1. Leasing
Chapter 21

2. Key Concepts and Skills
Understand the different types of leases.
Understand how to apply NPV to the lease vs. buy decision.
Understand the importance of tax rates in determining the benefit of leasing.

3. Leases
The Basics
A rental agreement that extends for a year or more and involves a series of fixed payments
A lease is a contractual agreement between a lessee and lessor.
The lessor owns the asset and for a fee allows the lessee to use the asset.
The lessor is either the asset’s manufacturer or an independent company
If the lessor is a independent company, it must buy the assets from manufacturer and then it lease to third parties

4. NAS 15
A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.

5. Operating Leases Usually not fully amortized
Payment required under the term of lease are not enough to recover the full cost of the asset for the lessor.
The life of operating lease is less than the economic life of the assets
Usually require the lessor to maintain and insure the asset
Lessee enjoys a cancellation option

6. Financial Leases Source of financing: like borrowing a money
Lessee assumes a binding agreement to make a full payment
Essentially opposite of an operating lease.
Do not provide for maintenance or service by the lessor.
Financial leases are fully amortized.
The lessee usually has a right to renew the lease at expiry.
Generally, financial leases cannot be cancelled.

7. Definition as per NAS (15)
A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership.
A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership.

8. NAS 15
Situations that individually or in combination would normally lead to a lease being classified as a finance lease are
(a) the lease transfers ownership of the asset to the lessee by the end of the lease term;
(b) the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised;
(c) the lease term is for the major part of the economic life of the asset even if title is not transferred;
(d) at the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset; and
(e) the leased assets are of such a specialized nature that only the lessee can use them without major modifications.

9. NAS (15) Economic life is either:
(a) the period over which an asset is expected to be economically usable by one or more users; or
(b) the number of production or similar units expected to be obtained from the asset by one or more users
Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.

10. Sale and Lease-Back A particular type of financial lease
Occurs when a company sells an asset it already owns to another firm and immediately leases it from them.
Two sets of cash flows occur:
The lessee receives cash today from the sale.
The lessee agrees to make periodic lease payments, thereby retaining the use of the asset.

11. Leveraged Leases A leveraged lease is another type of financial lease.
A three-sided arrangement between the lessee, the lessor, and lenders:
The lessor owns the asset and for a fee allows the lessee to use the asset.
The lessor borrows to partially finance the asset.
The lenders typically use a nonrecourse loan. This means that the lessor is not obligated to the lender in case of a default by the lessee.

12. Leveraged Leases As in other leases
the leases uses the assets and makes periodic lease payment
the lessor purchases the assets, deliver them to lessee and collect the lease payment.
However, the lessor puts up no more than 40 to 50 percent of the purchase price.
Lender supply the remaining financing and receive interest payments from the lessor

13. Leveraged Leases Manufacturer of asset
Lessor borrows from lender to partially finance purchase
Lessor buys asset, Firm U leases it.
Manufacturer of asset
The lenders typically use a nonrecourse loan. This means that the lessor is not obligated to the lender in case of a default by the lessee.
Lessor
Lessee (Firm U)
1. Owns asset
1. Uses asset
In the event of a default by the lessor, the lender has a first lien on the asset. Also, the lease payments are made directly to the lender after a default.
2. Does not use asset
2. Does not own asset
Equity shareholders
Creditors

14. Why Lease? Sensible Reasons for Leasing
Short-term leases are convenient
Cancellation options are valuable
Maintenance is provided
Standardization leads to low costs
Tax shields can be used
Leasing and financial distress
Avoiding the alternative minimum tax

15. Dubious Reasons for Leasing
Why Lease?
Dubious Reasons for Leasing
Leasing avoids capital expenditure controls
Leasing preserves capital
Leases may be off balance sheet financing
Leasing effects book income

16. Buying versus Leasing Buy Lease
Firm U buys asset and uses asset; financed by debt and equity.
Lessor buys asset, Firm U leases it.
Manufacturer of asset
Lessor
1. Owns asset
2. Does not use asset
Equity shareholders
Creditors
Lessee (Firm U)
1. Uses asset
2. Does not own asset
Manufacturer of asset
Firm U
Uses asset
Owns asset
Equity shareholders
Creditors

17. Accounting and Leasing
In the old days, leases led to off-balance-sheet financing.
Today, leases are either classified as capital leases or operating leases.
Operating leases do not appear on the balance sheet.
Capital leases appear on the balance sheet—the present value of the lease payments appears on both sides.

