FINANCIAL MANAGEMENT
THEORY & PRACTICE
ADAPTED FOR THE SECOND CANADIAN
EDITION BY:
JIMMY WANG
LAURENTIAN
UNIVERSITY
CHAPTER 15
LEASE FINANCING
CHAPTER 15 OUTLINE
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Types of Leases
Tax Effects
Financial Statement Effects
Evaluation by the Lessee
Evaluation by the Lessor
Other Issues in Lease Analysis
Other Reasons for Leasing
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Who are the Two Parties
to a Lease Transaction?
• The lessee, who uses the asset and makes the
lease, or rental, payments
• The lessor, who owns the asset and receives
the rental payments
• Note that the lease decision is a financing
decision for the lessee and an investment
decision for the lessor.
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Types of Leases
• Operating lease
– Short-term and normally cancellable
– Maintenance usually included
– Not fully amortized
• Financial, or capital, lease
– Long-term and normally not cancellable
– Maintenance usually not included
– Fully amortized
• Sale-and-leaseback arrangements
• Combination lease
• "Synthetic" lease
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Tax Effects
• Leases are reviewed by the Canada Revenue
Agency (CRA) to determine if they are an actual
lease or conditional sale.
• For an actual lease, the full lease payment is
deductible.
• If the lease did not meet the CRA guidelines, then
the lessee would treat the asset as a purchase
and only deduct CCA and the interest portion of
the lease payments.
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Financial Statement Effects
• For accounting purposes, leases are classified
as either capital or operating.
• Capital leases must be shown directly on the
lessee’s balance sheet.
• Operating leases, sometimes referred to as
off-balance sheet financing, must be disclosed
in the footnotes.
• Why are these rules in place?
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Please insert
Figure 15-1
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International Accounting Standards
(IAS 17)
• Firms entering a financial lease contract are obligated to
make lease payments as if they had signed a loan
agreement.
• Failure to make lease payments is taken as a default on
interest/principal and can bankrupt a firm.
• To capitalize a lease, the present value of the lease
payments is shown as debt.
• The same amount is shown as a fixed asset.
• The leasing firm would have the same balance sheet as
Firm B (a loan borrower) shown on the previous slide.
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Impact on Capital Structure
• Leasing is a substitute for debt.
• As such, leasing uses up a firm’s debt capacity.
• Assume a firm has a 50/50 target capital
structure. Half of its assets are leased. This
has the effect of raising its true debt ratio, and
thus its true capital structure is changed.
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Evaluation By the Lessee
• Based on regular capital budgeting
procedures, the firm decides to acquire a
certain capital asset.
• The next question is how to finance it: use
internally generated cash flows, borrow to
buy, or lease.
• As leasing is a substitute for debt financing,
the appropriate comparison would be with
debt financing.
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Evaluation By the Lessee:
An Example
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2-year-life equipment cost: $100
Loan rate on equipment = 10%
Marginal tax rate = 40%
Class 12, 100% CCA rate
If borrow and buy, a 2-year simple loan requires
$10 interest at ending of each year and $100
repayment at = 2
• Residual value at t = 2: $0
• Maintenance cost: $0
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Other Information for Lease
• If the equipment is leased:
– Lease contract runs for 2 years
– Lease meets CRA guidelines to deduct lease
payments for tax purposes
– Lease payment will be $55 at the end of each year
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CCA Schedule for Owning
• Owner is entitled to the CCA and the interest
deductions
Year
UCC before
CCA
CCA
@100%
UCC after
CCA
Tax Saving
from CCA
1
$100
$50
$50
$20
2
50
50
0
20
• Note the CCA tax shield for Year 1, is: $100 x
1 x ½ = $ 50
• $ 50 x 0.40 = $ 60
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Cash Flow Time Line: Borrow-To-Buy
Equipment cost
Inflow from loan
Interest expense
0
($100)
100
Interest tax savings
Principal repayment
CCA tax savings
NCF
0
PV@6% cost of buying= $63.33
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1
2
($10)
($10)
4
4
($100)
20
20
$14 ($86)
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Why Use 6% as the Discount Rate?
• Leasing is similar to debt financing.
– The cash flows have relatively low risk; most are
fixed by contract.
– Therefore, the firm’s 10% cost of debt is a good
candidate.
