21 Leasing and Other Asset-Based Financing Corporate Financial Management 3e Emery Finnerty Stowe Modified for course use by Arnold R. Cowan

Lease Financing A lease is a rental agreement that extends for one year or longer. The owner of the asset (the lessor) grants exclusive use of the asset to the lessee for a fixed period of time. In return, the lessee makes fixed periodic payments to the lessor. At termination, the lessee may have the option to either renew the lease or purchase the asset.

Types of Leases Full-service lease Net lease Lessor responsible for maintenance, insurance, and property taxes. Net lease Lessee responsible for maintenance, insurance, and property taxes.

Types of Leases Operating lease Financial lease short-term may be cancelable Financial lease long-term similar to a loan agreement

Types of Lease Financing Direct leases Sale-and-lease-back agreements Leveraged leases

Direct Lease Lessee Lessee Lessor Manufacturer/ Lessor Sale of Asset Manufacturer/ Lessor Lessee Lease Lessor

Sale-and-Lease-Back Sale of Asset Lessor Lessee Lease

Single Purpose Leasing Company Leveraged Lease Manufacturer Sale of Asset Lien Lender Single Purpose Leasing Company Loan Lessee Lease Equity Investor Equity

Synthetic Leases Firms have used synthetic leases to get the use of assets but keep debt off their balance sheets. An unrelated financial institution invests some equity and sets up a special-purpose-entity that buys the assets and leases it to the firm under an operating lease. Since the Enron bankruptcy, firms have been reluctant to use synthetic leases.

3 2 1 5 4 Enron’s Murky Deals Enron Equity Investor Outside investors inject at least 3% of the funding so that Enron doesn’t have to claim it as a subsidiary. Enron’s Murky Deals 3 Enron provided some or all of the 3%. Equity Investor Enron used outside partnerships to move assets off its balance sheet and monetize assets. But the company was deeply involved with funding those partnerships. 2 Partnership or Special Purpose Entity 1 5 Enron guarantees the loan. Sometimes with now-worthless Enron shares. Enron sells assets, gets debt off the balance sheet and recognizes a gain on the sale. Banks provided the other 97% of the financing. Enron 4 Lending Group

Enron’s Partnerships Reasons for setting up SPEs: By setting up partnerships, partly owned by the company, Enron could draw in capital from outside investors. If structured properly (the tax code requires that at least 3% of the partnership equity be obtained from outside investors), the partnerships could also be kept separate from Enron.

Enron’s Partnerships As a result, any debt incurred by the partnership could be kept off the company's balance sheet. As an added bonus, Enron often recognized a gain on the sale of the assets.

Why did Enron want debt off their balance sheet? The simple answer is that Enron feared that too much debt would damage its credit rating.

Why did Enron want debt off their balance sheet? A more complex answer lies with agency costs. Enron executives headed and partly owned some of the partnerships, which provided a huge source of outside income for those involved. Enron’s former CFO, Andrew Fastow, made more than $30 million from two partnerships that he ran. If you were a shareholder in a SPE buying an asset from your employer, where would your loyalties lie?

How Widespread Was This at Enron? There were hundreds, and perhaps even thousands, of these partnerships. The exact number isn't known. In all, Enron had about 3,500 subsidiaries and affiliates, many of them limited partnerships and limited-liability companies, which are a sort of hybrid between corporations and partnerships.

How Did They Get Away With It? The company and its board of directors claimed that allowing executives to be involved with the outside partnerships gave it the advantage of speed. Enron claimed that it set up safeguards to protect itself, but in retrospect they were clearly inadequate.

Advantages of Leases Efficient use of tax deductions and tax credits of ownership Reduced risk Reduced cost of borrowing Bankruptcy considerations Tapping new sources of funds Circumventing restrictions debt covenants off-balance sheet financing

Disadvantages of Leasing Lessee forfeits tax deductions associated with asset ownership. Lessee usually forgoes residual asset value.

Valuing Financial Leases Basic approach is similar to debt refunding. Lease displaces debt. Missed lease payments can result in the lessor claiming the asset. filing lawsuits. forcing firm into bankruptcy. Risk of a firm’s lease payments are similar to those of its interest and principal payments.

Equivalent Ways to Analyze Net Advantage to Leasing (NAL) approach: Lease if NAL > 0. The Internal Rate of Return (IRR) approach: Lease if IRR of leasing < after-tax cost of debt financing.

Leases Analysis Example The Emerson Co. needs the use of a special purpose stamping machine for the next 10 years. The machine costs $6 million, has a life of 10 years, and a salvage value of $300,000. Emerson can lease this machine from the General Supply Co. for 10 years, with annual year-end lease payments of $1.05 million. Emerson’s tax rate is 40%.

Leases Analysis Example If Emerson were to buy the machine, it would finance 80% of the purchase price with a 11.5% secured installment loan, with the remainder being borrowed as unsecured installment debt at 14% interest. The after-tax required return on the asset is 15%. Evaluate this leasing opportunity.

Leasing Displaces Borrowing Suppose initially that the Emerson Co. has net assets worth $50 million, and a debt ratio of 50%. Compute the debt ratio if Emerson uses: Conventional financing for the stamping machine. Leases the stamping machine. How would the target debt ratio be restored?

