LEASING

1. LEASING • A rental agreement lasting one year or more • Periodic (e.g., monthly, quarterly, etc)payments • Payments usually level, but could change over life of lease • Substitute for asset ownership • What are the benefits of ownership? • When would you be willing to give these up?

2. LEASE TYPES • Operating leases • short-term • cancelable at option of lessee prior to end of lease term • Financial leases • long-term (typically covers most of asset’s useful life) • typically non-cancelable

3. POSSIBLE LEASING ADVANTAGES • More efficient use of tax advantages of ownership • e.g., an owner with no taxable income can’t use depreciation tax shields • Risk shifting • more applicable to operating leases • Lower-cost financing • Creditors have a better claim on the asset

4. POSSIBLE DISADVANTAGES • Loss of tax deductions associated with ownership • Loss of residual asset value • If the advantages to some potential lessees are disadvantages to others, who should lease asset?

5. Benefits Purchase price of machine (opportunity cost benefit) Maintenance or other costs paid by lessor Note that business revenues and expenses are same whether we lease or buy Costs Stream of after-tax lease payments Stream of depreciation tax shields (forgone - opportunity cost) Future after-tax salvage value (forgone - opportunity cost) LESSEE CASH FLOWS

6. EXAMPLE • Machinery cost: 40 mil • Lease payment: 12 mil per year, payable at end of year for next four years • Depreciation: 10 mil per year for four years • Tax rate = .40 • Salvage value = 2 mil • rD= 8%; WACC = 12%

7. EXAMPLE CASH FLOWS

8. After-tax lease payments and depreciation tax shields: These are safe and would support 100% of value in debt - discount at after-tax cost of debt After-tax salvage value: This is riskier and more like other company activities - discount at WACC DISCOUNT RATE

9. NET ADVANTAGE TO LEASING • P.V. of four-year annuity of -11.2 per year @ 8(1-.4) = 4.8% = -39.9 mil • P.V. of -1.2 mil 4 years from now at 12% = -1.2/(1.12)4 = -.763 mil • NPV = +40 - 39.9 - .763 = -.662 mil • Buying better than leasing in this case

10. ADDITIONAL POINTS • Buying may be better than leasing, or vice versa, but make sure that one of them is worthwhile • To compute break-even lease payment, set NPV = 0 and solve for payment • If company is not in a tax-paying position, use pre-tax cash flows and pre-tax discount rate

11. PROJECT FINANCING • Separate a project from the rest of the company and finance it separately • Example: Problem 3, Problem Set #2 (RCI’s new project) • Rationale: project financing controls the underinvestment problem • Other examples: coal mines, oil fields, oil and gas pipelines

12. FEATURES SOMETIMES FOUND IN PROJECT FINANCING • Completion undertaking • guarantee project completion or minimum performance by a certain date or repay debt • helps control asset substitution • Purchase or throughput agreements • guarantee that project output will be purchased or at least put through pipeline • partial lender control over project cash flows

13. COMMON THREADS IN PROJECT FINANCING • Large-scale project with identifiable assets and cash flows • Protect project from other creditors • Project cash flows are predictable, or can be protected against certain risks • Higher debt ratio as a result of guarantees or improved lender oversight

14. LIMITED PARTNERSHIP FINANCING • Project is again separated from rest of company • Example: Genzyme’s RDLP • Gain: Proceeds from selling partnership shares plus savings in taxes • Cost: Portion of cash flows plus portion of salvage value allocated to limited partners