1. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-1 Chapter Twenty-four Leasing

2. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-2 24.1The Nature of Leases 24.2Types of Leases 24.3A Brief Look at Accounting for Leases 24.4Taxation and Leases 24.5An Evaluation of Leasing 24.6The Role of the Residual Value 24.7Setting Lease Premiums 24.8Alleged Advantages and Disadvantages of Leasing 24.9Summary and Conclusions Chapter Organisation

3. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-3 Chapter Objectives Understand the characteristics of the different types of leases. Explain how leases are recorded in a firm’s accounting records. Identify the tax implications of leases. Evaluate a lease by calculating the net advantage of leasing (NAL). Explain the calculation of lease premiums. Discuss the advantages and disadvantages of leases.

4. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-4 Leasing versus Buying Manufacturer of asset Manufacturer of asset Sass arranges financing and buys asset from manufacturer Sass 1. Uses asset 2. Owns asset Lessor 1. Owns asset 2. Does not use asset Lessee (Sass) 1. Uses asset 2. Does not own asset Sass buys asset and uses asset; financing raised by debt Sass leases asset from lessor; the lessor owns the asset Sass leases asset from lessor Lease Buy

5. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-5 Leasing What is a lease? – A lessee (user) enters an agreement in which they make lease payments to the lessor (owner) in return for the use of the leased property/asset. Who are the major providers of lease finance in Australia? – Finance companies and banks. What assets are leased? – Any asset including photocopiers, cars, construction equipment, computers, shop/office fittings and equipment.

6. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-6 Types of Leases Operating lease Financial lease – Sale and leaseback agreement – Leveraged lease

7. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-7 Operating Leases Short-term lease. Cancellable prior to the expiry date at little or no cost. Lessor is responsible for maintenance and upkeep of asset. The sum of the lease payments does not provide for full recovery of the asset’s costs. Includes telephones, televisions, computers, photocopiers, cars.

8. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-8 Financial Leases Long-term lease. Non-cancellable (without penalty) prior to expiry date. Lessee is responsible for the maintenance and upkeep of the asset. Lease period approximates asset’s economic life. The sum of the lease payments exceeds the asset’s purchase price. Includes specialist equipment, heavy industrial equipment.

9. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-9 Residual Value Clause Lease continues for its full term Lessee can purchase the asset for its residual value, return the asset to the lessor (paying any shortfall from residual value) or renew the lease. Lease is cancelled during its initial term Lessee must pay outstanding premiums (less interest component) plus residual value of asset.

10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-10 Types of Financial Leases Sale and leaseback agreements Companies sell an asset to another firm and immediately lease it back. Enables the company to receive cash and yet maintain use of the asset. Leveraged leases The lessor arranges for funds to be contributed by one or more parties—form of risk-sharing and transferring tax benefits. Often used to finance large-scale projects.

11. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-11 A. Statement of Financial Position with Purchase (company finances $100 000 truck with debt) Truck$100 000Debt$100 000 Other assets 100 000Equity 100 000 Total assets$200 000Debt plus equity$200 000 B. Statement of Financial Position with Operating Lease (co. finances truck with an operating lease) Truck$ 0Debt$ 0 Other assets 100 000Equity 100 000 Total assets$100 000Debt plus equity$100 000 C. Statement of Financial Position with Financial Lease (co. finances truck with a financial lease) Assets under financialObligations under lease$100 000financial lease $100 000 Other assets 100 000Equity 100 000 Total assets$200 000Debt plus equity$200 000 Leasing and the Statement of Financial Position

12. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-12 Criteria for a Financial Lease AAS17 ‘Accounting for Leases’ states that a financial lease occurs where substantially all risks and benefits pass to the lessee. A financial lease must be disclosed on the Statement of Financial Position if at least one of the following criteria is met: – the lease term is 75 per cent or more of the estimated economic life of the asset – the present value of the lease payments is at least 90 per cent of the fair market value of the asset at the start of the lease.

13. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-13 Leasing and Taxation Lease premiums paid under a lease contract are tax deductible. Any payment relating to the ultimate purchase of the asset is not deductible. The residual payment does not qualify as a tax deduction. Any profit made on the asset previously leased is subject to capital gains tax.

14. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-14 Example—Lease versus Buy Macca Co. has to decide whether to borrow the $15 000 needed to purchase a new gadget machine (with a borrowing cost of 10 per cent) or to lease the machine for $4000 per annum. If purchased, the asset could be depreciated using the straight-line method over the three-year life. The company tax rate is 30 per cent. Under the lease agreement, Macca Co. would be responsible for maintaining the machine.

15. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-15 Example—Lease versus Buy: Repayment Schedule

16. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-16 Example—Lease versus Buy: Tax Subsidises Borrowing

17. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-17 Example—Lease versus Buy: Tax Subsidises Leasing

18. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-18 Example—Lease versus Buy: Net Advantage of Leasing The advantage is greater than zero so Macca Co. should lease.

19. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-19 Residual Value The residual value is the amount for which the asset may be purchased by the lessee from the lessor at the end of the lease term. The salvage value is the amount the asset can be sold for in the market place by the lessee (once they have acquired the asset). In the previous example, assume a residual value of $2000 and a salvage value of $1500.

20. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-20 Example—Lease the Asset with Residual Value

21. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-21 Example—Borrow to Purchase the Asset with Residual Value

22. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-22 Net Advantage of Leasing

23. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-23 Setting Lease Premiums Lease premiums are paid in advance in Australia.

24. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-24 Example—Lease Premiums KAZ Co. has started a four-year lease of a photocopier which has a $70 000 purchase price. Had the company purchased the copier, the interest rate quoted on borrowings was 1.5 per cent per month. KAZ has agreed with the lessor to a residual value of $10 000 at the end of four years. What will be the amount of the lease premiums?

25. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-25 Solution—Lease Premiums

26. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-26 Advantages of Financial Leases No restrictions on future borrowing. Can be tailored to suit firm’s needs. Eliminates the need to raise extra capital. No unnecessary financial outlay. May be excluded from the Statement of Financial Position. Facilitates financing capital additions on a piecemeal basis. Is an allowable cost under government contracting. Offers tax advantages.

27. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-27 Advantages of Operating Leases Frees up capital for alternative uses. Increases the company’s working capital. Provides greater control due to greater certainty in future outlays. Assures more competent upkeep of asset. Avoids the risk of obsolescence. Avoids the equipment disposal problem. Future outlays cost less in real terms due to inflation.

28. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-28 Disadvantages of Leasing Interest cost often higher. May not offer the right to the residual value of the asset. Allows the acquisition of assets without submitting formal capital expenditure procedures. May cause distortions in the evaluation of interfirm and interdivision performance. Lacks the prestige associated with ownership.

29. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-29 Good Reasons for Leasing Taxes may be reduced by leasing. The lease contract may reduce certain types of uncertainty that might otherwise decrease the value of the firm. Leasing reduces the impact of obsolescence of an asset on a firm. Transaction costs may be lower for a lease contract than for buying the asset. Leasing may require fewer (if any) restrictive covenants than secured borrowing.

30. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 24-30 Bad Reasons for Leasing The perception of 100 per cent financing. The apparent low cost. Using leasing to artificially enhance accounting income.