Leasing

1. 26 Leasing

2. Key Concepts and Skills • Understand basic lease terminology • Understand the criteria for a capital lease vs. an operating lease • Understand the typical incremental cash flows to leasing • Be able to compute the net advantage to leasing • Understand the good reasons for leasing and the dubious reasons for leasing

3. Chapter Outline • Leases and Lease Types • Accounting and Leasing • Taxes, the IRS and Leases • The Cash Flows from Leasing • Lease or Buy? • A Leasing Paradox • Reasons for Leasing

4. Lease Terminology • Lease – contractual agreement for use of an asset in return for a series of payments • Lessee – user of an asset; makes payments • Lessor – owner of the asset; receives payments • Direct lease – lessor is the manufacturer • Captive finance company – subsidiaries that lease products for the manufacturer

5. Types of Leases • Operating lease • Shorter-term lease • Lessor is responsible for insurance, taxes and maintenance • Often cancelable • Financial lease (capital lease) • Longer-term lease • Lessee is responsible for insurance, taxes and maintenance • Generally not cancelable • Specific capital leases • Tax-oriented • Leveraged • Sale and leaseback

6. 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

7. 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

8. 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 – lessor should earn a fair return • Renewal options must be reasonable and consider fair market value at the time of the renewal

9. Incremental Cash Flows • Cash Flows from the Lessee’s point of view • After-tax lease payment (outflow) • Lease payment*(1 – T) • Lost depreciation tax shield (outflow) • Depreciation * tax rate for each year • Initial cost of machine (inflow) • Inflow because we save the cost of purchasing the asset now • May have incremental maintenance, taxes or insurance

10. Example: Lease Cash Flows • ABC, Inc. needs some new equipment. The equipment would cost $100,000 if purchased and would be depreciated straight-line over 5 years. No salvage is expected. Alternatively, the company can lease the equipment for $25,000 per year. The marginal tax rate is 40%. • What are the incremental cash flows? • After-tax lease payment = 25,000(1 - .4) = 15,000 (outflow years 1 - 5) • Lost depreciation tax shield = (100,000/5)*.4 = 8,000 (outflow years 1 – 5) • Cost of machine = 100,000 (inflow year 0)

11. Lease or Buy? • The company needs to determine whether it is better off borrowing the money and buying the asset or leasing • Compute the NPV of the incremental cash flows • Appropriate discount rate is the after-tax cost of debt since a lease is essentially the same risk as a company’s debt

12. Net Advantage to Leasing • The net advantage to leasing (NAL) is the same thing as the NPV of the incremental cash flows • If NAL > 0, the firm should lease • If NAL < 0, the firm should buy • Consider the previous example. Assume the firm’s cost of debt is 10%. • After-tax cost of debt = 10(1 - .4) = 6% • NAL = 3,116 • Should the firm buy or lease?

13. Work the Web Example • Many people have to choose between buying and leasing a car • Click on the web surfer to go to Kiplinger’s • Go to Tools: Spending Tools • Do the calculations for a $30,000 car, 5-year loan at 7% with monthly payments and a $3000 down payment. The available lease is for 3 years and requires a $550 per month payment with a $1000 security deposit and $1000 other upfront costs.

14. Good Reasons for Leasing • Taxes may be reduced • May reduce some uncertainty • May have lower transaction costs • May require fewer restrictive covenants • May encumber fewer assets than secured borrowing

15. Dubious Reasons for Leasing • Balance sheet, especially leverage ratios, may look better if the lease does not have to be accounted for on the balance sheet • 100% financing – except that leases normally do require either a down-payment or security deposit • Low cost – some may try to compare the “implied” rate of interest to other market rates, but this is not directly comparable

16. Quick Quiz • What is the difference between a lessee and a lessor? • What is the difference between an operating lease and a capital lease? • What are the requirements for a lease to be tax deductible? • What are typical incremental cash flows and how do you determine the net advantage to leasing? • What are some good reasons for leasing? • What are some dubious reasons for leasing?

17. 26 End of Chapter