Leases

1. Leases

2. What is a Lease? • A lease is a contract where the lessor agrees to let the lessee use their asset in exchange for compensation • Lessee: Needs the asset, pays a quasi-rent to the lessor to use the asset • Lessor: Owns the asset, lets the lessee use the asset in exchange for a quasi-rent • Two types of leases: Operating & Financial

3. Operating Lease • The lease payments are not enough to recoup the full cost of the asset • Generally short-term contracts, and the lessor expects to either sell the asset or renew the lease • The lessor maintains and insure the asset • The lessee can return the asset and cancel the lease at will

4. Financial Leases • Lease payments are enough to cover the cost of the asset • The lessee maintenance and insures the asset • Generally cannot be cancelled • The lessee usually has a right to renew the lease at expiry

5. Sale and Lease Back • A Special Financial Leases • A firm sells an asset, and then leases it back immediately • Why would a firm do this?

6. Buy or Lease Decision • ClumZee Movers, needs a truck, which will reduce costs by $6,500/year. • The truck costs $25,000 and has a 5 yr life • If the firm buys the truck, they will use straight-line depreciation to a zero salvage value. • ClumZee tax rate is 34% • Alternatively they can lease the truck from Tiger Leasing for $8,250/year • Should Clumzee buy or lease the truck?

7. Buy Cash flow

8. Leasing Cash flow

9. Leasing minus Buying Cash Flows • Year 0: • Lease CF____ • Buy CF _____ • Lease – Buy CF ______ • Year 1-5: • Lease CF____ • Buy CF _____ • Lease – Buy CF ______

10. Leasing Incremental Cash Flows Year 0 Years 1-5 $25,000 –$1,155 –$5,990 = –$7,145 • Should ClumZee lease the truck?

11. Why discount at the debt rate? • A lease payment is like the debt service (interest payment) on a secured bond issued by the lessee. • In the real world, many companies discount both the depreciation tax shields and the lease payments at the after-tax debt rate

12. NPV Analysis: Lease-v-Buy Decision • Discount the incremental lease cash flows • ClumZee’s pre tax debt rate is 7.6% • The after tax rate is 5% → 0.076 * (1-0.34)

13. Given: Leasing v Buy Example Xomox Corp needs a new pipe machine to meet it’s demands (Tax Rate =34%, uses straight line depreciation) IBMC makes such a machine for $10,000, with an expected life of 5 years, no salvage value This machine will save Xomox $6,000 in manufacturing costs Friendly Leasing Corp will lease the same machine to Xomox for $2,500 for 5 years What are the incremental cash flows?

14. Given: Lease v Buy Cash Flows

15. Given: Lease – Buy Cash Flows

16. Given: Discounting the Difference Xomox can borrow at 7.57575%, taxes are 34% So the after tax discount rate is 5% 0.0757575 * (1-.34) = 0.05

17. Alternative Lease Evaluation Method: Debt Displacement • Since leases replace conventional debt, compare how much the company could borrow • Suppose ClumZee leases the truck for $8,250/year • Incremental cost is the payment + lost tax shield

18. The Lessor’s Cash Flows • The NPV for Tiger is the exact opposite

19. Good Reasons to Lease • Taxes can be reduced: -Corporations are in different tax brackets • Reduces uncertainty (kind of) -Residual Value: the value of the asset at expiration -Leasing allows the person best able to bear the risk, to bear the risk • Transactions costs can be higher for buying an asset and financing it with debt or equity than for leasing the asset.

20. Bad Reasons to Lease • Manipulation of Accounting Numbers -Reduces the liabilities of the balance sheet -Improves the firm’s ROA • Avoid Capital Expenditure Controls • Possible to use Leases as Off-Balance Sheet Financing

21. Taxes, the IRS, and Leases • A principal benefit of long-term leasing is tax reduction. • Leasing allows the transfer of tax benefits from those who need equipment but cannot take full advantage of the tax benefits (Depreciation) to a party who can. • The IRS tries to limit this

22. Taxes, the IRS, and Leases • The lessee can deduct lease payments if the lease is qualified by the IRS. • The lease must be less than 30 years. • There can be no bargain purchase option. • The lease should not have a schedule of payments that is very high at the start and low thereafter. • The lease payments must provide the lessor with a fair market rate of return. • The lease should not limit the lessee’s right to issue debt or pay dividends. • Renewal options must be reasonable and reflect fair the market value of the asset.

23. Tax Arbitrage ClumZee’s tax rate is 25% Tiger Leasing’s tax rate is 34% If the lease payments drop to $8,200, can the lease happen?

24. A Tax Arbitrage: Clumzee Cash Flows ClumZee Movers: Leasing Instead of Buying Year 0 Years 1-5 Cost of truck we didn’t buy $25,000 Lost Depreciation Tax Shield 5,000×(.25) = –$1,250 After-Tax Lease Payments 8,200×(1 –.25) = –$6,150 $25,000 –$7,400

25. A Tax Arbitrage: Tiger • Cash Flows: Tiger Leasing Year 0 Years 1-5 Cost of truck –$25,000 Dep Tax Shield 5,000×(.34) = $1,700 Lease Payments 8,200×(1–.34)= $5,412 –$25,000 $7,112

26. Is a Lease Possible? We need to determine each firm’s break even payment

27. ClumZee Leasing’s Breakeven Payment • Solve for a 0 NPV payment • N = 5, I/Y = 5.7, PV=25,000, PMT = ?, FV = 0 • Subtract the Dep Tax Shield to get the after tax lease payment

28. Tiger Leasing’s Breakeven Payment • Solve for a 0 NPV payment • N = 5, I/Y = 5, PV=25,000, PMT = ?, FV = 0 • Subtract the Dep Tax Shield to get the after tax lease payment

29. Is a Lease Possible? • The most that ClumZee movers can afford to pay is: • The least that Tiger Leasing can accept is:

30. Salvage Value For the purpose of this class we will ignore the effects of salvage value, beyond how it impacts depreciation

31. Quick Quiz • Compare operating and financing leases. • Explain why tax rates affect the lease vs. buy decision.