1. Leasing Chapter 27 McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Outline Leases and Lease Types Accounting and Leasing
Taxes, the IRS, and Leases
The Cash Flows from Leasing
Lease or Buy Decision
A Leasing Paradox
Reason for Leasing

3. Chapter Outline Leases and Lease Types Accounting and Leasing
Taxes, the IRS, and Leases
The Cash Flows from Leasing
Lease or Buy Decision
A Leasing Paradox
Reason for Leasing

4. 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

5. Types of Leases Shorter-term lease
Operating lease
Shorter-term lease
Lessor is responsible for insurance, taxes, and maintenance
Often cancelable

6. Types of Leases Longer-term lease
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

7. Chapter Outline Leases and Lease Types Accounting and Leasing
Taxes, the IRS, and Leases
The Cash Flows from Leasing
Lease or Buy Decision
A Leasing Paradox
Reason for Leasing

8. 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”

9. Lease Accounting
Operating leases are still “off-balance-sheet” and do not have any impact on the balance sheet itself

10. 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

11. Chapter Outline Leases and Lease Types Accounting and Leasing
Taxes, the IRS, and Leases
The Cash Flows from Leasing
Lease or Buy Decision
A Leasing Paradox
Reason for Leasing

12. Taxes Must be used for business purposes and not to avoid 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

13. Taxes (continued)
Lessee can deduct lease payments for income tax purposes
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

14. Chapter Outline Leases and Lease Types Accounting and Leasing
Taxes, the IRS, and Leases
The Cash Flows from Leasing
Lease or Buy Decision
A Leasing Paradox
Reason for Leasing

15. 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

16. Incremental Cash Flows
Cash Flows from the Lessee’s point of view:
Initial cost of machine (inflow)
Inflow because we save the cost of purchasing the asset now
May have incremental maintenance, taxes, or insurance

17. 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%.

18. Example: Lease Cash Flows
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)

19. Chapter Outline Leases and Lease Types Accounting and Leasing
Taxes, the IRS, and Leases
The Cash Flows from Leasing
Lease or Buy Decision
A Leasing Paradox
Reason for Leasing

20. 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
The appropriate discount rate is the
after-tax cost of debt since a lease is essentially the same risk as a company’s debt

21. 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

22. Net Advantage to Leasing
Consider the previous example. Assume the firm’s cost of debt is 10%.
After-tax cost of debt
= 10(1 - .4) = 6%
Net Advantage to Leasing (NAL)
= $3,116
Should the firm buy or lease?

23. Work the Web 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.

24. Chapter Outline Leases and Lease Types Accounting and Leasing
Taxes, the IRS, and Leases
The Cash Flows from Leasing
Lease or Buy Decision
A Leasing Paradox
Reason for Leasing

25. Leasing Paradox
If leasing is good for one party of the proposed deal, isn’t it going to then be a bad deal for the other party?

26. Leasing Paradox
Are there other factors (other than NAL) that might influence the attractiveness of a lease from both party’s perspectives?

27. Chapter Outline Leases and Lease Types Accounting and Leasing
Taxes, the IRS, and Leases
The Cash Flows from Leasing
Lease or Buy Decision
A Leasing Paradox
Reason for Leasing

28. 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

29. 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

30. Dubious Reasons for Leasing
2. 100% financing – except that leases normally do require either a down- payment or security deposit 3. Low cost – some may try to compare the “implied” rate of interest to other market rates, but this is not directly comparable

31. 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?

32. 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?

33. 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%

34. Terminology Lease Lessee Lessor Direct Lease Captive finance company
Operating Lease
Financial Lease
Capital Lease
Incremental Cash Flows

35. Formulas If NAL > 0, the firm should lease
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

36. Key Concepts and Skills
Define the basic lease
terminology.
Describe and compare the
criteria of a capital lease versus an operating lease.
Compute the incremental
cash flows to leasing

37. Key Concepts and Skills
Compute the net
Advantage to leasing
(NAL) using a NPV computation.
Differentiate the good and
Dubious reasons for leasing.

38. What are the most important topics of this chapter?
A lease versus buy decision is a specialized case of capital budgeting, focusing on the incremental cash flows.
The capital budgeting comparison analysis is called the Net Advantage to Leasing (NAL).

39. What are the most important topics of this chapter?
3. There are accounting issues, tax considerations, and legal requirements for leases.
There are both good and questionable reasons for leasing versus buying an asset.

40. Questions?