CHAPTER 21
LEASING
SLIDES
CHAPTER ORGANIZATION
21.1 Key Concepts and Skills
21.2 Chapter Outline
21.3 Types of Leases
21.4 Buying versus Leasing
21.5 Operating Leases
21.6 Financial Leases
21.7 Sale and Lease-Back
21.8 Leveraged Leases
21.9 Leveraged Leases
21.10 Accounting and Leasing
21.11 Accounting and Leasing (Balance Sheet)
21.12 Capital Lease
21.13 Taxes, the IRS, and Leases
21.14 Taxes, the IRS, and Leases
21.15 The Cash Flows of Leasing
21.16 The Cash Flows of Leasing
21.17 The Cash Flows of Leasing
21.18 A Detour on Discounting and Debt Capacity with Corporate Taxes
21.19 NPV Analysis of the Lease-vs.-Buy Decision
21.20 NPV Analysis of the Lease-vs.-Buy Decision
21.21 NPV Analysis of the Lease-vs.-Buy Decision
21.22 Debt Displacement and Lease Valuation
21.23 Debt Displacement and Lease Valuation
21.24 Debt Displacement and Lease Valuation
21.25 Does Leasing Ever Pay: The Base Case
21.26 Reasons for Leasing
21.27 A Tax Arbitrage
21.28 A Tax Arbitrage
21.29 Tiger Leasing’s Breakeven Payment
21.30 Tiger Leasing’s Breakeven Payment
21.31 ClumZee Mover’s Breakeven Payment
21.32 ClumZee Mover’s Breakeven Payment
21.33 Is a Lease Possible?
21.34 Some Unanswered Questions
21.35 Quick Quiz
21.1 Types of Leases
The Basics
Operating Leases
Financial Leases
21.2 Accounting and Leasing
21.3 Taxes, the IRS, and Leases
21.4 The Cash Flows of Leasing
21.5 A Detour for Discounting and Debt Capacity with Corporate Taxes
Present Value of Riskless Cash Flows
Optimal Debt Level and Riskless Cash Flows
21.6 NPV Analysis of the Lease-versus-Buy Decision
The Discount Rate
21.7 Debt Displacement and Lease Valuation
The Basic Concept of Debt Displacement
Optimal Debt Level in the Xomox Example
21.8 Does Leasing Ever Pay: The Base Case
21.9 Reasons for Leasing
Good Reasons for Leasing
Bad Reasons for Leasing
21.10 Some Unanswered Questions
Are the Uses of Leases and Debt Complementary?
Why Are Leases Offered by Both Manufacturers and Third-Party Lessors?
Why Are Some Assets Leased More Than Others?
ANNOTATED CHAPTER OUTLINE
Slide 21.1 Key Concepts and Skills
Slide 21.2 Chapter Outline
21.1 Types of Leases
A. The Basics
Slide 21.3 Types of Leases
Lease – a contractual agreement between two parties: the lessee
and the lessor
Lessee – the party that has the right to use an asset and makes period
payments to the asset’s owner
Lessor – owner of the asset
Slide 21.4 Buying versus Leasing
Buying versus Leasing: The decision involves a comparison of the
alternative financing methods employed to secure the use of the
asset. In both cases, the company ends up using the asset.
A. Operating Leases
Slide 21.5 Operating Leases
Also called a service lease.
1. Payments are not high enough for the lessor to recover the full
cost of the asset (i.e., not fully amortized).
2. Life of the lease is often less than the economic life of the asset.
3. The lessor often provides the routine maintenance for the asset.
4. It is often cancelable.
B. Financial Leases
Slide 21.6 Financial Leases
Also called capital leases.
1. Payments are typically sufficient to cover the lessor’s cost of
purchasing the asset and to provide the lessor a fair return
(therefore, also called a fully amortized lease).
2. The lessee is responsible for insurance, maintenance and taxes.
3. There is generally no cancellation clause without sever penalty.
Slide 21.7 Sale and Lease-Back
Slide 21.8 –
Slide 21.9 Leveraged Leases
The three financial lease types are:
1. Tax-oriented leases – the lessor is the owner for tax purposes
2. Sale and leaseback agreements – lessee sells the asset to the lessor
and leases it back
3. Leveraged leases – lessor borrows a substantial portion of the
purchase price on a non-recourse basis
Lecture Tip: As described by Professor James Johnson in his
article “Predatory Leasing: The Curse of the No-Exit Lease”
(Corporate Finance Review, January/February 1999), some
lessors make it extremely difficult for lessees to escape the lease at
expiration. Typically lessees have the right to purchase the
equipment, extend the lease, or “walk away.” In a “predatory”
lease, the end-of-lease language traps the lessee. Consider the
following end-of-lease language provided in the article:
“At the expiration of the lease term …or at the expiration of an
extention [sic] term … lessee must (1) purchase the
leased property at a reasonable price; (2) return the
leased property …and lease replacement property
which has a cost at least equal to the original cost of
the returned property; or (3) extend the lease for an
additional year at the lease rate prevailing in the
expiring lease. Regarding options (1) and (2), lessor
and lessee shall agree to terms or not agree to terms in
their sole discretion.”
