0. Chapter 27
Leasing
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin

1. Key Concepts and Skills
Understand basic lease terminology
Understand the criteria for a capital lease vs. an operating lease
Understand the typical incremental cash flows to leasing
Be able to compute the net advantage to leasing
Understand the good reasons for leasing and the dubious reasons for leasing
27-1

2. Chapter Outline Leases and Lease Types Accounting and Leasing
Taxes, the IRS, and Leases
The Cash Flows from Leasing
Lease or Buy?
A Leasing Paradox
Reasons for Leasing
27-2

3. Lease Terminology
Lease – contractual agreement for use of an asset in return for a series of payments
Lessee – user of an asset; makes payments
Lessor – owner of the asset; receives payments
Direct lease – lessor is the manufacturer
Captive finance company – subsidiaries that lease products for the manufacturer
27-3

4. Types of Leases Operating lease Shorter-term lease
Lessor is responsible for insurance, taxes, and maintenance
Often cancelable
Financial lease (capital lease)
Longer-term lease
Lessee is responsible for insurance, taxes, and maintenance
Generally not cancelable
Specific capital leases
Tax-oriented
Leveraged
Sale and leaseback
Real-World Tip: As described by Professor James Johnson in his article, “Predatory Leasing: The Curse of the No-Exit Lease” (Corporate Finance Review, January/February 1999) some lessors make it extremely difficult for lessees to escape the lease at expiration. Typically lessees have the right to purchase the equipment, extend the lease, or “walk away.” In a “predatory” lease, the end-of-lease language traps the lessee. See further example of this in the IM.
Real-World Tip: Traditionally, sale and leaseback arrangements have involved expensive assets (e.g., buildings, airliners, railroad cars); however, “employee leasing” has grown from almost zero in 1984 and many millions today. Unlike traditional “temps,” these people are employed by the lessor, provided with health and other benefits, and then leased to a client firm. The development of this industry is perhaps a natural outgrowth of the downsizing and outsourcing of the 1990s.
27-4

5. Lease Accounting Leases are governed primarily by FASB 13
Financial leases are essentially treated as debt financing
Present value of lease payments must be included on the balance sheet as a liability
Same amount shown on the asset as the “capitalized value of leased assets”
Operating leases are still “off-balance-sheet” and do not have any impact on the balance sheet itself
27-5

6. Criteria for a Capital Lease
If one of the following criteria is met, then the lease is considered a capital lease and must be shown on the balance sheet
Lease transfers ownership by the end of the lease term
Lessee can purchase asset at below market price
Lease term is for 75 percent or more of the life of the asset
Present value of lease payments is at least 90 percent of the fair market value at the start of the lease
27-6

7. Taxes Lessee can deduct lease payments for income tax purposes
Must be used for business purposes and not to avoid taxes
Term of lease is less than 80 percent of the economic life of the asset
Should not include an option to acquire the asset at the end of the lease at a below market price
Lease payments should not start high and then drop dramatically
Must survive a profits test – lessor should earn a fair return
Renewal options must be reasonable and consider fair market value at the time of the renewal
27-7

8. Incremental Cash Flows
Cash Flows from the Lessee’s point of view
After-tax lease payment (outflow)
Lease payment*(1 – T)
Lost depreciation tax shield (outflow)
Depreciation * tax rate for each year
Initial cost of machine (inflow)
Inflow because we save the cost of purchasing the asset now
May have incremental maintenance, taxes, or insurance
27-8

9. Example: Lease Cash Flows
ABC, Inc. needs some new equipment. The equipment would cost $100,000 if purchased and would be depreciated straight-line over 5 years. No salvage is expected. Alternatively, the company can lease the equipment for $25,000 per year. The marginal tax rate is 40%.
What are the incremental cash flows?
After-tax lease payment = 25,000(1 - .4) = 15,000 (outflow years 1 - 5)
Lost depreciation tax shield = (100,000/5)*.4 = 8,000 (outflow years 1 – 5)
Cost of machine = 100,000 (inflow year 0)
The net advantage to leasing is calculated in slide 11.
27-9

10. Lease or Buy?
The company needs to determine whether it is better off borrowing the money and buying the asset, or leasing
Compute the NPV of the incremental cash flows
Appropriate discount rate is the after-tax cost of debt since a lease is essentially the same risk as a company’s debt
See the Lecture Tip in the IM for an extended example of the lease vs. buy decision.
27-10

11. Net Advantage to Leasing
The net advantage to leasing (NAL) is the same thing as the NPV of the incremental cash flows
If NAL > 0, the firm should lease
If NAL < 0, the firm should buy
Consider the previous example. Assume the firm’s cost of debt is 10%.
After-tax cost of debt = 10(1 - .4) = 6%
NAL = $3,116
Should the firm buy or lease?
Year Cash Flows
0 100,000
,000 – 8,000 = -23,000
Compute NPV at 6%
Positive NAL implies firm should lease.
27-11

12. Work the Web Example
Many people must choose between buying and leasing a car
Click on the web surfer to go to Kiplinger’s
Go to Tools & Calculators: Cars
Do the calculations for a $30,000 car, 5-year loan at 7% with monthly payments, and a $3,000 down payment. The available lease is for 3 years and requires a $550 per month payment with a $1,000 security deposit and $1,000 other upfront costs.
27-12

13. Good Reasons for Leasing
Taxes may be reduced
May reduce some uncertainty
May have lower transaction costs
May require fewer restrictive covenants
May encumber fewer assets than secured borrowing
27-13

14. Dubious Reasons for Leasing
Balance sheet, especially leverage ratios, may look better if the lease does not have to be accounted for on the balance sheet
100% financing – except that leases normally do require either a down-payment or security deposit
Low cost – some may try to compare the “implied” rate of interest to other market rates, but this is not directly comparable
27-14

15. Quick Quiz What is the difference between a lessee and a lessor?
What is the difference between an operating lease and a capital lease?
What are the requirements for a lease to be tax deductible?
What are typical incremental cash flows, and how do you determine the net advantage to leasing?
What are some good reasons for leasing?
What are some dubious reasons for leasing?
27-15

16. Ethics Issues
Suppose a manager chooses to lease an asset (operating lease) rather than buy, simply to keep the asset off-balance sheet and thereby avoid reporting the liability?
Although this may be legal, is there any ethical implication?
Are investors able to effectively monitor and analyze such activity?
27-16

17. Comprehensive Problem
What is the net advantage to leasing for the following project, and what decision should be made?
Equipment would cost $250,000 if purchased
It would be depreciated straight-line to zero salvage over 5 years.
Alternatively, it may be leased for $65,000/yr.
The firm’s after-tax cost of debt is 6%, and its tax rate is 40%
After-tax lease payment = (1 - .4) X $65,000 = $39,000
Lost tax shield = .4 x $50,000 = $20,000
Year CF
0 250,000
1-5 = -$39,000 – $20,000 = -$59,000
Discount at 6%
NPV = $1,471
Lease it!
27-17

18. End of Chapter
27-18