• The tax shield of interest payments must be
recognized, so the discount rate is:
• 10%(1 – T) = 10%(1 – 0.4) = 6.0%
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Cash Flow Time Line: Leasing
0
Lease pmt
1
2
($55) ($55)
Tax savings from payment
NCF
22
22
0 ($33) ($33)
PV cost of leasing @ 6% = $60.50
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What is the Net Advantage
to Leasing (NAL)?
• NAL = PV cost of owning – PV cost of leasing
= $63.33 - $60.50
= $2.83 > 0
• Should the firm lease or buy the equipment?
Why?
• Lease because NAL > 0 implying leasing is
cheaper than buying.
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Alternative Lease/Buy Analysis
• Instead of separately calculating the present values
of the cost of borrowing to buy and of the cost of
leasing and then comparing the two financing
methods, we may calculate NAL directly with these
cash flows:
1. the purchase price is an advantage to leasing and
may be treated as inflows;
2. the CCA tax shields and the residual value are
opportunity costs and thus are outflows; and
3. the same as those in calculating the cost of leasing.
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Alternative Lease/Buy Analysis:
An Illustration
NAL = Purchase Price – PV of Cash Flows
= $100 – $53/(1 + 6%) – $53/(1 + 6%)2
= $100 – $50 – $47.17
= $2.83 > 0
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Evaluation By the Lessor
• To the lessor, writing the lease is an
investment.
• Therefore, the lessor must compare the return
on the lease investment with the return
available on alternative investments of similar
risk.
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Evaluation By the Lessor (cont’d)
1. Net cash outlay at time 0
2. Periodic cash inflows (lease payments from the
lessee and CCA tax shields) and outflows
(income taxes on lease payments and after-tax
maintenance expenses if any)
3. Residual value of the asset (an inflow)
4. NPV = PV (inflows) – PV(outflows)
• Discount rate = after-tax rate of return on an
investment of similar risk
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Lessor’s Evaluation: An Example
• Lease payment = $320,000 at the beginning of
each year
• Cost of equipment = $1,000,000
• Loan rate on equipment = 10%
• Marginal tax rate = 40%
• Class 43, 30% CCA rate
• 4- year maintenance contract costs $20,000 at
the beginning of each year
• Residual value at t = 4: $200,000
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Time Line: Lessor’s Analysis
(In Thousands)
0
Cost
1
2
3
4
60
102
71.4
49.98
-20
-20
-20
-20
8
8
8
8
320
320
320
320
-128 -128
-128
-128
-1,000
CCA tax shield
Maint
Tax sav
Lse pmt
Tax
RV
200
RV tax
NCF
-80
-804
240
282 251.4
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Time Line: Lessor’s Analysis
(In Thousands) (cont’d)
• The NPV of the net cash flows, when
discounted at 6%, is $19,114.
• Should the lessor write the lease? Why?
• Yes! If the lease’s NPV is greater than zero,
then the lease should be written.
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Setting the Lease Payment
• The lessor may set the size of the lease
payments on its own or by negotiation with
the lessee.
• The lease payments are set so as to provide
the lessor with some specific rate of return.
• The NPV is set to zero with the target rate of
return as the discount rate and then solve the
equation for the lease payment.
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Remarks
• If all inputs for leasing analysis are
symmetrical between lessee and lessor,
leasing is a zero-sum game.
• The lessor’s cash flows would be equal, but
opposite in sign, to the lessee’s NAL.
• What are the implications?
• Differences between lessees and lessors must
exist to support a lease.
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Other Issues in Lease Analysis
• Do higher residual values make leasing less
attractive to the lessee?
• Is lease financing more available or “better”
than debt financing?
• Is the lease analysis presented here applicable
to real estate leases? To auto leases?
• Vehicle leases
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Other Reasons for Leasing
• Leasing is driven by various differences
between lessees and lessors. The top three
motivations are:
– tax rate differentials
– that lessors are often better to bear the residual
value risk than lessees
– that lessors can maintain the leased asset more
efficiently than lessees
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Other Reasons for Leasing (cont’d)
• Leasing provides operating flexibility (airlines
lease their aircraft).
• Leasing can reduce the risk of technological
obsolescence (hospitals lease high-technology
items).
• Leasing especially with a cancellation clause
can also be attractive when a firm is uncertain
about the demand for its products or services.
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Issues of Cancellation Clause
• A cancellation clause would lower the
risk of the lease to the lessee but raise
the lessor’s risk.
• To account for this, the lessor would increase
the annual lease payment or
else impose a penalty for early cancellation.
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