Financial Analysis, Planning and Forecasting Theory and Application

1. Financial Analysis, Planning and ForecastingTheory and Application Chapter 14 Leasing: Practices and Theoretical Developments By Alice C. Lee San Francisco State University John C. Lee J.P. Morgan Chase Cheng F. Lee Rutgers University

2. Outline • 14.1 Introduction • 14.2 Types of leasing arrangements and accounting treatments • Three leasing forms • Accounting for leases • 14.3 Cash-flow estimation and valuation methods • 14.4 The Modigliani and Miller propositions and the theoretical considerations of leasing • 14.5 Lease vs. buy decisions under uncertainty: the CAPM approach • 14.6 Summary and conclusion

3. 14.1 Introduction • Fabozzi (1981) has discussed the conventional reasons for leasing in detail. Here we shall discuss them only briefly. • True lease financing might be cheaper than borrowing or purchasing the asset. This kind of advantage is primarily due to different marginal tax rates faced by the lessor and lessee. • Since leasing generally does not require the firm to make a down payment (as most lending institutions do), the effect is to conserve working capital, although, in general, lease payments are prepaid and in that sense are like a down payment (although generally smaller than those required in most purchase arrangements). • Leasing may preserve the credit and debt capacity of the firm. This, as we shall see, is a result of the accounting conventions in use today. • Leasing can reduce the risk of obsolescence and capital-equipment disposal problems. Almost always the term of the lease is less than the life of the asset, particularly so in the case of leases that are cancelable at certain times at the option of the lessee. • Leasing is more flexible and convenient than buying an asset. Most lessors deal with leasing arrangements on a regular basis and are used to tailoring these arrangements, within reason, to their client’s best interest.

4. 14.2 Types of leasing arrangements and accounting treatments • Three leasing forms a) Direct Leasing b) Sale and Leaseback c) Leveraged Leasing • Accounting for leases a) Capital Lease Treatment b) Accounting for Operating Leases c) Accounting for Leases from the Lessor’s Standpoint

5. 14.2 Types of leasing arrangements and accounting treatments

6. 14.2 Types of leasing arrangements and accounting treatments

7. 14.2 Types of leasing arrangements and accounting treatments

8. 14.2 Types of leasing arrangements and accounting treatments

9. 14.2 Types of leasing arrangements and accounting treatments

10. 14.2 Types of leasing arrangements and accounting treatments

11. 14.3 Cash-flow estimation and valuation methods

12. 14.3 Cash-flow estimation and valuation methods where A = Net cash outflow at t=0, Rt – Ct = Period’s net operating inflows, Dt = Period’s depreciation expense, Sn = Expected salvage value at time n, tc = Ordinary income tax rate, and k = After-tax cost of capital for the firm.

13. 14.3 Cash-flow estimation and valuation methods

14. 14.3 Cash-flow estimation and valuation methods

15. 14.4 The Modigliani and Miller propositions and the theoretical considerations of leasing Vu = Total value of an unleveraged firm, = A perpetual stream of after-tax cash flows, and k = Investor’s required return on equity.

16. 14.4 The Modigliani and Miller propositions and the theoretical considerations of leasing (14.6) (14.7)

17. 14.4 The Modigliani and Miller propositions and the theoretical considerations of leasing

18. 14.4 The Modigliani and Miller propositions and the theoretical considerations of leasing

19. 14.4 The Modigliani and Miller propositions and the theoretical considerations of leasing where C = Net initial outlay, c = Applicable corporate tax rate, Rt = Cash flows before depreciation and taxes, Dt = Depreciation expense accruing in time t, = A weighted discount rate, weighted according to the risk of the component flows, and n = The life of the project.

20. 14.4 The Modigliani and Miller propositions and the theoretical considerations of leasing (14.10) where L0 = Lease payment at day 1, Lt = Lease payment at the end of time period t, Ft = Executory costs paid by the lessor, Pj = Purchase price of asset at end of lease term, D = Depreciation expense in time period t, i = Discount rate for a riskless cash flow, k = Discount rate for a risky cash flow, and j = term of lease.

21. 14.4 The Modigliani and Miller propositions and the theoretical considerations of leasing where Mt = Payment of interest and principal on the loan during period t, and At = Amortization of the loan for tax purposes in period t.

22. 14.4 The Modigliani and Miller propositions and the theoretical considerations of leasing (14.12) (14.13) (14.14)

23. 14.4 The Modigliani and Miller propositions and the theoretical considerations of leasing (14.15) where Pt = Lease payment at time t, c = The lessor’s marginal tax rate, Bt = Depreciation expense on the asset at time t, RD = Before-tax cost of debt, (1 - c)RD = Investor’s after-tax required return on debt, and  = Lessee’s marginal tax rate.

