1. 1 Leases

2. What is a Lease? A lease is a contract where the lessor agrees to let the lessee use their asset in exchange for compensation  Lessee: Needs the asset, pays a quasi-rent to the lessor to use the asset  Lessor: Owns the asset, lets the lessee use the asset in exchange for a quasi-rent Two types of leases: Operating & Financial 2

3. 3 Operating Lease The lease payments are not enough to recoup the full cost of the asset  Generally short-term contracts, and the lessor expects to either sell the asset or renew the lease The lessor maintains and insure the asset The lessee can return the asset and cancel the lease at will

4. Financial Leases Lease payments are enough to cover the cost of the asset The lessee maintenance and insures the asset Generally cannot be cancelled The lessee usually has a right to renew the lease at expiry 4

5. Sale and Lease Back A Special Financial Leases A firm sells an asset, and then leases it back immediately  Why would a firm do this? 5

6. Buy or Lease Decision ClumZee Movers, needs a truck, which will reduce costs by $6,500/year. The truck costs $25,000 and has a 5 yr life If the firm buys the truck, they will use straight- line depreciation to a zero salvage value. ClumZee tax rate is 34% Alternatively they can lease the truck from Tiger Leasing for $8,250/year Should Clumzee buy or lease the truck? 6

7. Buy Cash flow Year 0Year 1 – 5 Initial Purchase After Tax Op Saving Dep. Tax Shield Incremental CF 7

8. Leasing Cash flow Year 0Year 1 – 5 Initial Purchase After Tax Op Saving After Tax Lease Payments Incremental CF 8

9. Leasing minus Buying Cash Flows Year 0:  Lease CF____  Buy CF _____  Lease – Buy CF ______ Year 1-5:  Lease CF____  Buy CF _____  Lease – Buy CF ______ 9

10. Leasing Incremental Cash Flows Year 0 Years 1-5 $25,000–$1,155 – $5,990 = –$7,145 Should ClumZee lease the truck? 10

11. Why discount at the debt rate? A lease payment is like the debt service (interest payment) on a secured bond issued by the lessee. In the real world, many companies discount both the depreciation tax shields and the lease payments at the after-tax debt rate 11

12. NPV Analysis: Lease-v-Buy Decision  Discount the incremental lease cash flows  ClumZee’s pre tax debt rate is 7.6%  The after tax rate is 5% → 0.076 * (1-0.34) 12

13. 13 Given: Leasing v Buy Example Xomox Corp needs a new pipe machine to meet it’s demands (Tax Rate =34%, uses straight line depreciation) IBMC makes such a machine for $10,000, with an expected life of 5 years, no salvage value This machine will save Xomox $6,000 in manufacturing costs Friendly Leasing Corp will lease the same machine to Xomox for $2,500 for 5 years What are the incremental cash flows?

14. Given: Lease v Buy Cash Flows Year 012345 Buy Costs -$10,000 Op Savings After Tax$3,960 Dep Tax Benefit$680 Total -$10,000$4,640 Lease Payments -$2,500 Tax Benefit $850 Op Savings After Tax $3,960 Total $2,310 14

15. Given: Lease – Buy Cash Flows Year 012345 Lease Payments -$2,500 Payment’s Tax Benefit $850 Buy Cost -$10,000 Lost Dep Tax Shield -$680 Total$10,000 -$2,330 15

16. 16 Given: Discounting the Difference Xomox can borrow at 7.57575%, taxes are 34% So the after tax discount rate is 5% 0.0757575 * (1-.34) = 0.05 Year 01234 Cash Flow$10,000 -$2,330 Discount CF -$87.68Xomox prefers to buy

17. Alternative Lease Evaluation Method: Debt Displacement Since leases replace conventional debt, compare how much the company could borrow Suppose ClumZee leases the truck for $8,250/year  Incremental cost is the payment + lost tax shield 17

18. The Lessor’s Cash Flows The NPV for Tiger is the exact opposite 18 Year 0Year 1 Truck-25,000 Dep Tax Shield5,000*(1-.34)= 1,700 Lease Payment8,250*(1-.34) = 5,445 -$25,000$7,145

19. 19 Good Reasons to Lease 1. Taxes can be reduced: -Corporations are in different tax brackets 2. Reduces uncertainty (kind of) -Residual Value: the value of the asset at expiration -Leasing allows the person best able to bear the risk, to bear the risk 3. Transactions costs can be higher for buying an asset and financing it with debt or equity than for leasing the asset.

20. 20 Bad Reasons to Lease 1. Manipulation of Accounting Numbers -Reduces the liabilities of the balance sheet -Improves the firm’s ROA 2. Avoid Capital Expenditure Controls 3. Possible to use Leases as Off-Balance Sheet Financing

21. Taxes, the IRS, and Leases A principal benefit of long-term leasing is tax reduction. Leasing allows the transfer of tax benefits from those who need equipment but cannot take full advantage of the tax benefits (Depreciation) to a party who can. The IRS tries to limit this 21

22. Taxes, the IRS, and Leases The lessee can deduct lease payments if the lease is qualified by the IRS. 1. The lease must be less than 30 years. 2. There can be no bargain purchase option. 3. The lease should not have a schedule of payments that is very high at the start and low thereafter. 4. The lease payments must provide the lessor with a fair market rate of return. 5. The lease should not limit the lessee’s right to issue debt or pay dividends. 6. Renewal options must be reasonable and reflect fair the market value of the asset. 22

23. Tax Arbitrage ClumZee’s tax rate is 25% Tiger Leasing’s tax rate is 34% If the lease payments drop to $8,200, can the lease happen? 23

24. A Tax Arbitrage: Clumzee Cash Flows ClumZee Movers: Leasing Instead of Buying Year 0 Years 1-5 Cost of truck we didn’t buy$25,000 Lost Depreciation Tax Shield 5,000×(.25) = –$1,250 After-Tax Lease Payments 8,200×(1 –.25) = –$6,150 $25,000 –$7,400 24

25. A Tax Arbitrage: Tiger Cash Flows: Tiger Leasing Year 0Years 1-5 Cost of truck–$25,000 Dep Tax Shield 5,000×(.34) = $1,700 Lease Payments 8,200×(1–.34)= $5,412 –$25,000 $7,112 25

26. Is a Lease Possible? We need to determine each firm’s break even payment 26

27. ClumZee Leasing’s Breakeven Payment Solve for a 0 NPV payment  N = 5, I/Y = 5.7, PV=25,000, PMT = ?, FV = 0 Subtract the Dep Tax Shield to get the after tax lease payment 27

28. Tiger Leasing’s Breakeven Payment Solve for a 0 NPV payment  N = 5, I/Y = 5, PV=25,000, PMT = ?, FV = 0 Subtract the Dep Tax Shield to get the after tax lease payment 28

29. Is a Lease Possible? The most that ClumZee movers can afford to pay is: The least that Tiger Leasing can accept is: 29

30. Salvage Value For the purpose of this class we will ignore the effects of salvage value, beyond how it impacts depreciation 30

31. Quick Quiz Compare operating and financing leases. Explain why tax rates affect the lease vs. buy decision. 31