EXP 482Corporate Financial Policy

Clifford W. Smith, Jr. Winter 2007 Handout 6 * Covers readings on course outline through Smith/Wakeman (1984)

Just about any asset that can be purchased can also be leased.

Two parties to the contract

– the lessee is the user of the asset– the lessor is the owner of the asset

The largest group of lessors are the original equipment manufacturers (e.g. IBM, Xerox) but there are also many third party-leasing companies.

Leasing

Operating Lease (maintenance or service lease)

– short-term (less than 5 years)– not fully amortized– lessor supplies maintenance or service– often cancelable

Financial Lease (capital lease)

– long-term and fully amortized– lessee supplies service and maintenance– usually not cancelable

Types of Leases

Leasing

Modigliani/Miller theorem implies that with

no taxes,

no contracting costs,

and a fixed investment policy,

leasing policy does not affect firm value.

Leases contain options

– option to cancel or extend

– option to purchase

We can price these options with Black/Scholes model, but B/S requires M/M assumptions.

This approach cannot tell you why a lease is cancelable because all important effects of leasing are assumed away.

Traditional Approaches to Leasing

Leasing affects tax liability.

– Differential tax rates

– ITCs: Pan AM

– Double-dip leasing

Taxes are very important to understand leasing behavior, but the analysis here is frequently a mechanical application of tax rules in the capital budgeting decision.

Traditional Approaches to Leasing

Term must be less than 30 years.

Lessee should not have option to buy for less than fair market value.

No early balloon payments.

Lessor must make fair market return absent tax benefits.

Lessor should not limit lessee's ability to pay dividends or issue debt.

Renewal option must reflect fair market value.

Avoiding Constructive Sale Rules

Asset characteristics

Lessee characteristics

Lessor characteristics

Typical contract provisions

Questions to be Answered About Leasing

What Type of Assets are Most Commonly Leased?

Asset Characteristics

Period of use in relation to useful life.

Sensitivity to use and maintenance decisions

– Owners internalize the costs of these decisions. Since a lessee does not have a claim on the residual value of the asset, he has incentives to abuse or under maintain the asset.

– Adverse selection in leasing decisions

Controlling Asset Abuse

Penalty clause (security deposit)

Option to buy

Third party monitoring of maintenance

Service lease

Metering

Asset Characteristics

Firm specific assets

– Production facilities vs. office space

– Transportation and construction equipment vs. autobody stamping dies

Leasing and Firm Specific Assets

Suppose GM wants to build an R&D facility. A group of doctors come to GM and say, "We have high tax rates, and you don't. Let us buy the building and lease it to you."

Time 0 10 years 20 years

Value to GM 20 10 0

OpportunityCost 18 9 0

Klein, Crawford and Alchian ("Vertical integration, appropriable rents, and the competitive contracting process") discuss cases where ownership rights are important (i.e. leasing would be expensive).

The Fisher autobody case.

How can you solve the GM problem?

– Don't lease

– Include option to renew or option to extend lease in the lease contract

Leasing and Firm Specific Assets

Lessee Characteristics

Tax incentives to lease

Capital structure issues

– Leases are senior claims and can create claim dilution. Limited in bond contracts. Amortizing lease payments helps bondholders monitor outstanding senior claims.

– Leases have characteristics similar to secured debt. Can reduce underinvestment problem.

– Long-term noncancelable leases commit the firm to use the asset over the life of the lease. Can reduce asset substitution problem.

Compensation-related issues

– Leasing can affect return on invested capital and payments to bonus pool

– If lease is fully amortized, this problem is reduced

– Specialization in risk bearing

Lessee Characteristics

Lessor Characteristics

Tax incentives to lease

Leasing and market power

Lessor Characteristics

Tax incentives to lease

Leasing and market power

– How do you maximize profits if you face a downward sloping demand curve for your product?

P

Q

Leasing and Market Power

First-degree price discrimination is not legal under US antitrust laws (Robinson/Patman Act)

Often the more inelastic demanders use asset more intensively than the elastic demanders.

– One solution: Tie-in sales - IBM sold early computers and required that all purchasers use only IBM punch cards.

– Tie-in sales are now also in violation of antitrust laws.

An alternative solution: Lease and charge metering fee.

– Metering fees have passed the antitrust test because there is an economic justification for them in addition to price discrimination (i.e. curbing the asset abuse problem).

For some time, Xerox and IBM only leased their products, they did not sell them. Why?

Does this mean that a producer would never want to both lease and sell its product?

Leasing and Market Power

Lessor Characteristics

Comparative advantage in disposing of asset

– At one time, Kodak handled all short-term cancelable leases (rentals) in house but Citibank handled most long-term noncancelable leases.

Bonding quality by manufacturer

– Lease with option to cancel

Contract Provisions

Deposits and penalty clauses

Option to buy asset or extend lease

Restrictions on subleasing

Service vs. net lease

Capital vs. operating lease

Metering

Bonding of maintenance by third parties

Investment Opportunity Set

Financial Architecture Leverage High Low Maturity Long Short Priority DiffuseConcentrated Conversional Rights Low High Leasing High Low

Compensation Level of Pay Low High Conditional Pay Low High

Assets inPlace

GrowthOpportuniti

es

Firm Characteristics Leasing Policy

Growth Options (Merck) LowerLeverage LowerCredence Goods (Eastern) LowerProduct Warranties (Yugo) LowerFuture Product Support (Yugo/Wang) LowerSupplier Financing (Campeau) LowerClosely Held Firm HigherSize –Regulation ?Firm Specific Assets LowerInvestment Tax Credits HigherMarginal Corporate Tax Rate ?Marginal Personal Tax Rate ?

Benchmarking Corporate Leasing Policy