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Leasing

Chapter 27

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

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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

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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

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Lease Terminology

Lease – contractual agreement for use of an asset in return for a series of payments

Lessee – user of an asset; makes paymentsLessor – owner of the asset; receives

paymentsDirect lease – lessor is the manufacturerCaptive finance company – subsidiaries that

lease products for the manufacturer

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Types of LeasesOperating lease

Shorter-term leaseLessor is responsible for insurance, taxes, and maintenance

Often cancelable

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Types of LeasesFinancial lease (capital lease)Longer-term leaseLessee is responsible for insurance, taxes, and maintenance

Generally not cancelable

Specific capital leasesTax-orientedLeveragedSale and leaseback

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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

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Lease Accounting

Leases are governed primarily by FASB 13

Financial leases are essentially treated as debt financingPresent 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”

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Lease Accounting

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

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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:

1. Lease transfers ownership by the end of the lease term

2. Lessee can purchase asset at below market price

3. Lease term is for 75 percent or more of the life of the asset

4. Present value of lease payments is at least 90 percent of the fair market value at the start of the lease

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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

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TaxesLessee can deduct lease payments for income tax purposesMust 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

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Taxes (continued)Lessee can deduct lease payments for income tax purposesLease 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

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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

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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

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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

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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%.

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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)

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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

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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

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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

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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)

= $3,116Should the firm buy or lease?

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Work the Web

Many people must choose between buying and leasing a carClick 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.

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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

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

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

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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

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Good Reasons for Leasing

Taxes may be reducedMay reduce some uncertainty

May have lower transaction costs

May require fewer restrictive covenants

May encumber fewer assets than secured borrowing

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Dubious Reasons for Leasing

1. Balance sheet, especially leverage ratios, may look better if the lease does not have to be accounted for on the balance sheet

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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

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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?

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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?

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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%

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Terminology

LeaseLesseeLessorDirect LeaseCaptive finance companyOperating LeaseFinancial LeaseCapital LeaseIncremental Cash Flows

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Formulas

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

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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

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Key Concepts and Skills

•Compute the net Advantage to leasing(NAL) using a NPV computation.

Differentiate the good and Dubious reasons for leasing.

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1. A lease versus buy decision is a specialized case of capital budgeting, focusing on the incremental cash flows.

2. The capital budgeting comparison analysis is called the Net Advantage to Leasing (NAL).

What are the most important topics of this chapter?

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3. There are accounting issues, tax considerations, and legal requirements for leases.

4. There are both good and questionable reasons for leasing versus buying an asset.

What are the most important topics of this chapter?

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Questions?