Types of leases Tax Treatment of Leases Effects on financial statements Lessee s analysis Lessor s analysis Leveraged Le

1. Finance 404 1 Types of leases Tax Treatment of Leases Effects on financial statements Lessee�s analysis Lessor�s analysis Leveraged Leases Other issues in lease analysis

2. Finance 404 2 Importance of Leasing Over 30 percent of all new capital equipment is financed through lease arrangements. Currently leasing companies buy about 50 percent of all new commercial aircraft sold.

3. Finance 404 3 Who are the two parties to a lease transaction? The lessee, who uses the asset and makes the periodic lease, or rental payments. The lessor, who owns the asset and receives the rental payments Note that the lease decision is a financing decision for the lessee and an investment decision for the lessor. For the lessee, a lease is comparable to a loan. The cost of leasing is compared to the cost of borrowing.

4. Finance 404 4 Who provides leases? Independent leasing companies Equipment manufacturers such as IBM Finance companies like General Electric Credit Corporation Banks Individuals

5. Finance 404 5 What are the primary lease types? Operating lease Short-term and normally cancelable Maintenance usually included Financial Lease Long-term and normally noncancelable Maintenance usually not included Sale and Leaseback Combination Lease Leveraged Lease

6. Finance 404 6 Operating Leases Usually provide maintenance service. Are not fully amortized. Often contain a cancellation cause. Are for a short term relative to the asset�s life. Full service

7. Finance 404 7 Financial or Capital Leases Typically do not provide for maintenance service Are not cancelable Are fully amortized (the lessor receives rental payments equal to the full price of the leased equipment plus a return on invested capital) Lessee generally pays property taxes and insurance on the leased property

8. Finance 404 8 How are leases treated for tax purposes? Leases are classified by the IRS as either guideline (tax-oriented) or nonguideline. For a guideline lease, the entire lease payment is deductible to the lessee. For a nonguideline lease, only the imputed interest payment is deductible. Why should the IRS be concerned about lease provisions?

9. Finance 404 9 Main Provisions of Tax Guidelines Lease term must not exceed 80 percent of the estimated useful life of equipment Estimated residual value at the expiration of the lease must equal at least 20 percent of its value at the start of the lease Leased equipment must not be �limited use� property Lessee can be given an option to buy the asset only at its fair market value

10. Finance 404 10 FASB Statement 13 sets forth the rules for capital and operating leases. Capital leases Run for at least 75% of the asset�s expected useful life. The present value of the lease payments is equal to or greater than 90 percent of the initial value of the asset. Are shown directly on the balance sheet.

11. Finance 404 11 For accounting purposes, leases are classified as either capital or operating. Capital leases must be shown directly on the lessee�s balance sheet. If an asset is leased and the lease is not a capital lease, then the lease will not be shown on the balance sheet. It must be disclosed in the footnotes. As a result, financial ratios may not be comparable between a firm that leases and one that does not.

12. Finance 404 12 Leasing is a substitute for debt. As such, leasing uses up a firm�s debt capacity. Assume a firm has a 50/50 target capital structure. Half of its assets are leased. How should the remaining assets be financed?

13. Finance 404 13 Net Advantage to Leasing

14. Finance 404 14 Net Advantage to Leasing (NAL) When analyzing the NAL from the viewpoint of the lessee, choose leasing if the NAL is positive. You can also reverse all numbers from the previous slide and examine the lease from the viewpoint of the lessor. Then if the NAL is positive, you can �write the lease.� Given the appropriate tax rates and residual values, leasing can be beneficial for both the lessee and the lessor.

15. Finance 404 15 If leased: Firm could obtain a 4-year lease on the equipment. Lease meets IRS guidelines to expense lease payments. An annual payment of $280,000 is payable at the beginning of each year. (Note: lease payments are usually made at the beginning of the period.)

16. Finance 404 16 Other information: Equipment cost: $1,000,000. Could borrow at 10%. Marginal tax rate = 40%. 3 year MACRS life. If company borrows and buys, 4-year maintenance contract costs $20,000 per year. Beginning of year payment. Residual value at t = 4: $100,000.

17. Finance 404 17

18. Finance 404 18 Note the depreciation shield in each year equals the depreciation expense times the lessee�s tax rate. For Year 1, the depreciation shield is $330,000(0.40) = $132,000. The present value of the cost of owning cash flows, when discounted at 6%, is -$639,267.

19. Finance 404 19

20. Finance 404 20 Leasing is similar to debt financing. The cash flows have relatively low risk; most are fixed by contract. Therefore, the firm�s 10% cost of debt is considered the risk-free rate for the firm. The tax shield of interest payments must be recognized, so the discount rate is 10%(1-T) = 10%(1- 0.4) = 6.0%

21. Finance 404 21 NAL = PV cost of owning - PV cost of leasing= $639,267 - $617,066= $22,201. (Methodology preferred by text) A positive NAL indicates that leasing is less expensive than borrowing and buying, so the firm should lease the equipment.

22. Finance 404 22 Some Comments About Net Advantage to Leasing (NAL) We will use NAL in the problems at the end of the chapter. You can determine the Net Present Value for the Lessor by calculating the reverse of the NAL. Thus, you can use NAL for both the Lessee and the Lessor. We will not use IRR analysis for leasing in Finance 404. Please review your leasing materials from Finance 312.

