26-0 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

26-1 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 Sale and leaseback

26-2 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

26-3 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

26-4 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

26-5 Incremental Cash Flows Cash Flows from the Lessee’s point of view After-tax lease payment (outflow) Lease payment*(1 – t C ) 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, insurance, or salvage value

26-6 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 $26,300 per year. The marginal tax rate is 40%. What are the incremental cash flows? After-tax lease payment = 26,300(1 -.4) = 15,780 (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)

26-7 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

26-8 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%

26-9 NAL = $100,000 - $15,780(PVIFA 6%,5 ) - $8,000(PVIFA 6%,5 ) NAL = -$ Do not lease the machine What is NAL to lessor?

26-10 Differential taxes Lessee pays no tax Return = 10% NAL = $100,000 - $26,300(PVIFA 10%,5 ) NAL = $ Lease the machine

26-11 Maximum Lease Payment NAL = $0

26-12 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

26-13 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