Notice that: the first option does not say “fair market value” – thus,
the lessor can insist on an exorbitant price, effectively taking this
option off the table. The second option does not specify the terms
of the subsequent lease, which allows the lessor to specify
exorbitant terms, taking the second option off the table. And, the
third option results in the lessee paying the same lease rate for
equipment that is worth a fraction of its original value. As
Professor Johnson points out, the “reasonable exit – simply
returning the equipment when the lease ends – has been ruled out”
by the wording of the document.
Lecture Tip: Traditionally, sale and leaseback arrangements have
involved expensive assets (e.g., buildings, airliners, railroad cars);
however, according to a piece in The Wall Street Journal, the
number of employees hired out by “employee leasing” has grown
significantly. Unlike traditional “temps,” these people are
employed by the lessor, provided with health and other benefits,
and then leased to a client firm. The development of this industry
is perhaps a natural outgrowth of the downsizing and outsourcing
of the 1990s; it remains to be seen whether the anticipated savings
materialize.
21.2 Accounting and Leasing
Slide 21.10 Accounting and Leasing
Slide 21.11 Accounting and Leasing (Balance Sheet)
Accounting treatment is primarily covered by Statement of Financial
Accounting Standards No. 13, “Accounting for Leases.”
Financial (capital) leases – capitalized and reported on the balance
sheet (a debit to the asset for the present value of the lease
payments and a credit recognizing the financial obligation of the
lease).
Operating leases – not disclosed on the balance sheet, but discussed in
the footnotes.
Slide 21.12 Capital Lease
A lease is declared a capital lease if one or more of the following
criteria is met:
1. Property ownership is transferred to the lessee by the end of the
lease term.
2. Lessee can purchase the asset for below market value at the lease’s
expiration.
3. Lease term is 75 percent of the asset’s economic life.
4. Present value of payments is at least 90 percent of the market value
of the asset at inception.
Note: Often it is an arbitrary distinction between financial and
operating leases. An advantage of operating lease classification is
that the balance sheet may appear stronger (such as a lower total
debt to total asset ratio).
21.3 Taxes, the IRS and Leases
Slide 21.13 –
Slide 21.14 Taxes, the IRS, and Leases
A valid lease from the IRS’s perspective will meet these standards:
1. Lease term is less than 30 years.
2. The contract should not have an option to buy at a price below fair
market value when the lease contract expires.
3. The lease contract should not have a payment schedule that is
initially very high and lower thereafter—it suggests that tax
avoidance is the motive for the lease.
4. The lease payment plan should provide the lessor a fair rate of
return.
5. The lease should not limit the lessee’s right to issue debt or pay
dividends.
6. Renewal options must be reasonable, reflecting market value.
21.4 The Cash Flows of Leasing
Slide 21.15 –
Slide 21.17 The Cash Flows of Leasing
Three important cash flow differences between leasing and buying:
1. The lessee’s lease payments are fully tax deductible. The
aftertax lease payment is equal to the pre-tax payment times (1 –
tax rate).
2. The lessee does not own and may not depreciate the asset. The lost
depreciation tax shield is depreciation expense times tax rate.
3. The lessee does not have the upfront cost of purchasing the asset.
As with any type of NPV analysis, remember to evaluate
incremental tax flows. Since operating cost savings should be
equivalent whether bought or leased, these are not included.
21.5 A Detour for Discounting and Debt Capacity with Corporate Taxes
Slide 21.18 A Detour on Discounting and Debt Capacity with Corporate
Taxes
A. Present Value of Riskless Cash Flows
In a world with corporate taxes, firms should discount riskless cash
flows at the aftertax riskless rate of interest.
B. Optimal Debt Level and Riskless Cash Flows
In a world with corporate taxes, one determines the increase in the
firm’s optimal debt level by discounting a future guaranteed
aftertax inflow at the aftertax riskless interest rate.
21.6 NPV Analysis of the Lease-versus-Buy Decision
Slide 21.19 –
Slide 21.21 NPV Analysis of the Lease-vs.-Buy Decision
The NPV, which is also called the net advantage to leasing (NAL), can
be determined by discounting the cash flows back at the lessee’s
aftertax cost of borrowing. IRR can also be used. Note, however,
that normally you determine the advantage to leasing over
borrowing, so you lease if the IRR is lower than the aftertax cost of
borrowing. If you determine the advantage of borrowing over
leasing (reverse all the signs), then you are back to “conventional
cash flows,” and you would lease if the IRR is higher than the
aftertax cost of borrowing.
Lecture Tip: Here is another example of the lease versus buy decision.
