Leasing
Lease Financing
Corporate Finance
Shanghai 2014 Session 2 FINC 5880
Leasing is typically used




For aircraft financing (Airlines)
Real estate (Retail)
Valuable production
installations…
Trucks and cars (Transport
Industry)
In short all fixed assets financing
Two or more parties involved

The less..ee: party that
will use the asset and
has to pay the lease
payments

The less..or: party that
will finance the asset
and receives the lease
payments
Forms of leasing





Operational lease (rent)
Financial lease
Sale-and-leaseback
arrangements
Combination leases
Hybrid forms
Operational lease





Provides both maintenance and finance
Used for computers, copiers, trucks/cars
The lease contract is considerable shorter then the
economic life of the asset since the asset is not
fully amortized
Cancellation clauses are normal
The lessor negotiates the price of the asset with
the manufacturer
Financial (capital) Leases






Do not provide for maintenance services
Are not cancellable
Are fully amortized
The interest rate is based on a secured term
loan considering the rating of the lessee
Lessee pays property taxes and insurance
The lessee negotiates the price with the
manufacturer
Sale-and-leaseback (special type financial lease)





Alternative for a
mortgage
Used for land, buildings
and equipment
The lessee uses the
property
The leased assets are
normally not new
Very similar to financial
lease
Combination Leases




Combination of operational and financial lease
The lessee company can use the lease pay as a tax
deductible expense
The IRS will check if the lease is not in fact a loan…
If the lease contract complies with the IRS standards
for lease such a lease is called:


Guideline lease or
Tax-oriented lease
GE Capital…
G
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C
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N
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G
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TIMELINESS
SAFETY
TECHNICAL
BETA
1.20
3
3
2
High:
Low:
Lowered 4/15/11
Lowered 3/13/09
Raised 1/13/12
(1.00 = Market)
2
0
1
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1
6
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H
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L
o
w 30
(+60%)
Insider Decisions
t
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60.5
41.6
53.6
28.5
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41.8
21.4
32.4
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2014 2015 2016
LEGENDS
10.5 x ²Cash Flow² p sh
. . . . Relative Price Strength
3-for-1 split 5/00
Options: Yes
Shaded areas indicate recessions
80
60
50
40
30
25
20
15
A
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30%
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FM
AMJ JASO
0 1 0 1 0 0 0 0 0
0 0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0 0
% TOT. RETURN 12/11
Institutional Decisions
1
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760
773
729
H
ld
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(
0
0
0
)551274555589985490539
1995
1996
1997
1998
Percent
shares
traded
1999
THIS
STOCK
12
8
4
2000
1
y
r
.
3
y
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5
y
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2001
2002
2003
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©
1
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3
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7
4
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5
10
7.5
VL ARITH.*
INDEX
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celerated earnings growth in 2012. An
ongoing recovery at the key Energy Infrastructure unit may well be in store. Plus,
reaps the rewards of outlays over the past
several years. Healthcare orders were also
up a mid-teens percentage, driven largely
General Electric’s web site….




Buy or Lease Equipment ?
Type of financing?
Types of collateral
CFO solutions….
The IRS guidelines include:






The lease term is max. 80% of useful
remaining life time of the asset
Residual value should be at least 20% of
the assets value at the start of the lease
The lessee can not buy the asset at a
preset price
The lessee can not pay for the asset
other then through lease payments
The asset should be a widely used asset
that can be released/sold at the end of
the lease
The IRS has set these rules to prevent
the use of illegal tax deductions…
Financial statement effects



Leasing is often called off
balance sheet financing; the
leased asset or financing
can not be seen on the
balance sheet
FASB has launched FAS 13
to make sure that 3th parties
will be able to see
obligations from the lease
The lease will be capitalized;
the asset will be shown
under assets and the NPV of
the lease payments under
liabilities
FAS 13 states:





A lease has to be capitalized
when:
Ownership of the asset is
transferred to the lessee
When the lease expires the
lessee can buy the asset at
less then its market price
If the lease extends over
75% of the assets useful live
The present value of the
lease payments is greater
then 90% of the initial value
of the asset
Website www.fasb.org/st/



Summary of Statement No. 13
Accounting for Leases (Issued 11/76)
Summary
This Statement establishes standards of financial accounting and reporting for leases by
lessees and lessors. For lessees, a lease is a financing transaction called a capital lease if
it meets any one of four specified criteria; if not, it is an operating lease. Capital leases are
treated as the acquisition of assets and the incurrence of obligations by the lessee.
Operating leases are treated as current operating expenses. For lessors, a financing
transaction lease is classified as a sales-type, direct financing, or leveraged lease. To be a
sales-type, direct financing, or leveraged lease, the lease must meet one of the same
criteria used for lessees to classify a lease as a capital lease, in addition to two criteria
dealing with future uncertainties. Leveraged leases also have to meet further criteria.
These types of leases are recorded as investments under different specifications for each
type of lease. Leases not meeting the criteria are considered operating leases and are
accounted for like rental property.
Recommendation: READ FAS 13 ….
Evaluation of the Lessee:




