Prepared by Ken Hartviksen INTRODUCTION TO CORPORATE FINANCE Laurence Booth W. Sean Cleary

CHAPTER 16 Leasing

CHAPTER 16 – Leasing Lecture Agenda Learning ObjectivesLearning Objectives Important TermsImportant Terms Leasing ArrangementsLeasing Arrangements Accounting for LeasesAccounting for Leases Evaluating the Lease DecisionEvaluating the Lease Decision Motivation for LeasingMotivation for Leasing Summary and ConclusionsSummary and Conclusions –Concept Review Questions

CHAPTER 16 – Leasing Learning Objectives The basic characteristics of leases and how to differentiate between operating and financial (or capital) leasesThe basic characteristics of leases and how to differentiate between operating and financial (or capital) leases The accounting treatment of both operating and financial leasesThe accounting treatment of both operating and financial leases The benefits and disadvantages of leasesThe benefits and disadvantages of leases How the lease decision can be evaluated using the discounted cash flow valuation methodsHow the lease decision can be evaluated using the discounted cash flow valuation methods

CHAPTER 16 – Leasing Important Chapter Terms Asset-based lendingAsset-based lending Captive finance companiesCaptive finance companies Financial leaseFinancial lease LesseeLessee LessorLessor Leveraged leaseLeveraged lease Off-balance-sheet financingOff-balance-sheet financing Operating leaseOperating lease Sale and leaseback (SLB) agreementSale and leaseback (SLB) agreement Secured financingSecured financing Small and medium-sized enterprises (SMEs)Small and medium-sized enterprises (SMEs)

CHAPTER 16 – Leasing Leasing Arrangements Introduction The decision to invest in an asset that has a long life is a capital budgeting decision.The decision to invest in an asset that has a long life is a capital budgeting decision. The decision to acquire is a separate decision from the decision on the method of financing the acquisitionThe decision to acquire is a separate decision from the decision on the method of financing the acquisition When these two decisions are combined, this is called asset-based lending because the financing is tied directly to a particular asset.When these two decisions are combined, this is called asset-based lending because the financing is tied directly to a particular asset. Examples of asset-based lending include:Examples of asset-based lending include: –Secured loans –Conditional sales contracts –Leases

CHAPTER 16 – Leasing Leasing Arrangements The Institutional Framework Canadian Finance and Leasing Association (CFLA) acts as the trade association for asset-based lendersCanadian Finance and Leasing Association (CFLA) acts as the trade association for asset-based lenders –160 members –Represents three group of financial companies: 1.Independent asset-based finance companies –Involved in machinery and equipment financing with 60% of customers begin SMEs. –40% of the assets financed are transportation equipment (buses, trucks, trailers or office equipment) 2.Captive finance companies of major manufacturers (eg. GMC Finance and Ford Credit Canada) where 1/3 of all new vehicles are leased. 3.Chartered banks –Chartered banks are not allowed to lease consumer household property and are therefore focussed on leasing commercial transportation equipment and real property such as land and buildings

CHAPTER 16 – Leasing Lease What is it? A lease contract is an agreement where the owner conveys to the user the right to use an asset in return for a number of specified payments over an agreed period of time Lessor is the owner of the asset Lessee is the user of the asset

CHAPTER 16 – Leasing Leasing Types of Leases Operating Lease A lease where some of the benefits of ownership do not transfer to the lessee and remain with the lessor.A lease where some of the benefits of ownership do not transfer to the lessee and remain with the lessor. Financial (Capital) Lease A lease where essentially all the benefits of ownership transfer to the lessee; also known as a capital or full payout lease.A lease where essentially all the benefits of ownership transfer to the lessee; also known as a capital or full payout lease. (See Table 16-1 on the following slide for the distinguishing features between the two types of leases)

