LEASING

1. LEASING • Corporation lease both short term and long term rental agreement (more than five years) • Every lease contract has two parties : • Lessee is the user of leased asset (the user of equipment) • Lessor is the owner of a leased • A lease is a contractual agreement between a lessee and lessor. • Because the user can also buy the asset, leasing and buying involve alternative financing arrangements for the use of an asset. • The lessor is independent leasing company who purchased the equipment from a manufacturer such as IBM or Apple (Lease of this type are called direct leases) • A manufacturer like IBM could lease its own computers (Lease of this type are called sales type leasing)

2. FIGURE 21.1 Buying versus Leasing Buy Firm U buys and uses asset: financing raised by debt and equity Lease Firm U lease asset from lessor: The lessor owns the asset Manufacturer of asset Manufacturer of asset Firm U buys asset form manufacturer Lessor buys asset Firm U leases asset form lessor • Firm U • Uses asset • Owns asset • Lessor • Owns asset • Does not uses asset • Lessee (Firm U) • Uses asset • Does not own asset Creditors and equity shareholders supply financing to Firm U Creditors and shareholders supply financing to lessor Equity shareholders Creditors Equity shareholders Creditors

3. Operating lease : a lease where the lessee received an operator along with the equipment. • Operating leases are usually not fully amortized • Operating leases usually require the lessor to maintain and insure the leased assets. • Perhaps the most interesting feature of an operating lease is the cancellation option. • Financial Lease are the exact opposite of operating leases : • Financial lease do not provide for maintenance or service by the lessor • Financial lease are fully amortized • The lessee usually has a right to renew the lease on expiration • Financial lease cannot be canceled. • Two special types of financial lease : • A sale and lease-back occurs when a company sell an asset it owns to another firm and immediately leases it back. • Leverage lease : • The lessee uses the assets and makes periodic lease payment. • The lessor purchases the assets, delivers them to the lessee, and collects the lease payments. • The lenders supply the remaining financing and receive interest payments from lessor.

4. In the USA before November 1976, financial leases were off balance-sheet financing (Lessee needed only to report information on leasing activity in the footnotes of their financial statements) • ‘Accounting for leases’, under FAS 13, certain lease classified as capital leases. For capital lease, the present value of the lease payment appears on the value of the lease payment appears on the right-hand side of the balance sheet. The identical value appears on the left hand side of the balance sheet as an asset. • In order to implement this new requirement the FASB had to come up with objective rules for distinguishing between operating and capital (financial) lease. • They defined capital leases as lease which meet any one of the following requirements : • The lease agreement transfers ownership to the lessee before the lease expires. • The lessee can purchase the asset for a bargain price when the lease expires. • The lease term is 75% or more of the estimated economic life of the asset. • The present value of the lease payment is at least 90% of the assets value. • All other leases are operating leases as far as the accountants are concerned.

5. TABLE 21.1 Example of Balance Sheet under FAS 13

6. Financial leases may be evaluated by discounting the lease cash flows at the after-tax interest rate that the firm would pay on an equivalent loan. # Example : case xomox (manufactures pipe) currently has a five years backlog of pip orders for the Trans-Honduran Pipeline. IBMC makes a pipe-boring machine that can be purchased for $10,000. xomox has determined that it needs a new machine, & the IBMC will save xomox $6,000 per year for the next five years. Xomox has a corporate tax rate of 34% ; straight-line depreciation & worthless after five years. However, Friendly Leasing Corporation has offered to lease the same pipe-boring machine to Xomox for $2,500 per year for five years. Simon Smart, a recently hired MBA, has been asked to calculated the incremental cash flows leasing the IBMC machine in lieu of buying it.

7. Cash flows to friendly leasing as lessor of IBMC Pip-Boring Machine : exactly the opposite of those of Xomox. • Good Reasons for leasing • Taxes may be reduced by leasing • The lease contract may reduce certain types of uncertainty • Transaction costs can be higher for buying an asset and financing it with debt or equity than for leasing the asset • Bad Reasons for Leasing • Leasing and accounting Income : • Firm’s balance sheet shows fewer liabilities with an operating lease than with either a capitalized lease or a purchase financed with debt. • One Hundred-Percent Financing : • It is often claimed that leasing provides 100%, whereas secured equipment loans require an initial down payment.

8. TABLE 21.2 Cash Flows to Xomox from Using the IBMC Pipe-Boring Machine: Buy Versus Lease

9. TABLE 21.3 Incremental Cash Flow Consequences for Xomox from Leasing instead of Purchasing We could have expressed the cash flows from the purchase relative to the cash flows from leasing (the opposite of those in the bottom line of table 21.3)

10. NPV analysis of the Lease Versus Buy Decision • Discount all cash flows at the after-tax interest rate. Xomox’s incremental cash flows from leasing versus purchasing are Let us assume that xomox can either borrow or lend at the interest rate of 7.57575 percent. If the corporate tax rate is 34%, the correct discount rate is the after-tax rate of 5% (7.57575% x (1 – 0.34). So, NPV = $10,000 - $2,330 x A50.05 = -$87.68 Because the NPV of the incremental cash flows from leasing relative to purchasing is negative, Xomox prefers to purchase. • We describe the precise method for calculating the difference in optimal debt levels between purchase and lease in the Xomox example. • Increase in optimal debt level from purchase alternative relative to lease alternative : • $10,087.68 = ($2,330/1.05) + ($2,330/1.052) + ($2,330/1.053) + ($2,330/1.054) + ($2,330/1.055)

12. TABEL 21.7 Cash Flows to Friendly Leasing as Lessor of IBMC Pipe-Boring Machine

13. TABEL. Cash Flows consequences of the lease contract offered to Greymare Bus Lines (in thousands)

14. Example 2. What-Not, Inc. is evaluated the lease of a minicomputer which, if purchased, would cost $150,000. Its estimated useful life is 5 years, at the end of which time it will be obselete. The annual lease payments are $35,000 payable in six installments, the first being payable when the contract is signed. The company is in the 34% marginal income tax bracket. • What-Not, Inc. before tax borrowing rate on long term debt is 12%. • Set up a statement of cash flow consequences of the lease contact. • Estimate the NPV at 12% of the lease arrangement • cash flow consequences of the lease contact (value to lease) • After tax borrowing rate = (1 – 0.34)(12%) = 7.92% • NPV = 116.70-(39.42/1.0792) - … -(26.04/1.07925) = -$10.268