Leasing Lease Financing Corporate Finance Shanghai 2013 Session 2 FINC 5880

Leasing is typically used For aircraft financing (Airlines) Real estate (Retail) Valuable production installations… Trucks and cars (Transport Industry) In short all fixed assets financing

Two or more parties involved The less..ee: party that will use the asset and has to pay the lease payments The less..or: party that will finance the asset and receives the lease payments

Forms of leasing Operational lease (rent) Financial lease Sale-and-leaseback arrangements Combination leases Hybrid forms

Operational lease Provides both maintenance and finance Used for computers, copiers, trucks/cars The lease contract is considerable shorter then the economic life of the asset since the asset is not fully amortized Cancellation clauses are normal The lessor negotiates the price of the asset with the manufacturer

Financial (capital) Leases Do not provide for maintenance services Are not cancellable Are fully amortized The interest rate is based on a secured term loan considering the rating of the lessee Lessee pays property taxes and insurance The lessee negotiates the price with the manufacturer

Sale-and-leaseback (special type financial lease) Alternative for a mortgage Used for land, buildings and equipment The lessee uses the property The leased assets are normally not new Very similar to financial lease

Combination Leases Combination of operational and financial lease The lessee company can use the lease pay as a tax deductible expense The IRS will check if the lease is not in fact a loan… If the lease contract complies with the IRS standards for lease such a lease is called: Guideline lease or Tax-oriented lease

GE Capital…

General Electric’s web site…. Buy or Lease Equipment ? Type of financing? Types of collateral CFO solutions….

The IRS guidelines include: The lease term is max. 80% of useful remaining life time of the asset Residual value should be at least 20% of the assets value at the start of the lease The lessee can not buy the asset at a preset price The lessee can not pay for the asset other then through lease payments The asset should be a widely used asset that can be released/sold at the end of the lease The IRS has set these rules to prevent the use of illegal tax deductions…

Financial statement effects Leasing is often called off balance sheet financing; the leased asset or financing can not be seen on the balance sheet FASB has launched FAS 13 to make sure that 3th parties will be able to see obligations from the lease The lease will be capitalized; the asset will be shown under assets and the NPV of the lease payments under liabilities

FAS 13 states: A lease has to be capitalized when: Ownership of the asset is transferred to the lessee When the lease expires the lessee can buy the asset at less then its market price If the lease extends over 75% of the assets useful live The present value of the lease payments is greater then 90% of the initial value of the asset

Website Summary of Statement No. 13 Accounting for Leases (Issued 11/76) Summary This Statement establishes standards of financial accounting and reporting for leases by lessees and lessors. For lessees, a lease is a financing transaction called a capital lease if it meets any one of four specified criteria; if not, it is an operating lease. Capital leases are treated as the acquisition of assets and the incurrence of obligations by the lessee. Operating leases are treated as current operating expenses. For lessors, a financing transaction lease is classified as a sales-type, direct financing, or leveraged lease. To be a sales-type, direct financing, or leveraged lease, the lease must meet one of the same criteria used for lessees to classify a lease as a capital lease, in addition to two criteria dealing with future uncertainties. Leveraged leases also have to meet further criteria. These types of leases are recorded as investments under different specifications for each type of lease. Leases not meeting the criteria are considered operating leases and are accounted for like rental property. Recommendation: READ FAS 13 ….

Evaluation of the Lessee: Is leasing better then buying? Do the lease payments balance with the effective use of the assets? Leasing is a finance decision; if leasing is more beneficial depends on the total cash flows over the life time of the assets including the tax-cash flows Long leases can be compared to LT debt financing and as such should enter the WACC% calculation…

Class assignment Leasing: Assume the following case; A company considers and investment of $100; the asset is depreciated over 2 years straight line; no residual value and tax rate 40%; if the company borrow the money the interest is 10% per year A guideline lease requires a yearly lease fee of $55 Estimate the cash flows under the 2 scenarios; which has the lower present value? (assume dcf=6% this is the after tax cost of debt: 10%*(1-40%))

Class Assignment: Leasing Consider a $10 M investment (10 year life) to be discontinued after 5 year Borrow at 10% interest per year (before tax) if you Buy the Equipment After 5 years residual value $2 M A 5 year lease would trigger annual lease payments of $ 2,6M starting immediately in t=0 Under the lease the lessor maintains the equipment If the company buy/borrow this equipment the maintenance cost will need to be paid additionally at $0.5M per year at the beginning of each year starting immediately (t=0) Tax rate of the Lessee is 35% Modified Accelerated Cost Recovery System (MACRS) depreciation: over the 5 years is resp. 20%, 32%, 19%, 12% and 11% Compare the PV of the cost of owning (buy/borrow) with the PV of the cost of leasing….which one is lower?

Class assignment: From the Lessor’s point of view Assuming: Lessor’s tax rate is 40% Lessor’s alternative investment is a 5 year bond with an after tax yield of 9%(1-40%)=5.4% Asset will be depreciated to book value of $600,000 after 5 years and the before tax residual value is $ 2M This implies that Lessor can expect to receive $2M – 40%*$1.4M=$1,440,000 after the lease expires selling the asset directly… Develop the cash flows and determine the IRR% of this investment Is 5.4%>,< or= IRR%? So what would the lessor invest his money in in the Lease or the Bonds…?

Since the tax savings When the asset is bought is only calculated over the interest payment and other costs over a spread life time When leased the period is shorter and thus the period to recover the tax savings over the lease payment This causes leases (cash wise) sometimes to be the better decision (compare page 798)

Evaluation of the Lessor; Is this a good investment? The lessor calculates the rate of return on the lease and includes in this calculation: The net cash outlay The periodic cash inflows from lease payments The after tax residual value The rate of return>WACC or NPV>0 The lessor can use (partly) debt financing for the lease and include this effect in his calculations (so called leveraged lease)

Other issues in leasing Lessors are easier on accepting the same risk as lenders since they legally have a better position Lessors that specialize in certain equipment will know how to re-allocate the asset in case of non-payment or at the end of the contract Retailers use leasing for their stores (up to 20yr leases or more) Leases are highly negotiated and shaped by lessor and lessee in specific cases Parties use the tax laws to their advantage and individual situation to create win-win leases

Tax effects on leases Investment Tax Credits (ITC) a direct reduction of the investment Tax rates; higher rates include higher tax savings on payments Depreciation rules effect the lease; faster depreciation implies faster tax savings The alternative minimum tax (AMT) is 20% and prevent that companies who are tax-wise to pay a minimum rate of 20% on profits shown to shareholders! Moving the AMT rate will effect leasing…

Other reasons for leasing then tax… Operating flexibility (aircraft) Costs related to use (copier leases consist of fixed amount plus price per copy) Economy of scale benefits replacements of leased assets that follow a complex pattern (technological assets)

Assignment : Leasing in Valuation Copy Paste the relevant paragraph on Leasing from the 10K of your company to this homework assignment! Operating leases will have a relevant effect on the value of a company Therefore in valuing a company all operational leases should be capitalized at the firms Kd (cost of debt) This will increase the firms fixed assets, depreciation and LT debt The effective tax effect has to be recalculated The FCF of the company will be adjusted Value will be different accordingly… Evaluate the financials of your company Recalculate leases and revaluate the Value of your company USE DAMODARAN’s LEASE CONVERTER

Assignment alternative: If your company does not have operational leases Pick an S&P 500 company that has… Value the company before the lease recalculation (V=FCF/WACC%) and after… Show the effects of your recalculation…

The new Airbus 380 First Class…