CHAPTER 16 – Leasing Types of Leases Operating versus Financial Leases

CHAPTER 16 – Leasing Conditional Sales Agreement What is it? CRA Perspective According to Canada Revenue Agency (CRA) a conditional sales agreement exists if one of the following occurs: The lessee automatically acquires ownership at some pointThe lessee automatically acquires ownership at some point The lessee is required to buy the asset at some point or guarantee that the lessor gets a certain value for itThe lessee is required to buy the asset at some point or guarantee that the lessor gets a certain value for it The lessee has the right to buy the asset at some point for substantially less than the likely fair market valueThe lessee has the right to buy the asset at some point for substantially less than the likely fair market value The lessee has the right to buy the asset at a price that would cause a reasonable person to conclude that they will buy it.The lessee has the right to buy the asset at a price that would cause a reasonable person to conclude that they will buy it. CRA’s interest in this issue is that it must determine which party to the contract has the legal right to claim CCA for tax purposes. If any of the other above conditions are satisfied, CRA regards the user (lessee) as having the right to claim CCA.

CHAPTER 16 – Leasing Financial/Capital/Full Payout Lease What is it? Accounting Perspective According to the Canadian Institute of Chartered Accountants (CICA), all of the benefits of ownership transfer to the lessee with these lease agreements. The lessee is deemed to own the asset and will claim depreciation on the firm’s income statement and record the value as an asset and liability on the balance sheet. Such leases usually: Require the lessee to carry out maintenance and insure the assetRequire the lessee to carry out maintenance and insure the asset Provides the lessee with a fixed purchase optionProvides the lessee with a fixed purchase option The lease agreement covers 75% of the economic life of the assetThe lease agreement covers 75% of the economic life of the asset Is structured so that the present value of lease payments exceeds 90 % of the costIs structured so that the present value of lease payments exceeds 90 % of the cost Involves fixed rental payments.Involves fixed rental payments.

CHAPTER 16 – Leasing Operating Lease What is it? Accounting Perspective If a lease is NOT a capital lease, then it is an operating leaseIf a lease is NOT a capital lease, then it is an operating lease Operating leases do not transfer to the lessee the benefits of ownership (ability to deduct CCA)Operating leases do not transfer to the lessee the benefits of ownership (ability to deduct CCA)

CHAPTER 16 – Leasing Sale and Leaseback Agreement What is it? An agreement in which the owner of an asset sells it to another party and then leases the asset backAn agreement in which the owner of an asset sells it to another party and then leases the asset back Popular type of lease for organizations in low tax brackets because they are unable to use the tax shield offered by CCAPopular type of lease for organizations in low tax brackets because they are unable to use the tax shield offered by CCA SLBs can mean that part of the tax savings can be transferred back to the seller in the form of lower lease payments, reducing the cost of the assetSLBs can mean that part of the tax savings can be transferred back to the seller in the form of lower lease payments, reducing the cost of the asset 1989 federal budget significantly reduced the benefits from such agreements by forcing the lessor to deduct depreciation on leased assets only from income derived from leasing.1989 federal budget significantly reduced the benefits from such agreements by forcing the lessor to deduct depreciation on leased assets only from income derived from leasing.

CHAPTER 16 – Leasing Leveraged Lease What is it? A three-way agreement among the lessee, the lessor, and a third party lender in which the lessor buys the asset with only a small down payment and the lender supplies the financingA three-way agreement among the lessee, the lessor, and a third party lender in which the lessor buys the asset with only a small down payment and the lender supplies the financing Popular in U.S. because lessor puts up only a portion of the asset purchase price, but receives all of the tax benefits of ownershipPopular in U.S. because lessor puts up only a portion of the asset purchase price, but receives all of the tax benefits of ownership Not popular in Canada because CRA restricts use of CCA to the party at risk, and CCA deductions cannot be carried over to offset taxes on other incomeNot popular in Canada because CRA restricts use of CCA to the party at risk, and CCA deductions cannot be carried over to offset taxes on other income

