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Chapter 19 Lease Financing

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Chapter 19 Lease Financing

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    1. Finance 312 1 Chapter 19 Lease Financing

    2. Finance 312 2 Lease A lease is a contract that allows an individual or a firm to make economic use of an asset for a stated period of time without obtaining ownership interest in it.

    3. Finance 312 3 Lease Contract Lessee Obtains use of an asset Specific period of time Ownership to lessor Agrees to make a series of payments to lessor Leases Alternative to term financing Arrangements to transfer tax benefits

    4. Finance 312 4 Providers of Lease Financing Equipment Manufacturers Finance Companies such as GE Credit Banks Independent Leasing Companies

    5. Finance 312 5 Classes of Leases Operating lease Service lease Maintenance lease Maintenance and insurance included Financial lease Noncancellable Lessee responsible for Maintenance Insurance Property taxes Direct lease Sale and leaseback Leveraged lease

    6. Finance 312 6 Operating Lease An Operating Lease is an agreement for period to period use of an asset. Maintenance and insurance are usually included in the lease The lease is cancelable.

    7. Finance 312 7 Financial or Capital Lease A financial or capital lease is noncancelable. Lessee is responsible for maintenance, insurance and property taxes. Can renew at expiration Types of Financial Leases Direct Lease -- the lessee acquires the use of an asset it has not owned. Sale and Leaseback -- The lessor purchases the asset from the lessee and then leases it back to the lessee. Leveraged Lease Three-party financial lease

    8. Finance 312 8 Leveraged Lease A leveraged lease is a three-party financial lease consisting of the lessee who acquires the use of the asset, the lessor who holds an equity interest in the asset (at least 20%), and a lender (or lenders) who finance the purchase of the asset by the lessor. 85% of the value of all financial leases Cash flows to the lessor might be “nonnormal.” - + -+ (negative, positive, negative, positive)

    9. Finance 312 9 Leveraged Lease - continued Advantages to Lessor Tax benefits from MACRS depreciation Tax benefits from interest paid to lender Lease income Put up only 20% to 50% of the asset Limited exposure Salvage value

    10. Finance 312 10 Leveraged Lease - continued Advantages to Lessee Low effective interest rate Can’t use tax benefits and pass them on Use of the asset Advantages to Lender(s) Good return First lien on the asset Assignment of the lease rental payments

    11. Finance 312 11 Advantages to Leasing Lower payments because tax benefits accrue to lessor Lease agreements tend to be more flexible Lessor is able to obtain a higher salvage value Piecemeal Financing Convenient Avoid some risk of obsolescence Smoother earnings and EPS Lessor can maintain equipment more efficiently

    12. Finance 312 12 Advantages to Leasing - continued Liquidity in the case of Sale and Leaseback For small or marginally profitable firms, leases may be the only source of financing available. Leasing may provide divisional/plant managers some flexibility in acquiring assets

    13. Finance 312 13 Disadvantages to Leasing More expensive for profitable firms Salvage value goes to lessor Difficult to get approval for modifications on leased real estate May not be canceled without penalty

    14. Finance 312 14 Tax and Accounting Considerations Recognized by IRS as a lease Remaining useful life must be greater than 1 year or 20% of cost of property May not exceed 30 years Reasonable ROI Renewal options Purchase options but at “arms length” Lessor must provide 20 % equity in leveraged leases Property valuable only to the lessee can’t be leased Lease contract disallowed for tax purposes if lease is set up purely to speed up tax deductions.

    15. Finance 312 15 Financial Accounting Standards Board ( FASB # 13) Requires that financial leases be capitalized Liability = to the PV of the lease payments Discounted at the firm’s borrowing rate Secured loan Similar maturity Report asset value Footnotes - Full Disclosure Financial leases Operating leases

    16. Finance 312 16 Financial Accounting Standards Board ( FASB # 13) - continued Present Value of lease payments must be at least 90% of fair market value Lease term is 75% of the estimated economic life of the asset

    17. Finance 312 17 Small Firms Reasons for leasing Fewer restrictive covenants Less cash required "up front" Better protection against obsolescence Quicker approvals Expensive reasons High effective interest cost if a profitable firm Loss of tax benefits Loss of salvage value

    18. Finance 312 18 Lease Payments Lessor’s required payment Three-step process Step 1: Compute the lessor’s amount to be amortized Initial outlay Less: PV of after-tax salvage Less: PV of depreciation tax shelter Equals: Amount to be amortized Step 2: Compute after-tax lease income required Amount to be amortized = PV of after-tax lease payment - Use your BGN button on your calculator if lease payments are at the beginning of the year. Step 3: Compute before-tax lease payment

    19. Finance 312 19 Lease Vs Borrowing to Buy You have already made the decision in that the investment project has a positive NPV. Compute the NAL If NAL is positive cheaper to lease If NAL is negative cheaper to borrow and own

    20. Finance 312 20 Net Advantage to Leasing (NAL) Calculations Installed cost of asset Less: PV of after-tax lease payments Use your BGN button, if applicable and discount at the after-tax cost of Debt Less: PV of depr tax shield (use MACRS) Plus: Present value of after-tax operating costs incurred if owned but not if leased Less: PV of Salvage value (Discount at the lessee’s weighted cost of capital) Equals Net Advantage to Leasing (to lessee)

    21. Finance 312 21 Net Advantage to Leasing The present value of the after-tax lease payment is calculated by using the after-tax marginal cost of borrowing. The annual depreciation tax shield is the depreciation times the lessee’s marginal tax rate. Use MACRS depreciation. Use the after-tax marginal cost of borrowing to calculate the present value of the depreciation tax shield.

    22. Finance 312 22 The installed cost is the purchase price plus installation and shipping charges. If leased, some operating costs (such as property tax payments, insurance, etc.) may be paid by the lessor. Discount the savings at the after-tax marginal cost of borrowing. The salvage value belongs to the lessor and should be discounted at the after-tax cost of capital to reflect its uncertainty.

    23. Finance 312 23 Lease Analysis from the Lessor’s Perspective Use the Net Advantage to Leasing (NAL) approach except that all the positive items are now negative (such as the Installed Cost of the Asset. All the negative items (such as After-Tax Lease Payments) are now negative. Leasing can be beneficial to both the lessor and the lessee depending on different tax rates and perhaps different salvage values.

    24. Finance 312 24 Lease Financing - Conclusion Types of Leases Operating Lease Financial Lease Direct Lease Sale and Leaseback Leveraged Lease Tax Considerations FASB # 13 Lease Payments Net Advantage to Leasing

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