FINANCE IN A CANADIAN
SETTING
Sixth Canadian Edition
Lusztig, Cleary, Schwab
CHAPTER
TWENTY-FIVE
Leasing
Learning Objectives
1. Discuss the advantages for the lessor and the
lessee under a lease agreement.
2. Compare the differences between operating and
financial (or capital) leases.
3. Discuss the three most important cash flows under
a lease.
4. Compare the internal rate of return (IRR) and net
present value (NPV) methods of evaluating leasing
costs. State why one is preferable to the other.
5. Identify three major reasons for the popularity of
leasing.
Introduction


Most leases fall into the class of
intermediate-term financing
Under a lease two parties are involved:
1. lessor – owns the asset
2. lessee – has full use of the asset and
makes periodic lease payments to the
lessor

Leasing has become a popular alternative
to buying assets
Introduction
Introduction

Operating leases

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
contract covers a period that is shorter than
the life of the asset
usually longer than a year
operating leases are advantageous for lessee
when:
 the assessment of risk of obsolescence for
an asset is higher than that of the lessor
 managers want the flexibility to exchange
assets on short notice without penalties
Introduction

Financial leases



also called “full payout” leases
a long-term contract that allows the lessor
to recover the full cost of the asset plus a
return during the period of the lease
financial leases can take two forms:
direct lease – lessee gets the use of an
asset not previously owned
 sales and leaseback – lessee sells an asset
to a financial institution which than leases
the asset back to the lessee

Introduction

Tax-leveraged leases



developed to meet the financing of milliondollar capital equipment projects with
economic lives between 10 to 25 years
lessor provides 20 to 40 percent of the
capital needed to purchase the equipment
while the remainder is provided by a
financial institution
lessor as the owner of the asset is
permitted to deduct CCA on the leased
asset for income purposes
Evaluation of
Financial Leases


Relevant cash flow must be estimated to determine
the economic desirability of leasing versus purchasing
an asset
The lessee avoids the initial outlay of capital required
in purchasing the asset but subsequent costs are
incurred including:
1. direct cash outflows associated with the lease contract
 periodic lease payments minus taxes
2. opportunity costs associated with not owning the asset
 tax shields from CCA
Evaluation of
Financial Leases

Leasing as a form of debt financing


lease and debt financing affects a firm’s financial
position in the way they are committed to fixed
payments before any earning are accrued to
shareholders
Framework for discounted cash flow analysis


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both NPV and IRR can be used to analyse leases
if IRR > than after-tax borrowing cost,
borrowing is preferred and vice versa
if NPV of the leasing cost is > than the asset
value, borrowing is preferred and vice versa
Evaluation of
Financial Leases

Residual value


when evaluating whether to lease or
purchase an asset, we have to charge a lease
with the loss of any residual value
The present value of net benefit from salvage
is equal to:
 S n   S n dT   1 
 (1  k )    (d  r )   (1  k ) n 

 



residual values are often difficult to estimate
because a judgmental risk-adjusted discount
rate needs to be applied
Reasons For Leasing

Leasing and taxes


Many firms find it advantageous to lease
rather than borrow because of the
differential tax treatments between lessors
and lessees
Leases and accounting

to overcome the effects of leasing on
companies balance sheets, the CICA
provides guidelines on distinguishing
between operating and financial leases and
how to treat financial leases
Reasons For Leasing
Other reasons for leasing include:
1. ready availability


companies with poor credit ratings can
sometimes obtain 100 percent financing
through a lease compared to only partial
loan financing on the same asset
2. payment provisions

If payments on a loan are variable while
lease payments are fixed, the borrowing
option contains an additional element of
risk, giving incentive to lease
Reasons For Leasing


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Organizational considerations
 some leases are written simply to
circumvent organizational restrictions on
capital expenditures
Lease financing through manufacturers
 terms under a manufacturers lease may be
more attractive than those that a customer
could get under a comparable loan
Flexibility and obsolescence
 leases provide the lessee with flexibility
and insurance against obsolescence
Summary
1. The lessor retains title to the asset and makes
it available to a lessee in return for periodic
lease payments. The lessor takes capital cost
allowance (CCA) and any residual value on the
asset at the end of the lease agreement.
2. Operating leases provide for a contractual
commitment that is short relative to the life of
the asset. The risk of obsolescence rests with
the lessor.
Summary
3. Financial (or capital leases) call for a
contractual arrangement of sufficient length
to allow the lessor to recover the full costs of
the asset plus a return. From the viewpoint of
the lessee, reliance on a financial lease is
very similar to raising funds through debt.
Financial leases may take the form of direct
leases or sale-and-leaseback arrangements,
and they may be two-party leases or thirdparty, tax-leveraged leases.
Summary
4. The quantitative analysis of leasing versus borrowing
is carried out within the framework of discounted cash
flow analysis. The relevant cash flows under a lease
consist of:


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the initial financing obtained in the amount of the
purchase price of the asset (an inflow or saving)
subsequent direct cash outflows in the amount of the
after-tax lease payments
subsequent indirect costs that consist of the tax savings
lost by being unable to claim CCA on the asset, and net
benefits lost through foregoing any residual value that
the assets may have at the end of the lease period
Summary
5. The effective cost of a lease is given by its internal
rate of return (IRR). The IRR is compared to the aftertax interest cost of a term loan, and the alternative
with the lower cost is preferred.
6. The lease’s net present value (NPV) is given by:
NPV leasing = + purchase price of asset
- present value of after-tax lease payments
- present value of tax savings from
lost capital cost allowance
- present value of lost net benefits
from residual value
Summary
7. The discount rate employed in
calculating the NPV is the after-tax
interest cost on a comparable term
loan. A higher, risk-adjusted discount
rate, however, may be appropriate for
the residual value.
Summary

Major reasons that have contributed to the
popularity of leasing include:

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differences in tax rates and regulations
applicable to lessor and lessee
different accounting treatments of lease
and debt financing
different provisions governing lessors and
creditors in case of default
Summary
9. Other considerations that may play a role
in evaluations of leasing and borrowing
include differences in payment provisions
(fixed versus variable payments),
organizational restrictions regarding
capital acquisitions, and differences in the
flexibility afforded.