Leasing Displaces Borrowing Initial Capitalization Conventional Debt Financial Lease Obligation Total Debt Equity Total $ 25 M $ 0 M $25 M $50 M Debt Ratio 50%

Leasing Displaces Borrowing Conventional Financing Conventional Debt Financial Lease Obligation Total Debt Equity Total $ 28 M $ 0 M $25 M $28 M $56 M Debt Ratio 50%

Leasing Displaces Borrowing Lease Financing Conventional Debt Financial Lease Obligation Total Debt Equity Total $ 2 5 M $ 6 M $ 31 M $25 M $56 M Debt Ratio 5 5.36%

Leasing Displaces Borrowing Debt Ratio Restored Conventional Debt Financial Lease Obligation Total Debt Equity Total $ 22 M $ 6 M $28 M $56 M 50%

Analyzing Leases The Net Advantage to Leasing (NAL) equals the purchase price (P) minus the present value of the incremental after-tax cash flows (CFAT) associated with the lease. NAL = P – PV(CFATs)

Analyzing Leases - the Discount Rate The discount rate should be the lessee’s after-tax cost of similarly secured debt. Since the lease obligation is not overcollateralized, the secured debt rate should reflect this. Fully secured means the asset is worth more than 25% of the loan. $80M loan on $100M asset: $20/$80 = 25% Use weighted average of secured and unsecured debt rates if necessary.

Analyzing Leases - the Cash Flows Cost of asset (saving) Lease payments (cost) Incremental differences in operating and other expenses (cost or savings) Depreciation tax shelter (foregone benefit) Expected net residual value (foregone benefit) Investment tax credits (foregone benefit)

Net Advantage to Leasing Dt = year t depreciation deduction DEt = year t cash expense savings from leasing ITC = investment tax credit, if available CFt = lease payment in year t N = life of lease (in years) P = purchase price of asset r = asset’s after-tax required return r′ = cost of debt (secured & unsecured) Salvage = net salvage value T = lessee’s marginal income tax rate

Net Advantage to Leasing We save paying the purchase price P. We lose the ITC and salvage value. We pay the lease payment CF; this may be partly offset by savings on operating and other cash expenses (E) and by tax deductibility. We lose the depreciation tax shield TD. Discount main cash flows at the after-tax cost of debt.

Net Advantage to Leasing For the Emerson Co., P = $6 million CFt = $1.05 million per year for 10 years Dt = ($6,000,000 - $300,000) / 10 = $570,000 per year for 10 years DEt = 0, ITC = 0 r = 15% r′ = 80%(11.5%) + 20%(14%) = 12.0%

Net Advantage to Leasing

The IRR Approach For Emerson’s leasing opportunity, the IRR is 7.58%. The after-tax cost of debt financing is 12%×(1– 0.40) = 7.20%. Since the IRR (the cost of lease financing) is greater than the after-tax cost of debt financing, Emerson should not lease the machine.

Break-Even Lease Payments The break-even lease payments can be computed by setting the NAL to zero. In the case of Emerson’s lease, the annual break-even payments are $1,039,206. Since the lease contract calls for payments of $1,050,000; the leasing alternative is not preferred.

NPV of Lease to the Lessor In a perfect market with no tax, leasing is a zero-sum game. The NPV of the lease to the lessor will be - (NAL to the lessee). If lessee and lessor have the same marginal income tax rates, leasing is still a zero sum game in an otherwise perfect market.

NPV of Lease to the Lessor where T′ = lessor’s marginal income tax rate.

NPV of Lease to the Lessor

Effect of Tax Asymmetries Suppose lessee’s (Emerson’s) tax rate is zero. Also assume that the before-tax required return on the asset for the lessee is 17.50%. The NAL to Emerson is then $7,460. The NPV to the lessor is still $45,068. Thus, both parties gain from the leasing arrangement.

Tax Treatment of Financial Leases IRS has guidelines for distinguishing between true leases and installment sales agreements. secured loans. If lessor meets these guidelines: lessor can claim tax deductions and credits of asset ownership. lessee can deduct full amount of lease payment for tax purposes.

IRS Guidelines for Financial Leases Term of lease < 80% of asset’s useful life. Lessor must maintain an equity investment of at least 10% of asset’s original cost. Exercise price of the purchase option must equal the asset’s fair market value at the time the option is exercised. Lessee does not pay any portion of the asset’s purchase price. Lessor must hold title to the property.

Accounting Treatment of Financial Leases SFAS 13 requires lessees to capitalize all leases that meet any one of the following: Lease transfers ownership of asset to lessee before the lease expires. Lessee has option to purchase asset at a bargain price. Term of lease is greater than or equal to 75% of assets useful economic life. PV of lease payments is ≥ 90% of asset value.

Project Financing Desirable when Examples: Project can stand alone as an economic unit. Project will generate enough revenue (net of operating costs) to service project debt. Examples: Mines & mineral processing facilities Pipelines Oil refineries Paper mills

Project Financing Arrangements Completion undertaking Purchase, throughput, or tolling agreements Cash deficiency agreements

Advantages and Disadvantages of Project Financing Risk sharing Expanded debt capacity Lower cost of debt Disadvantages Significant transaction costs and legal fees Complex contractual agreements Lenders require a higher yield premium

Limited Partnership Financing Another form of tax-oriented financing. Allows the firm to “sell” the tax deductions and credits associated with asset ownership to the limited partners. Income (or loss) for tax purposes flows through to the partners. Limited partners are passive investors. General partner operates the limited partnership and has unlimited liability.