24. 14.4 The Modigliani and Miller propositions and the theoretical considerations of leasing (14.16) (14.16) (14.17) (14.18)

25. 14.4 The Modigliani and Miller propositions and the theoretical considerations of leasing (14.19) (14.19) (14.20)

26. 14.5 Lease vs. buy decisions under uncertainty: the CAPM approach (14.21) where Lit = Lease payment at time t, Xit = Asset’s purchase price, and dit = Economic depreciation of the asset in time t.

27. 14.5 Lease vs. buy decisions under uncertainty: the CAPM approach (14.22) E(Rit) = Rf - Bit[E(Rm) - Rf] (14.23) Lit = Xit [Rf - Bit (E(Rm) - Rf) + E(dit)] (14.24)

28. 14.5 Lease vs. buy decisions under uncertainty: the CAPM approach (14.25) E(Vij) = 1 + Rf + Bj (E(Rm) - Rf). (14.26) (14.27)

29. 14.5 Lease vs. buy decisions under uncertainty: the CAPM approach (14.28) (14.29) (14.30)

30. 14.5 Lease vs. buy decisions under uncertainty: the CAPM approach (14.31) (14.32) (14.33)

31. 14.6 Summary and conclusion In this chapter we have uncovered many of the interesting facets of leasing. The conventional rationales for leasing deal primarily with reducing the risk of making use of an asset vis-à-vis that of actually owning said asset, and with maintaining greater borrowing capacity than would otherwise be possible. The latter rationale is subject to greater question, given the recent emphasis, in the field of leasing accounting, on making these fixed obligations known to all viewers of the firm’s financial statements, rather than allowing quasi-debt instruments to be, for the most part, hidden in footnotes. There still should exist some concern, however, as to the effects that leases have on the various financial statements, for bond covenants and other restrictions may become binding if leases that could conceivably be treated in more than one way for accounting purposes are not optimally treated. The risk factor, the element of lease contracts that attracts most of the attention, raises the question of whether compensating returns must be made between the agreeing parties, while the existence of the various forms of leasing arrangements testify toward a willingness on the parts of these parties to engage in leasing activities, with the knowledge that such risk transfers exist.

32. 14.6 Summary and conclusion In the area of lease valuation we found that the minimum discount rate applied to the cash flows of a leasing scheme was the risk-free rate, and not some other rate deflated by the interest-tax-break percentage so that this figure would be less than the risk-free rate. In confronting the problem of valuation under conditions of market equilibrium, whether it is the specification of Modigliani and Miller, or of the more specialized CAPM framework, we found no rationale for leasing in competitive markets. Even including the often troublesome market imperfection known as taxation, this result was seen to hold, and no abnormal returns were found to be possible through leasing, due to the competitive element of the market. Unfortunately, the types of taxation considered in these market-equilibrium models generally avoid those irregular tax considerations such as investment tax credits, the inclusion of which greatly complicates the analysis because the element of negotiation is involved. All is not lost though, as the Myers et al. formulation shows where such subsidies are taken account of in a general form. With the existence of specialized leasing companies, either as a subsidiary of a manufacturer or as a separate entity altogether, we find it difficult to accept the restrictive view that leasing offers no net benefit to selected lessor-lessee consortiums. As such, the lease-versus-buy decision does require separate analysis for each leasing opportunity, and analysts must consider each proposal (lease versus buy) separately if they believe there are differences between the net costs and/or benefits from leasing and those of legal ownership.

33. Appendix 14A. The Application of Adjusted Present Value (APV) Method to Lead versus Buy Decision (14.A.1) where Rt = pretax operating cash revenue gathered by the project during time period t Ct = pretax operating cash expenses due to the project during time period t dept = additional depreciation due to the project during time period t = the market rate of return on unlevered flows of the indicated risk class. r = the interest rate paid on debt = corporate tax rate

34. Appendix 14A. The Application of Adjusted Present Value (APV) Method to Lead versus Buy Decision Table 14.A.1

35. Appendix 14A. The Application of Adjusted Present Value (APV) Method to Lead versus Buy Decision Table 14.A.2

36. Appendix 14A. The Application of Adjusted Present Value (APV) Method to Lead versus Buy Decision

37. Appendix 14A. The Application of Adjusted Present Value (APV) Method to Lead versus Buy Decision Table 14.A.3.