© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Leasing Chapter Twenty-Six

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved Key Concepts and Skills Understand the basic lease terminology Understand the criteria for a capital lease vs. an operating lease Understand the typical incremental cash flows to leasing Be able to compute the net advantage to leasing Understand the good reasons for leasing and the dubious reasons for leasing

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved Chapter Outline Leases and Lease Types Accounting and Leasing Taxes, the IRS and Leases The Cash Flows from Leasing Lease or Buy? A Leasing Paradox Reasons for Leasing

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved 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

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved 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 Leveraged Sale and leaseback

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved 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

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved 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

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved 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 –Renewal options must be reasonable and consider fair market value at the time of the renewal

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved Incremental Cash Flows After-tax lease payment (outflow) –Lease payment*(1 – T) 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 or insurance depending on the type of lease and whether the leased asset is replacing one currently owned

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved 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 $25,000 per year. The marginal tax rate is 40%. –What are the incremental cash flows? After-tax lease payment = 25,000(1 -.4) = 15,000 (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)

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved 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 companys debt

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved 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 firms cost of debt is 10%. –After-tax cost of debt = 10(1 -.4) = 6% –NAL = 3,116 Should the firm buy or lease?

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved Work the Web Example Many people have to choose between buying and leasing a car Click on the web surfer to go to Kiplingers –Go to more calculators and chose the lease vs. buy –Do the calculations for a $30,000 car, 5-year loan at 7% with monthly payments and a $3000 down payment. The available lease is for 3 years and requires a $550 per month payment with a $1000 security deposit and $1000 other upfront costs.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved 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

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved 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 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

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved Quick Quiz What is the difference between a lessee and a lessor? What is the difference between an operating lease and a capital lease? What are the requirements for a lease to be tax deductible? What are typical incremental cash flows and how do you determine the net advantage to leasing? What are some good reasons for leasing? What are some dubious reasons for leasing?