Chapter 21 – Lease Analysis -- Terms u Lessee u The person using the asset u Lessor. u The person who owns the asset

Operating Lease u Also called service lease or service contract u The lessor maintains the asset

Financial Lease u Also called a capital lease u Lessee maintains the asset u Lessee may negotiate terms of sale with the manufacturer, with the lessor acting as a creditor with a secured position

Leveraged Lease u Lessor uses borrowed money to finance the lease u Lessor typically needs the tax-deductible interest or the depreciation expense u Lender is in a low tax bracket u Tax laws are tightening -- Passive loss rules

Sale and Leaseback u Owner sells the asset to a third party and then leases it back

Reasons for leasing u Increased availability of financing u Lessor has a more secured position and typically this: u Makes the lease less risky from the lessor point of view u Makes the lease easier and quick u Allows a higher amount to be “borrowed” u May allow the company around restrictive covenants on debt

Reasons for leasing u Shift of ownership risk u serviceability u obsolescence u residual value u Flexibility u With cancellation provisions the lessee has an option to put the asset back to the lessor

Reasons for leasing u Tax Advantages u A lease can transfer depreciation savings to the lessor who may be in a higher tax bracket u A lease payment may be higher than depreciation expense and transfer benefit to the lessee

Reasons for leasing u Accounting benefits u Within generally accepted accounting guidelines leases can still provide some form of “off-balance sheet” financing u This “off-balance sheet financing” does not appear on the balance sheet as debt -- but instead in the footnotes

Reasons for leasing u Circumvent the decision process u Government unit, for example, may have restrictions on capital expenditures but fewer restrictions on leasing u Lower cost: The net present value of leasing may be less than the net present value of owning

Reasons for leasing u Reimbursement u When the asset is purchased the firm may not be reimbursed for the cost on financing u When the asset is leased, and the lease payment is reimbursed, the financing cost is in the lease payment u Common with hospitals

Taxes and Leasing u The IRS has guideline for determining if a lease is really and installment sale u When the lease does not meet these guidelines, the agreement is not a lease and the tax benefits shift

Cash flow analysis of Leases u Cost to lease u Present value of the lease payments -- discounted at the after tax cost of debt

Cash Flow Analysis of Leases u Cost to buy u Present value of the after tax operating cost of ownership: if highly predictable, use the after tax cost of debt u Present value of the after tax depreciation expense: highly predictable, use the after tax cost of debt u Present value of the net terminal salvage value: not very predictable, use the weighted average cost of capital

Cost to Lease or Buy u Cost to lease n =  [(1 – T)L t ]  (1 + k d ) t t=0 u Cost to buy n = I 0 +  [(1-T)OC t - TDep t ]  (1+k d ) t t=0 - Net terminal value  (1 + K o ) n

Financial Statement Impact of Leases u You can acquire the use of assets without showing the correlating financing cost by “structuring the deal” as an operating lease rather than a capital lease.

Current Leasing Practice u Ang and Peterson u Those who use more debt also use more leasing u Sharp and Ngyun u Leases are more common with cash-poor firms

Current Leasing Practice u Krishnan and Moyer u Firms more likely to lease in industries with high bankruptcy cost u Mehran, et. al u Companies with high CEO ownership are more likely to lease u Smith and Wakeman u Identify eight variable that correlate with leasing