Is leasing better then buying?
Do the lease payments balance with the effective
use of the assets?
Leasing is a finance decision; if leasing is more
beneficial depends on the total cash flows over the
life time of the assets including the tax-cash flows
Long leases can be compared to LT debt financing
and as such should enter the WACC% calculation…
Class assignment Leasing:
Assume the following case;



A company considers and investment of $100; the
asset is depreciated over 2 years straight line; no
residual value and tax rate 40%; if the company
borrow the money the interest is 10% per year
A guideline lease requires a yearly lease fee of $55
Estimate the cash flows under the 2 scenarios;
which has the lower present value? (assume dcf=6%
this is the after tax cost of debt: 10%*(1-40%))
Class Assignment: Leasing

Consider a $10 M investment (10 year life) to be discontinued after 5 year

Borrow at 10% interest per year (before tax) if you Buy the Equipment

After 5 years residual value $2 M

A 5 year lease would trigger annual lease payments of $ 2,6M starting immediately in t=0

Under the lease the lessor maintains the equipment

If the company buy/borrow this equipment the maintenance cost will need to be paid
additionally at $0.5M per year at the beginning of each year starting immediately (t=0)

Tax rate of the Lessee is 35%

Modified Accelerated Cost Recovery System (MACRS) depreciation: over the 5 years is
resp. 20%, 32%, 19%, 12% and 11%

Compare the PV of the cost of owning (buy/borrow) with the PV of the cost of
leasing….which one is lower?
Class assignment:
From the Lessor’s point of view

Assuming:

Lessor’s tax rate is 40%
Lessor’s alternative investment is a 5 year bond with an after tax yield
of 9%(1-40%)=5.4%
Asset will be depreciated to book value of $600,000 after 5 years and
the before tax residual value is $ 2M
This implies that Lessor can expect to receive $2M –
40%*$1.4M=$1,440,000 after the lease expires selling the asset
directly…
Develop the cash flows and determine the IRR% of this investment
Is 5.4%>,< or= IRR%? So what would the lessor invest his money in in
the Lease or the Bonds…?





Since the tax savings



When the asset is bought is only calculated
over the interest payment and other costs over
a spread life time
When leased the period is shorter and thus the
period to recover the tax savings over the lease
payment
This causes leases (cash wise) sometimes to
be the better decision (compare page 798)
Evaluation of
the Lessor;


Is this a good investment?
The lessor calculates the rate of return on the
lease and includes in this calculation:





The net cash outlay
The periodic cash inflows from lease payments
The after tax residual value
The rate of return>WACC or NPV>0
The lessor can use (partly) debt financing for
the lease and include this effect in his
calculations (so called leveraged lease)
Other issues in leasing





Lessors are easier on accepting the same risk as lenders
since they legally have a better position
Lessors that specialize in certain equipment will know how
to re-allocate the asset in case of non-payment or at the
end of the contract
Retailers use leasing for their stores (up to 20yr leases or
more)
Leases are highly negotiated and shaped by lessor and
lessee in specific cases
Parties use the tax laws to their advantage and individual
situation to create win-win leases
Tax effects on leases




Investment Tax Credits (ITC) a direct reduction
of the investment
Tax rates; higher rates include higher tax
savings on payments
Depreciation rules effect the lease; faster
depreciation implies faster tax savings
The alternative minimum tax (AMT) is 20% and
prevent that companies who are tax-wise to
pay a minimum rate of 20% on profits shown to
shareholders! Moving the AMT rate will effect
leasing…
Other reasons for leasing then tax…



Operating flexibility (aircraft)
Costs related to use (copier leases consist of
fixed amount plus price per copy)
Economy of scale benefits replacements of
leased assets that follow a complex pattern
(technological assets)
Assignment : Leasing in Valuation










Copy Paste the relevant paragraph on Leasing from the 10K of
your company to this homework assignment!
Operating leases will have a relevant effect on the value of a
company
Therefore in valuing a company all operational leases should
be capitalized at the firms Kd (cost of debt)
This will increase the firms fixed assets, depreciation and LT
debt
The effective tax effect has to be recalculated
The FCF of the company will be adjusted
Value will be different accordingly…
Evaluate the financials of your company
Recalculate leases and revaluate the Value of your company
USE DAMODARAN’s LEASE CONVERTER
Assignment alternative:




If your company does not have operational
leases
Pick an S&P 500 company that has…
Value the company before the lease
recalculation (V=FCF/WACC%) and after…
Show the effects of your recalculation…
The new Airbus 380 First Class…