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Chapter 27 – Leasing

CHAPTER 27

LEASING

CHAPTER WEB SITES

Section Web Address

Introduction www.monitordaily.com

27.1 www.bloomberg.com

www.keystoneleasing.com

27.5 www.lease-vs-buy.com

www.cars.com

27.7 www.ilfc.com

CHAPTER ORGANIZATION

27.1 Leases and Lease Types

Leasing versus Buying

Operating Leases

Financial Leases

27.2 Accounting and Leasing

27.3 Taxes, the IRS, and Leases

27.4 The Cash Flows from Leasing

The Incremental Cash Flows

A Note about Taxes

27.5 Lease or Buy?

A Preliminary Analysis

Three Potential Pitfalls

NPV Analysis

A Misconception

27.6 A Leasing Paradox

27.7 Reasons for Leasing

Good Reasons for Leasing

Dubious Reasons for Leasing

Other Reasons for Leasing

27.8 Summary and Conclusions

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Chapter 27 – Leasing

ANNOTATED CHAPTER OUTLINE

27.1 Leases and Lease Types

Basic Terminology:

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

A. Leasing versus Buying

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.

B. Operating Leases

Also called a service lease.

Characteristics:

1. Payments are not high enough for the lessor to recover the full

cost of the asset

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

C. Financial Leases

Also called capital leases.

Characteristics:

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 severe penalty

The three financial lease types are:

1. Tax-oriented leases – the lessor is the owner for tax purposes

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Chapter 27 – Leasing

2. Leveraged leases – lessor borrows a substantial portion of the

purchase price on a non-recourse basis

3. Sale and leaseback agreements – lessee sells the asset to the

lessor and leases it back

Real-World 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.

Real-World Tip: Traditionally, sale and leaseback arrangements

have involved expensive assets (e.g., buildings, airliners, railroad

cars); however, “employee leasing” has grown from almost zero in

1984 and many millions today. 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.

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Chapter 27 – Leasing

27.2 Accounting and Leasing

Statement of Financial Accounting Standards No. 13, “Accounting

for Leases.”

Financial 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.

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 there 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).

27.3 Taxes, the IRS and Leases

A valid lease from the IRS’s perspective will meet these standards:

1. Lease term is less than 80 percent of the asset’s economic life

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. Renewal options must be reasonable, reflecting market value

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Chapter 27 – Leasing

27.4 The Cash Flows From Leasing

A. The Incremental Cash Flows

Three important cash flow differences between leasing and buying:

1. The lessee’s lease payments are fully tax deductible. The after–

tax 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.

B. A Note on Taxes

The size of the lease advantage is often a question of who can best

utilize the tax shelters associated with the lease arrangement.

27.5 Lease or Buy?

A. A Preliminary Analysis

Leasing is advantageous if the implied after-tax interest rate on the

lease is less than the company’s after-tax 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.

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Chapter 27 – Leasing

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%. For

simplicity, assume straight-line depreciation.

Year 0 1 2 3 4 5

Purchase Savings 25,00

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

–

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 after-tax

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%.

B. Three Potential Pitfalls

Potential pitfalls to using the implied rate of interest on the lease

instead of the NPV:

1. Since the cash flows are positive, then negative, you have to

adjust the interpretation of the IRR rule. The IRR represents the

rate paid in this instance, and you should choose the lower number.

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Chapter 27 – Leasing

2. Normally, you determine the advantage to leasing over

borrowing – as was done above – so you lease if the IRR is lower

than the after-tax 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 after-tax cost of borrowing.

3. The implied rate is based on the net cash flows of leasing instead

of borrowing – you have to use incremental cash flows.

C. NPV Analysis

The net advantage to leasing can be determined by discounting the

cash flows back at the lessee’s after-tax cost of borrowing. This is

the same as the NPV computed in the example above.

D. A Misconception

The present value of the loan payments, if we borrow and buy, is

the cost of the equipment regardless of the loan repayment

schedule. So, it doesn’t really matter if we pay cash to purchase the

asset or we borrow and buy the asset; the initial cost is the same

either way.

27.6 A Leasing Paradox

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?

27.7 Reasons For Leasing

A. Good Reasons for Leasing

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.

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Chapter 27 – Leasing

5. Leasing may encumber fewer assets than secured borrowing.

B. Dubious 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 after-tax cash flows.

C. Other Reasons for Leasing

Many government agencies use leasing to circumvent bureaucratic

capital expenditure controls.

27.8 Summary and Conclusions

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