Hill Australia Pty Ltd
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-34
Chattel Mortgages and Hire
Purchase (cont.)
• Equipment finance and the GST:
– CM and HP agreements and leasing are treated differently
under GST.
– CM are treated as a loan (financial supply):
 GST applies only to cost of asset; no GST on loan or loan
repayments.
– Lease rentals are subject to GST.
– HP agreements can be split into financial supply and asset
purchase components:
 No GST on financial supply component; GST applies only to
cost of asset.
– If GST input credits can be claimed, the GST differences
between CM and HP agreements and leasing are not
relevant.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-35
Summary
• Reasons for leasing differ between types of lease.
• Operating lease — separates risk of ownership from
use of leased asset.
• Finance lease — risk of ownership on lessee and
lease is an alternative method of finance, reducing
transaction costs of obtaining finance.
• Leasing can be driven by tax benefits — changes in
tax rules, government charges and GST treatment
can have important effects on leasing arrangements
and their popularity.
• Leasing is more common for general or marketable
assets.
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
15-36