CHAPTER 16 – Leasing Accounting for Leases Accounting for Leases Financial leases are included on the balance sheet of the lesseeFinancial leases are included on the balance sheet of the lessee –Present value of all lease payments is recorded on the right-hand side of the balance sheet –The same amount is recorded as an asset on the left-hand side of the balance Operating leases are off-balance-sheet financing for the lessee (included only in the notes to the financial statements)Operating leases are off-balance-sheet financing for the lessee (included only in the notes to the financial statements)

CHAPTER 16 – Leasing Accounting for Leases Financial Statement Effects of Lease Classification Capital/Financial/Full Payout Leases: Income Effects 1.Net income will generally be lower for capital leases in the early years and higher in the later years. 2.CFO will be higher with capital leases. CCA may be deducted in measuring Net Income after tax, however, CCA is added back when determining CFO. Capital/ financial leases expense only the interest portion of the payments in determining EBT. Balance Sheet Effects 1.Lower current ratios, higher debt and leverage ratios, lower asset turnover and lower profitability ratios (especially in the early years of asset life)

CHAPTER 16 – Leasing Accounting for Leases Financial Statement Effects of Lease Classification Operating Leases: Income Effects 1.Net income will generally be higher for operating leases in the early years and lower in the later years because interest expense charged for the financial lease declines as the liability is amortized by the lease payments. 2.CFO will be lower with operating leases since the full lease payment is subtracted from CFO, unlike financial leases where only the interest portion of the payments is subtracted. Balance Sheet Effects 1.Higher current ratios, lower debt and leverage ratios, higher asset turnover and higher profitability ratios (especially in the early years of asset life)

CHAPTER 16 – Leasing Evaluating the Lease Decision Lease Versus Buy Leasing is an alternative means of obtaining the use of an assetLeasing is an alternative means of obtaining the use of an asset There are four main differences in the cash flows for a company that leases an asset instead of buying it:There are four main differences in the cash flows for a company that leases an asset instead of buying it: 1.It does not have to pay for the asset up front 2.It does not get to sell the asset when it is finished with it, if it is an operating lease, or if title is not transferred through a financial lease 3.It makes regular lease payments. If the lease is an operating lease, then the full amount of the lease payments is tax deductible; only the interest portion is deductible for capital leases 4.Operating leases are not depreciated.

CHAPTER 16 – Leasing Evaluating the Lease Decision Lease Versus Buy Evaluative Frameworks IRR of Leasing Analysis –Estimate incremental cash flows that result from leasing –Solve for the discount rate (IRR) that equates the incremental cash flows with the initial value of the asset. (This is the after-tax IRR or cost of leasing) If IRR of leasing > after-tax cost of borrowing (borrow and buy the asset)If IRR of leasing > after-tax cost of borrowing (borrow and buy the asset) If IRR of leasing < after-tax cost of borrowing (lease the asset)If IRR of leasing < after-tax cost of borrowing (lease the asset)

CHAPTER 16 – Leasing Evaluating the Lease Decision Lease Versus Buy Evaluative Frameworks NPV of Leasing Analysis –Estimate incremental cash flows that result from leasing –Calculate NPV using after-tax cost of borrowing as the discount rate. If NPV of leasing is – (borrow and buy the asset)If NPV of leasing is – (borrow and buy the asset) If NPV of leasing + after-tax cost of borrowing (lease the asset)If NPV of leasing + after-tax cost of borrowing (lease the asset)

CHAPTER 16 – Leasing Motivation for Leasing 1.Cheaper financing (which party can make better use of the CCA tax shield/) 2.Reduce the risks of asset ownership 3.Implicit interest rates 4.Maintenance 5.Convenience 6.Flexibility 7.Capital budgeting restrictions 8.Financial statement effects

CHAPTER 16 – Leasing Summary and Conclusions In this chapter you have learned: –That firms can gain the use of assets through leasing rather than outright ownership –The general differences between operating and financial leases –How to evaluate a potential lease decision using discounted cash flow analysis –The various reasons firms might have for entering into lease arrangements

CHAPTER 16 – Leasing Copyright Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.