23. Finance 404 23 Note that we have assumed the company will not continue to use the asset after the lease expires. The project life is the same as the term of the lease. If the firm planned to continue using the asset after the lease, it would have to buy it at the residual value, which would be an outflow in the lease cash flows. If the firm was in that situation, they would have to consider the entire residual value.

24. Finance 404 24 Assume that the RV could be $0 or $200,000, with an expected value of $100,000. How could this risk be reflected? The discount rate applied to the residual value inflow (a positive CF) should be increased to account for the increased risk. All other cash flows should be discounted at the original 6% rate.

25. Finance 404 25 If the residual value were included as an outflow (a negative CF) in the cost of leasing cash flows, the increased risk would be reflected by applying a lower discount rate to the residual value cash flow. Again, all other cash flows have relatively low risk, and hence would be discounted at the 6% rate.

26. Finance 404 26 The lessor, not the lessee, owns the equipment when the lease expires. The residual value risk is passed from the lessee to the lessor. Increased residual value risk makes the lease more attractive to the lessee.

27. Finance 404 27 To the lessor, writing the lease is an investment. You can use the NAL method. The lessor should compare the return on the lease with returns available on alternative investments of similar risk. This rate most likely would be different than the rate used by the lessee. If the NPV > 0, then the lease should be written.

28. Finance 404 28 All information given in the previous example for the lessee applies except: $300,000 lease (rental) payment Maintenance of $20,000 per year payable at beginning of year.

29. Finance 404 29

30. Finance 404 30 The NPV of the net cash flows, when discounted at 6%, is $21,875. The IRR is 7.35%. Should the lessor write the lease? Why? You can use Goal Seeking in EXCEL to set a lease payment amount, given a desired return. Go to Tools first, then Goal Seeking.

31. Finance 404 31 With lease payments of $280,000, the lessor�s cash flows would be equal, but opposite in sign to the lessee�s. Thus, lessor�s NPV = -$22,201. If all inputs are symmetrical, leasing is a zero-sum game. If lessor�s and lessee�s tax rates differed, so would the NPVs. The key to leasing revolves about taxes and/or residual value.

32. Finance 404 32 Advantages to both the lessor and the lessee Conditions are often such that leasing can provide benefits to both parties. This situation arises because of differentials in: Tax rates Estimated residual values The ability to bear the residual value risk

33. Finance 404 33 A cancellation clause would lower the risk of the lease to the lessee but raise the lessor�s risk. To account for this, the lessor would increase the annual lease payment or else impose a penalty for early cancellation.

34. Finance 404 34 The lessor can borrow $500,000 of the $1,000,000 purchase price with a four-year loan at 10%. Only interest is paid until maturity in 4 years, when the full principal is due.

35. Finance 404 35

36. Finance 404 36 The NPV of the leveraged lease, when discounted at 6%, is $21,875. Note that the NPV is unchanged (See Slide 31). This is because the loan cost is the same as the discount rate. However, the $21,875 leveraged NPV requires an investment of only $500,000, as opposed to $1,000,000 with the unleveraged lease. Or you can view it as an net outlay of $332,000 vs. $832,000.

37. Finance 404 37 Thus, with a $1 million investment, the lessor could finance two such leases and obtain double the amount of NPV: 2($21,875) = $43,750 in profit. With the leveraged lease, we get two IRRs: -3.5% and +29.6%. The MIRR of the leveraged lease is about 6%. However, leveraging increases the risk to the lessor, so the decision to leverage involves a risk/return tradeoff.

38. Finance 404 38 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)

39. Finance 404 39 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

40. Finance 404 40 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

41. Finance 404 41 Other Issues in Lease Analysis Do higher residual values make leasing less attractive to the lessee? Is lease financing more available or �better� than debt financing? Is the lease analysis presented in this chapter applicable to real estate leases? To auto leases? Would spreadsheet models be useful in lease analysis?

42. Finance 404 42 What impact do tax laws have on the attractiveness of leasing? Tax rate differentials between the lessee and the lessor Alternative minimum tax (AMT) Lessors often have a more favorable position than lenders should the lessee actually go bankrupt. Lessors that specialize in certain types of equipment may be in a better position to dispose of repossessed equipment than banks or other lenders. Perhaps the lessor can maintain the leased equipment more efficiently than the lessee.

43. Finance 404 43 Numerical analysis often indicate that owning is less costly than leasing. Why, then, is leasing so popular? Provision of maintenance services Risk reduction for the lessee Project life Residual life Operating Risk Portfolio risk reduction enables lessor to better bear these risks. Leasing provides operating flexibility.

44. Finance 404 44 Feedback Effects on Capital Budgeting If the cost of leasing is less than the cost of debt, it is possible that leasing might make a previously rejected project acceptable. If all projects could be leased, the firm should use the cost of leasing in place of the cost of debt when calculating the cost of capital.

45. Finance 404 45 If only one project can be leased, the true NPV of the project (if leased) is the NPV based on the �regular� cost of capital plus the lease�s NAL. If neither of the two extreme positions hold, no simple rule can be used to incorporate �feedback� effects.

46. Finance 404 46 Conclusion Types of Leases Tax-Oriented Lease Accounting Treatment of Leases Net Advantage to Leasing Leveraged Leasing Other Issues in Leasing