19 Lease Financing

Introduction This chapter explores the reasons a firm might choose to lease rather than borrow and then buy some of their assets. It examines the type of analysis that should go into a lease versus borrow-and-purchase decision to maximize shareholder wealth. It examines the costs and benefits to leasing companies offering this type of financing.

Glossary of Leasing Terms This Web site has a glossary of leasing terms for researching the right alternative between leasing or borrowing and purchasing assets: http://www.ge.com/capital/vendor/glosterm.htm

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

Types of Leases Operating lease Service lease • Maintenance lease Maintenance and insurance included Financial lease Noncancelable Lessee responsible for Maintenance • Insurance • Property taxes Direct lease Sale and leaseback Leveraged lease Three-party financial lease Lessee • Lessor • Lender

Sale and Leaseback Transaction Investigate the sale and leaseback transaction at this Web site: http://www.amcity.com/southflorida/stories/012797/focus5.html

Advantages to Leasing Flexible Convenient Lower payments Avoid some risk of obsolescence Smoother earnings and EPS 100% financing Liquidity

Disadvantages to Leasing More expensive Salvage value Difficult approval for modifications May not be canceled

Tax Considerations A lease must have economic benefits separate from tax consideration. Recognized by IRS as a lease (Rules) Remaining useful life May not exceed 30 years Reasonable ROI Renewal options Purchase options Level schedule of lease payments 20% equity Property valuable only to the lessee

Leases and Accounting Practices Types of Leases Financial leases Operating leases FASB requires that leases be capitalized. Value of lease Equal to the PV of the lease payments Discounted at the firm’s borrowing rate for a secured loan with similar maturity Disclosure of details in footnotes

Footnotes Financial Leases As of the date of the balance sheet Gross amount of assets by major classes Amount of accumulated lease amortization Future minimum lease payments In total for each of the next five fiscal years

Footnotes Operating Leases As of the date of the latest balance sheet Future minimum rental payments required In total for each of the following five fiscal years An income statement is presented for rental expense in each period

Small Firms Reasons for leasing Expensive reasons Less cash required upfront Better protection against obsolescence Quicker approvals Fewer restrictive covenants Expensive reasons High interest cost Loss of tax benefits

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

After-tax lease income required 1 – lessor’s marginal tax rate Lease Payments (cont) Step 2: Compute after-tax lease income required Amount to be amortized = PV of after-tax lease payment Step 3: Compute before-tax lease payment Lease Payment = After-tax lease income required 1 – lessor’s marginal tax rate

Lease vs. Borrowing to Buy Compute the NAL. If NAL is positive, it is cheaper to lease. If NAL is negative, it is cheaper to own. Considerations Installed costs PV of after-tax lease payments PV of depreciation tax shield PV of after-tax operating costs if owned PV of after-tax salvage value at the lessee’s weighted cost of capital