A florist can purchase a delivery truck from her local GM dealer
for $25,000. The GM dealer will also lease the truck for $6,100
per year over five years. The truck has an expected life of seven
years. The truck is expected to be worth $2,500 in five years and
the florist has the option to buy it at fair market value at that time.
If the florist wants to purchase the truck, she must borrow the
money from Boone National Bank at a current rate of 10%. Which
financing option is better?
First, if we ignore taxes, the implied interest rate of these payments
is (assuming lease payments are end of year) 9.5%. This implies
that the GM dealer is willing to loan money to the florist at 9.5%
instead of the conventional 10% loan being offered by the bank.
The decision appears clear – lease the truck.
Unfortunately, lease versus buy decisions are not this simple. Taxes
are very important. In this lease, the entire lease payment is tax
deductible since the lease term is less than 80 percent of the asset’s
life and the option to purchase at the end is for fair market value.
If she purchases the truck, the purchase price is deductible only
through depreciation. Lease contracts also often include
maintenance, insurance, etc. Consider the following after-tax cash
flows when making the decision. The florist’s tax rate is 34%, and,
for simplicity, assume straight-line depreciation.
Year 0 1 2 3 4 5
Purchase Savings 25,00
0
After–tax lease payment
6100(1-.34)
–
4,026
–
4,026
–
4,026
–
4,026
–
4,026
Lost depreciation tax
shield
(25,000/5)(.34)
–
1,700
–
1,700
–
1,700
–
1,700
–
1,700
Purchase truck –
2,500
Incremental Cash Flows 25,00
0
–
5,726
–
5,726
–
5,726
–
5,726
–
8,226
After–tax discount rate = 10%(1-.34) = 6.6%
NPV = -547.50, she should purchase now instead of leasing. The
savings of 25,000 today is not supported by the future aftertax
costs.
The after–tax loan rate (compute the IRR) would have to be
7.37% to be indifferent between the two options. This corresponds
to a pre-tax loan rate of 11.16%.
A. The Discount Rate
A lease payment is equivalent to the debt service on a secured bond
issued by the lessee, and the discount rate should be approximately
the same as the interest rate on such debt. This also explains why
the WACC should not be used as the discount rate.
21.7 Debt Displacement and Lease Valuation
Slide 21.22 –
Slide 21.24 Debt Displacement and Lease Valuation
A. The Basic Concept of Debt Displacement
A firm will generally issue debt to finance an equipment purchase,
resulting in tax shield savings. With a lease, this benefit is foregone
(i.e., debt is displaced).
A. Optimal Debt Level in the Xomox Example
21.8 Does Leasing Ever Pay: The Base Case
Slide 21.25 Does Leasing Ever Pay: The Base Case
It is important to recognize that the cash flows to the lessee are exactly
the opposite of the cash flows to the lessor when they have the
same tax rate and cost of debt. As a result, a lease arrangement is
often a zero-sum game. Since, in this situation, either one party
wins and one party loses, or both parties break even, why would
leasing take place? The answer, as we discuss below, is a result of
differential tax rates, as well as other possible factors.
21.9 Reasons For Leasing
Slide 21.26 Reasons for Leasing
A. Good Reasons for Leasing
Slide 21.27 –
Slide 21.28 A Tax Arbitrage
1. Taxes may be reduced by leasing. A potential tax shield that cannot
be used effectively by one firm can be transferred to another firm
through a leasing arrangement. The firm in the higher tax bracket
would act as the lessor and then utilize the majority of the tax
shields. (The loser is the IRS.)
2. Leasing may reduce uncertainty regarding the asset’s residual value.
This uncertainty may reduce firm value.
3. Transaction costs may be lower for leasing than buying.
4. Leasing may require fewer restrictive covenants than borrowing.
5. Leasing may encumber fewer assets than secured borrowing.
Slide 21.29 –
Slide 21.30 Tiger Leasing’s Breakeven Payment
Slide 21.31 –
Slide 21.32 ClumZee Mover’s Breakeven Payment
Slide 21.33 Is a Lease Possible?
B. Bad Reasons for Leasing
1. The balance sheet may appear stronger when operating leases are
used (since they are considered off-balance sheet financing).
2. A firm may secure a lease arrangement when additional debt would
violate existing loan agreements.
3. Basing the lease decision on the interest rate implied by the lease
payments and not on the incremental aftertax cash flows.
21.10 Some Unanswered Questions
Slide 21.34 Some Unanswered Questions
A. Are the Uses of Leases and Debt Complementary?
Firms with high debt tend to lease frequently, which may make
sense in that high debt capacity increases the capacity to lease.
B. Why Are Leases Offered by Both Manufacturers and Third-Party
Lessors?
Most likely, both can be explained by offsetting tax effects.
C. Why Are Some Assets Leased More Than Others?
The more sensitive the value of an asset is to use and maintenance,
the more likely it is to be leased.
Slide 21.35 Quick Quiz
To access Appendix 21A (APV Approach to Leasing), go to www.mhhe.com/rwj.