Fundamentals of Corporate Finance/3e,ch24

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

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Chapter Twenty-fourLeasing


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24.1 The Nature of Leases24.2 Types of Leases24.3 A Brief Look at Accounting for Leases24.4 Taxation and Leases24.5 An Evaluation of Leasing24.6 The Role of the Residual Value24.7 Setting Lease Premiums24.8 Alleged Advantages and Disadvantages of

Leasing24.9 Summary and Conclusions

Chapter Organisation


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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.


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Leasing versus Buying

Manufacturerof asset

Manufacturerof 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

LeaseBuy


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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.


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Types of Leases

• Operating lease

• Financial lease– Sale and leaseback agreement– Leveraged lease


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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.


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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.


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Residual Value Clause

• Lease continues for its full termLessee 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 termLessee must pay outstanding premiums (less interest component) plus residual value of asset.


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Types of Financial Leases

• Sale and leaseback agreementsCompanies 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 leasesThe 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.


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A. Statement of Financial Position with Purchase (company finances $100 000 truck with debt)

Truck $100 000 Debt $100 000Other assets 100 000 Equity 100 000Total assets $200 000 Debt plus equity $200 000

B. Statement of Financial Position with Operating Lease (co. finances truck with an operating lease)

Truck $ 0 Debt $ 0Other assets 100 000 Equity 100 000Total assets $100 000 Debt plus equity $100 000

C. Statement of Financial Position with Financial Lease (co. finances truck with a financial lease)

Assets under financial Obligations under lease $100 000 financial lease $100 000Other assets 100 000 Equity 100 000Total assets $200 000 Debt plus equity $200 000

Leasing and the Statement of Financial Position


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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.


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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.


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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.


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Example—Lease versus Buy: Repayment Schedule

6032$

100 /101 / 1 - 1 / 00015 Repayment 3

..


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Example—Lease versus Buy:Tax Subsidises Borrowing


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Example—Lease versus Buy:Tax Subsidises Leasing


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Example—Lease versus Buy:Net Advantage of Leasing

514 $3 5052$ 538 $1 -

052 $5 - 522 $4 - 984 $2 costy Opportunit - savingsNet tax NAL

052) ($5 000 $15 - 2.4869 000 $4

cost Borrowing - payments lease of PV cost y Opportunit

The advantage is greater than zero so Macca Co. should lease.


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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.


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Example—Lease the Asset with Residual Value


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Example—Borrow to Purchase the Asset with Residual Value


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Net Advantage of Leasing

576 $2

550 $3 - $974

costy Opportunit - savingsNet tax NAL

550) ($3

000 $15 -1.10 / 000 $2 2.4869 000 $4

cost Borrowing - valueresidual PV pay. lease PV cost Opp3


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Setting Lease Premiums

Lease premiums are paid in advance in Australia.

payments 1- tforfactor annuity PV 1 valueresidual PV - eAsset valu advancein premium Lease


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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?


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Solution—Lease Premiums

221884$

553233110665

0150015111101510001000070

payments1forfactor annuity PV1 valueresidual PVeAsset valupremium Lease

47

48

.

. /

. / . / - . -

-t -


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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.


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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.


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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.


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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.


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Bad Reasons for Leasing

• The perception of 100 per cent financing.

• The apparent low cost.

• Using leasing to artificially enhance accounting income.

Fundamentals of Corporate Finance/3e,ch24

Economy & Finance

Transcript of Fundamentals of Corporate Finance/3e,ch24