Chapter 27 Leasing Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

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 27-1

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 27-2

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 27-3

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 Real-World Tip: As described by Professor James Johnson in his article, “Predatory Leasing: The Curse of the No-Exit Lease” (Corporate Finance Review, January/February 1999) some lessors make it extremely difficult for lessees to escape the lease at expiration. Typically lessees have the right to purchase the equipment, extend the lease, or “walk away.” In a “predatory” lease, the end-of-lease language traps the lessee. See further example of this in the IM. Real-World Tip: Traditionally, sale and leaseback arrangements have involved expensive assets (e.g., buildings, airliners, railroad cars); however, “employee leasing” has grown from almost zero in 1984 and many millions today. Unlike traditional “temps,” these people are employed by the lessor, provided with health and other benefits, and then leased to a client firm. The development of this industry is perhaps a natural outgrowth of the downsizing and outsourcing of the 1990s. 27-4

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 27-5

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 27-6

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 27-7

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 27-8

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) The net advantage to leasing is calculated in slide 11. 27-9

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 See the Lecture Tip in the IM for an extended example of the lease vs. buy decision. 27-10

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? Year Cash Flows 0 100,000 1-5 -15,000 – 8,000 = -23,000 Compute NPV at 6% Positive NAL implies firm should lease. 27-11

Work the Web Example Many people must choose between buying and leasing a car Click on the web surfer to go to Kiplinger’s Go to Tools & Calculators: Cars Do the calculations for a $30,000 car, 5-year loan at 7% with monthly payments, and a $3,000 down payment. The available lease is for 3 years and requires a $550 per month payment with a $1,000 security deposit and $1,000 other upfront costs. 27-12

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 27-13

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 27-14

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? 27-15

Ethics Issues Suppose a manager chooses to lease an asset (operating lease) rather than buy, simply to keep the asset off-balance sheet and thereby avoid reporting the liability? Although this may be legal, is there any ethical implication? Are investors able to effectively monitor and analyze such activity? 27-16

Comprehensive Problem What is the net advantage to leasing for the following project, and what decision should be made? Equipment would cost $250,000 if purchased It would be depreciated straight-line to zero salvage over 5 years. Alternatively, it may be leased for $65,000/yr. The firm’s after-tax cost of debt is 6%, and its tax rate is 40% After-tax lease payment = (1 - .4) X $65,000 = $39,000 Lost tax shield = .4 x $50,000 = $20,000 Year CF 0 250,000 1-5 = -$39,000 – $20,000 = -$59,000 Discount at 6% NPV = $1,471 Lease it! 27-17

End of Chapter 27-18