0 Buying versus Leasing BuyLease Firm U buys asset and uses asset; financed by debt and equity. Lessor buys asset, Firm U leases it. Manufacturer of asset.

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Presentation transcript:

0 Buying versus Leasing BuyLease Firm U buys asset and uses asset; financed by debt and equity. Lessor buys asset, Firm U leases it. Manufacturer of asset Equity shareholders Firm U 1. Uses asset 2.Owns asset Creditors Manufacturer of asset Lessor 1. Owns asset 2. Does not use asset Equity shareholders Creditors Lessee (Firm U) 1. Uses asset 2. Does not own asset

1 Operating Leases  Usually not fully amortized.  Usually require the lessor to maintain and insure the asset.  Lessee enjoys a cancellation option.

2 Financial Leases The exact opposite of an operating lease. 1.Do not provide for maintenance or service by the lessor. 2.Financial leases are fully amortized. 3.The lessee usually has a right to renew the lease at expiry. 4.Generally, financial leases cannot be cancelled.

3 Sale and Lease-Back  A particular type of financial lease.  Occurs when a company sells an asset it already owns to another firm and immediately leases it from them.  Two sets of cash flows occur: –The lessee receives cash today from the sale. –The lessee agrees to make periodic lease payments, thereby retaining the use of the asset.

4 Leveraged Leases  A leveraged lease is another type of financial lease.  A three-sided arrangement between the lessee, the lessor, and lenders. –The lessor owns the asset and for a fee allows the lessee to use the asset. –The lessor borrows to partially finance the asset. –The lenders typically use a nonrecourse loan. This means that the lessor is not obligated to the lender in case of a default by the lessee.

5 Accounting and Leasing  Leases can lead to off-balance-sheet financing.  Under FASB 13, leases are either classified as capital leases or operating leases. –Operating leases do not appear on the balance sheet. –Capital leases appear on the balance sheet— the present value of the lease payments appears on both sides.

6 Accounting and Leasing Balance Sheet Truck is purchased with debt Truck$100,000Debt$100,000 Land$100,000Equity$100,000 Total Assets$200,000Total Debt & Equity $200,000 Operating Lease TruckDebt Land$100,000Equity$100,000 Total Assets$100,000Total Debt & Equity $100,000 Capital Lease Assets leased$100,000Obligations under capital lease$100,000 Land$100,000Equity$100,000 Total Assets$200,000Total Debt & Equity$200,000 Consider a firm with two assets: a truck and some land.

7 Capital Lease  A lease must be capitalized if any one of the following is met: –The present value of the lease payments is at least 90 percent of the fair market value of the asset at the start of the lease. –The lease transfers ownership of the property to the lessee by the end of the term of the lease. –The lease term is 75 percent or more of the estimated economic life of the asset. –The lessee can buy the asset at a bargain price at expiry.

8 Taxes, the IRS, and Leases  The principal benefit of long-term leasing is tax reduction.  Leasing allows the transfer of tax benefits from lessee to lessor.  Naturally, the IRS seeks to limit this, especially if the lease appears to be set up solely to avoid taxes.

9 Taxes, the IRS, and Leases  The lessee can deduct lease payments if the lease is qualified by the IRS. 1.The term must be less than 30 years. 2.There can be no bargain purchase option. 3.The lease should not have a schedule of payments that is very high at the start of the lease and low thereafter. 4.The lease payments must provide the lessor with a fair market rate of return. 5.The lease should not limit the lessee’s right to issue debt or pay dividends. 6.Renewal options must be reasonable and reflect fair market value of the asset.

10 NPV Analysis of the Lease-vs.-Buy Decision  A lease payment is like the debt service on a secured bond issued by the lessee.  In the real world, many companies discount both the depreciation tax shields and the lease payments at the after-tax interest rate on secured debt issued by the lessee.

11 Debt Displacement and Lease Valuation  Considering the issues of debt displacement allows for a more intuitive understanding of the lease versus buy decision.  Leases displace debt—this is a hidden cost of leasing. If a firm leases, it will not use as much regular debt as it would otherwise. –The interest tax shield will be lost.

12 Reasons for Leasing  Good Reasons –Taxes may be reduced by leasing. –The lease contract may reduce certain types of uncertainty. –Transactions costs can be higher for buying an asset and financing it with debt or equity than for leasing the asset.  Bad Reasons –Accounting

13 Some Unanswered Questions  Are the Uses of Leases and of Debt Complementary?  Why are Leases offered by Both Manufacturers and Third Party Lessors?  Why are Some Assets Leased More than Others?

14 Analysis of Leases  Cash Flows –Lease payment Tax deductible if criteria are met –Depreciation tax shield Depr. Expense * Marginal tax rate –Equipment (Asset) Cost  Discount rate = After-tax cost of debt  Decision (output) variable –2 alternatives: leasing versus buy-and-borrow Can compare NPV under both alternatives If combining cash flows, be sure to lable what the NPV represent: Advantage to leasing OR Advantage to buy and borrow.