18. Capital Lease
A lease must be capitalized if any one of the following is met:
The present value of the lease payments is at least 90 percent of the fair market value of the asset at the start of the lease.
The lease transfers ownership of the property to the lessee by the end of the term of the lease.
The lease term is 75 percent or more of the estimated economic life of the asset.
The lessee can buy the asset at a bargain price at expiry.

19. NPV of leasing
Wadia Co, pipe manufacturing wants to buy a pipe boring 10,000.
The new machine will save Rs per year in electricity bill.
Corporate tax rate is 34%
Straight line depreciation
Lease option:
Falguni Co offered same 2500 per year for five years
What should Wadia Co. do? Buy or Lease?

20. Example Buy Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Cost of Machine
-10000
After tax operating savings=6000X )
3960
Tax benefit from Depreciation
680
Total
-10,000
4640
Depreciation= 10,000/5= 2,000
Tax rate: 0.34*2,000=680

21. Example Lease Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Lease payment
-2500
Tax benefit from Leasing (2500*0.34)
850
After tax operating savings
3960
Total
2310

22. Incremental cash Flow from Leasing instead of buying
Lease Minus Buy
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Lease payment
-2500
Tax benefit from Leasing (2500*0.34)
850
Total
-1650
Buy (Minus)
Cost of machine
10,000
Lost Deprecation tax benefit
-680
Total (Net Cash Flow)
-2330
These numbers represents the cash flows from leasing relative to the cash flow from the purchase

23. What next? Discount the cash flow What is the discount rate?
Difficult question
The answer is: Discount all cash flows at the after-tax interest rate

24. Discount Rate After tax riskless rate of return??
A lease payment is like debt service on a secured bond issued by the lessee
A discount rate should be approximately the same as the interest rate of such debt
Slightly higher due to changes in corporate tax rate

25. NPV Lest assume that Wadia can borrow or lend @ 7.57%
Corporate Tax rate is 34%
Aftear tax discount rate is { %*(1-0.34)}= 5%
NPV=10, X PVIA (0.05,5)=-87.68
Since the NPV of incremental cash flows from leasing relative to purchasing is negative, Wadia prefers to purchase

26. Debt Displacement and Lease
A firm that purchase equipment will generally issue debt to finance the purchase
It’s a liability
A lessee incurs liability equal to the present value of al future lease payments.
Debt displacement is a hidden cost
If a firm leases, it will not use as much regular debt as it would otherwise.
The benefit of lower tax

27. Accounting and Leasing (Balance Sheet)
Truck is purchased with debt Truck Rs.100,000 Debt Rs.100,000 Land Rs.100,000 Equity Rs.100,000 Total Assets Rs.200,000 Total Debt & Equity Rs.200,000 Operating Lease Truck Debt Total Assets Rs.100,000 Total Debt & Equity Rs.100,000 Capital Lease Assets leased Rs.100,000 Obligations under capital lease Rs.100,000 Total Assets Rs.200,000 Total Debt & Equity Rs.200,000
Consider a firm with two assets: a truck and some land.

28. Calculation of NPV for lease against purchase
NPV = Purchase Price – OCF * PVIFA kdt%,n
Where,
OCF= lease payment after tax+ Depreciation tax shield
OCF = lease payment (1-tax%) + Depreciation * tax% OR
NPV = Purchase price – lease payment (1-tax%) * PVIFA kdt%,n – Depreciation * tax% * PVIFA kdt%, n