Lease Financing RWJ Chp 21

1. Lease FinancingRWJ Chp 21

2. Types of Leases • The Basics • A lease is a contractual agreement between a lessee and lessor. • The lessor owns the asset and for a fee allows the lessee to use the asset.

3. Operating Leases • Usually not fully amortized. • Usually require the lessor to maintain and insure the asset. • Lessee enjoys a cancellation option.

4. Financial Leases The exact opposite of an operating lease. • Do not provide for maintenance or service by the lessor. • Financial leases are fully amortized. • The lessee usually has a right to renew the lease at expiry. • Generally, financial leases cannot be cancelled.

5. Sale and Lease-Back • A particular type of financial lease. • Occurs when a company sells an asset it already owns to another firm and immediately leases it from them. • Two sets of cash flows occur: • The lessee receives cash today from the sale. • The lessee agrees to make periodic lease payments, thereby retaining the use of the asset.

6. Leveraged Leases • A leveraged lease is another type of financial lease. • A three-sided arrangement between the lessee, the lessor, and lenders. • The lessor owns the asset and for a fee allows the lessee to use the asset. • The lessor borrows to partially finance the asset. • The lenders typically use a nonrecourse loan. This means that the lessor is not obligated to the lender in case of a default by the lessee.

7. Lease Accounting • Leases are governed primarily by FASB 13 • Financial leases are essentially treated as debt financing • Present value of lease payments must be included on the balance sheet as a liability • Same amount shown on the asset as the “capitalized value of leased assets” • Operating leases are still “off-balance-sheet” and do not have any impact on the balance sheet itself

8. Criteria for a Capital Lease • If one of the following criteria is met, then the lease is considered a capital lease and must be shown on the balance sheet • Lease transfers ownership by the end of the lease term • Lessee can purchase asset at below market price • Lease term is for 75 percent or more of the life of the asset • Present value of lease payments is at least 90 percent of the fair market value at the start of the lease

9. Taxes • Lessee can deduct lease payments for income tax purposes • Must be used for business purposes and not to avoid taxes • Term of lease is less than 80 percent of the economic life of the asset • Should not include an option to acquire the asset at the end of the lease at a below market price • Lease payments should not start high and then drop dramatically • Must survive a profits test • Renewal options must be reasonable and consider fair market value at the time of the renewal

10. Accounting and Leasing Balance Sheet Truck is purchased with debt Truck RM100,000 Debt RM100,000 Land RM100,000 Equity RM100,000 Total Assets RM200,000 Total Debt & Equity RM200,000 Operating Lease Truck Debt Land RM100,000 Equity RM100,000 Total Assets RM100,000 Total Debt & Equity RM100,000 Capital Lease Assets leased RM100,000 Obligations under cap. lease RM100,000 Land RM100,000 Equity RM100,000 Total Assets RM200,000 Total Debt & Equity RM200,000

11. Capital Lease • A lease must be capitalized if any one of the following is met: • The present value of the lease payments is at least 90 percent of the fair market value of the asset at the start of the lease. • The lease transfers ownership of the property to the lessee by the end of the term of the lease. • The lease term is 75 percent or more of the estimated economic life of the asset. • The lessee can buy the asset at a bargain price at expiry.

12. The Cash Flows of Leasing Consider a firm, ClumZee Movers, that wishes to acquire a delivery truck. The truck is expected to reduce costs by RM4,500 per year. The truck costs RM25,000 and has a useful life of 5 years. If the firm buys the truck, they will depreciate it straight-line to zero. They can lease it for 5 years from Tiger Leasing with an annual lease payment of RM6,250.

13. Cash Flows: Buy Year 0 Years 1-5 Cost of truck –RM25,000 After-tax savings 4,500×(1-.34) = RM2,970 Depreciation Tax Shield 5,000×(.34) = RM1,700 –RM25,000 RM4,670 Cash Flows: Lease Year 0 Years 1-5 Lease Payments –6,250×(1-.34) = – RM4,125 After-tax savings 4,500×(1-.34) = RM2,970 –RM1,155 • Cash Flows: Leasing Instead of Buying • Year 0 Years 1-5 • RM25,000 –RM1,155 – RM4,670 = –RM5,825 The Cash Flows of Leasing

14. The Cash Flows of Leasing • Cash Flows: Leasing Instead of Buying Year 0 Years 1-5 RM25,000 –RM1,155 – RM4,670 = –RM5,825 • Cash Flows: Buying Instead of Leasing Year 0 Years 1-5 –RM25,000 RM4,670 –RM1,155 = RM5,825 • However we wish to conceptualize this, we need to have an interest rate at which to discount the future cash flows. • That rate is the after-tax rate on the firm’s secured debt.

15. NPV Analysis of the Lease-vs.-Buy Decision • A lease payment is like the debt service 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 interest rate on secured debt issued by the lessee.

16. There is a simple method for evaluating leases: discount all cash flows at the after-tax interest rate on secured debt issued by the lessee. Suppose that rate is 5 percent. • NPV Leasing Instead of Buying • Year 0 Years 1-5 • RM25,000 –RM1,155 – RM4,670 = -RM5,825 NPV Buying Instead of Leasing Year 0 Years 1-5 -RM25,000 RM4,670 – RM1,155 = RM5,825 NPV Analysis of the Lease-vs.-Buy Decision

17. Reasons for Leasing • Good Reasons • Taxes may be reduced by leasing. • The lease contract may reduce certain types of uncertainty. • Transactions costs can be higher for buying an asset and financing it with debt or equity than for leasing the asset. • Bad Reasons • Accounting