®2002 Prentice Hall Publishing 1 Chapter 18 Lease Financing

®2002 Prentice Hall Publishing 2 Features of a Lease Lessor/LesseeLessor/Lessee Advanced paymentAdvanced payment Maintenance leaseMaintenance lease Net leaseNet lease Residual valueResidual value

®2002 Prentice Hall Publishing 3 Operating Versus Financial Leases Operating leaseOperating lease –Relative short-term < asset’s useful life< asset’s useful life –Cancellable with proper notice Financial lease –Longer term Asset’s useful life –Noncancellable

®2002 Prentice Hall Publishing 4 Types of Lease Contracts Sale and leasebackSale and leaseback Direct leasingDirect leasing Leveraged involves 3 partiesLeveraged involves 3 parties –Lessee –Lessor (Equity Participant) –Lender

®2002 Prentice Hall Publishing 5 Accounting and Tax Treatment of Leases FASB No. 13 Asset Liability Value shown on the balance sheet

®2002 Prentice Hall Publishing 6 Capital Lease Conditions Title transfers to lesseeTitle transfers to lessee Option to purchaseOption to purchase Lease period  75% of economic lifeLease period  75% of economic life Present value (PV) of lease payments  90% of the fair value of the leased propertyPresent value (PV) of lease payments  90% of the fair value of the leased property

®2002 Prentice Hall Publishing 7 Recording the Value of a Capital Lease Value appears on the balance sheetValue appears on the balance sheet Amount reflectedAmount reflected –PV of the minimum lease payments over the lease period Discount rate employedDiscount rate employed –Lessee’s incremental borrowing rate –Lessor’s implicit interest rate

®2002 Prentice Hall Publishing 8 Disclosure of Operating Leases Total future minimum lease paymentsTotal future minimum lease payments Schedule by year for next five yearsSchedule by year for next five years Total sublease rentals to be receivedTotal sublease rentals to be received Basis for contingent rental paymentsBasis for contingent rental payments Existence and terms of purchaseExistence and terms of purchase Renewal options and escalation clausesRenewal options and escalation clauses Lease agreement restrictionsLease agreement restrictions

®2002 Prentice Hall Publishing 9 IRS Guidelines for the Tax Treatment of Lease Contracts Lessor have a minimum “at risk” investmentLessor have a minimum “at risk” investment Remaining life the longer ofRemaining life the longer of –One year –20% of asset’s original estimated life No bargain purchase optionNo bargain purchase option No loan from lessee to lessorNo loan from lessee to lessor Expected profit to lessor > tax benefitsExpected profit to lessor > tax benefits

®2002 Prentice Hall Publishing 10 Lessor’s Return Depends on Three Things Length of the lease Periodic lease payments Residual value assumption Beginning End

®2002 Prentice Hall Publishing 11 Calculating the Lease Payment n = length of the lease in yearsn = length of the lease in years m = number of times a year periodic lease payments are madem = number of times a year periodic lease payments are made R = implicit interest rate for which we solveR = implicit interest rate for which we solve RV = assumed residual value at the end of the lease termRV = assumed residual value at the end of the lease term

®2002 Prentice Hall Publishing 12 Analysis of Lease Versus Buy/Borrow After taxAfter tax Discounted cash flowsDiscounted cash flows Financial decisionFinancial decision The investment decision is to acquire an asset Then a company decides how to finance it

®2002 Prentice Hall Publishing 13 Methods of Analysis Present value method (PV)Present value method (PV) –Compare PV’s of alternatives –Lowest PV is the most desirable Internal rate of return (IRR)Internal rate of return (IRR) –Compare costs of lease/borrowing After-taxAfter-tax –Select alternative with lowest rate

®2002 Prentice Hall Publishing 14 Favorable Factors for Buy/Borrow Alternative Use of accelerated cost recovery depreciationUse of accelerated cost recovery depreciation Residual value at the end of the projectResidual value at the end of the project Greater residual valueGreater residual value Tax deductibility of interest paymentsTax deductibility of interest payments High tax bracketsHigh tax brackets

®2002 Prentice Hall Publishing 15 Residual Value Usually subject to considerable uncertaintyUsually subject to considerable uncertainty Could require higher discount rateCould require higher discount rate Higher rate favors lease financingHigher rate favors lease financing

®2002 Prentice Hall Publishing 16 Sensitivity Analysis of Uncertain Borrowing Costs Interest rate change Speed of rate change Change financing decision How probable is the interest rate change?

®2002 Prentice Hall Publishing 17 What if the Asset can Only be Leased? Intertwined decisionsIntertwined decisions –Investing –Financing Lease if PV of cash benefits > the cash- equivalent priceLease if PV of cash benefits > the cash- equivalent price Reject lease if benefits < priceReject lease if benefits < price

®2002 Prentice Hall Publishing 18 Sources of Value in Leasing Perfect capital marketsPerfect capital markets –Firm indifferent Bankruptcy costsBankruptcy costs –Lessor’s position somewhat superior to lender Effect of differing taxesEffect of differing taxes –Low tax-bracket firms lease more and borrow less Market equilibration processMarket equilibration process –Competition encourages sharing of tax benefits

®2002 Prentice Hall Publishing 19 Alleged Lessor’s Benefits Economies of scaleEconomies of scale Different estimateDifferent estimate –Life of the asset –Residual value –Discount rate Face different borrowing costsFace different borrowing costs Provide expertise to customersProvide expertise to customers –Equipment selection –Equipment maintenance