1. 19
Lease Financing

2. Introduction
This chapter explores the reasons a firm might choose to lease rather than borrow and then buy some of their assets.
It examines the type of analysis that should go into a lease versus borrow-and-purchase decision to maximize shareholder wealth.
It examines the costs and benefits to leasing companies offering this type of financing.

3. Glossary of Leasing Terms
This Web site has a glossary of leasing terms for researching the right alternative between leasing or borrowing and purchasing assets:

4. Lease Contract Leases Lessee Alternative to term financing
Arrangements to transfer tax benefits
Lessee
Obtains use of an asset
Specific period of time
Ownership to lessor
Agrees to make a series of payments to lessor

5. Types of Leases Operating lease Service lease • Maintenance lease
Maintenance and insurance included
Financial lease
Noncancelable
Lessee responsible for
Maintenance • Insurance • Property taxes
Direct lease
Sale and leaseback
Leveraged lease Three-party financial lease
Lessee • Lessor • Lender

6. Sale and Leaseback Transaction
Investigate the sale and leaseback transaction at this Web site:

7. Advantages to Leasing Flexible Convenient Lower payments
Avoid some risk of obsolescence
Smoother earnings and EPS
100% financing
Liquidity

8. Disadvantages to Leasing
More expensive
Salvage value
Difficult approval for modifications
May not be canceled

9. Tax Considerations
A lease must have economic benefits separate from tax consideration.
Recognized by IRS as a lease (Rules)
Remaining useful life
May not exceed 30 years
Reasonable ROI
Renewal options
Purchase options
Level schedule of lease payments
20% equity
Property valuable only to the lessee

10. Leases and Accounting Practices
Types of Leases
Financial leases
Operating leases
FASB requires that leases be capitalized.
Value of lease
Equal to the PV of the lease payments
Discounted at the firm’s borrowing rate for a secured loan with similar maturity
Disclosure of details in footnotes

11. Footnotes Financial Leases
As of the date of the balance sheet
Gross amount of assets by major classes
Amount of accumulated lease amortization
Future minimum lease payments
In total for each of the next five fiscal years

12. Footnotes Operating Leases
As of the date of the latest balance sheet
Future minimum rental payments required
In total for each of the following five fiscal years
An income statement is presented for rental expense in each period

13. Small Firms Reasons for leasing Expensive reasons
Less cash required upfront
Better protection against obsolescence
Quicker approvals
Fewer restrictive covenants
Expensive reasons
High interest cost
Loss of tax benefits

14. Lease Payments Lessor’s required payment three-step process
Step 1: Compute the lessor’s amount to be amortized
Initial outlay
Less: PV of after-tax salvage
Less: PV of depreciation tax shelter
Equals: Amount to be amortized

15. After-tax lease income required 1 – lessor’s marginal tax rate
Lease Payments (cont)
Step 2: Compute after-tax lease income required
Amount to be amortized = PV of after-tax lease payment
Step 3: Compute before-tax lease payment
Lease
Payment =
After-tax lease income required
1 – lessor’s marginal tax rate

16. Lease vs. Borrowing to Buy
Compute the NAL.
If NAL is positive, it is cheaper to lease.
If NAL is negative, it is cheaper to own.
Considerations
Installed costs
PV of after-tax lease payments
PV of depreciation tax shield
PV of after-tax operating costs if owned
PV of after-tax salvage value at the lessee’s weighted cost of capital