Peirson Business Finance

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides prepared by Farida Akhtar and Barry Oliver, Australian National University

Chapter 15

Leasing and Other Equipment Finance

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Learning Objectives• Explain the main features of finance leases

and operating leases.

• Understand the reasons for leveraged leases and cross-border leases.

• Outline the accounting and tax treatment of leases in Australia.

• Calculate rentals for a finance lease.

• Evaluate a finance lease from the lessee’s point of view.

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Learning Objectives (cont.)

• Evaluate an operating lease from the lessee’s viewpoint.

• Critically evaluate the suggested advantages of leasing.

• Explain the factors that can influence leasing policy.

• Outline the main features of chattel mortgages and hire-purchase agreements.

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Introduction• Leasing is distinguished from most other forms of

finance by the fact that the financier (the lessor) is the legal owner of the leased asset.

• The asset user (the lessee) obtains the right to use the asset in return for periodic payments (lease rentals) to the lessor.

• Equipment finance: a general term that encompasses leasing hire-purchase and chattel mortgages.

• Recent figures from the Australian Equipment Lessors Association (2004) estimate that around 20% of all new capital equipment acquired by Australian businesses is leased.

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Finance Leases• A long-term agreement that generally covers

most of the economic life of the asset.

• Non-cancellable, or cancellable only if the lessee pays a substantial penalty to the lessor.

• The obligation is essentially the same as a borrower’s obligation to repay a loan.

• From the lessor's point of view it is, in effect, a secured loan.

• The risks and benefits of ownership of the asset are effectively transferred from the lessor to the lessee.

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Operating Leases• Essentially a rental agreement.

• More attractive to lessors if there is an active second-hand market for the leased asset.

• In Australia, operating leases have been limited mainly to motor vehicles and multi-purpose industrial equipment such as forklifts.

• Normally only for a short period, which is considerably less than the useful life of the leased asset. The assets are likely to be leased to a series of users.

• Risks of ownership borne by the lessor.

• Maintenance lease: operating lease where the lessor is responsible for all maintenance and service of the leased asset.

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Sale and Lease-Back Agreements• The owner of an asset sells the asset to a financial

institution for an amount usually equal to its current market value and immediately leases it back from the institution.

• An alternative to raising cash by borrowing, using the asset as security.

• Lessor is typically an insurance company, super fund, bank, or specialist lease company.

• Typical assets include commercial real estate, railway rolling stock, and vehicle fleets.

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Leveraged Leasing

• Form of finance lease.

• A lease in which most of the funds needed to purchase the leased asset are borrowed by the lessor.

• Involves at least three parties instead of the normal two. The additional party is a lender, normally referred to as a ‘debt participant’.

• Typically involves a non-recourse loan, whereby the lessor is not responsible for its repayment.

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Cross-Border Leasing• A lease in which the lessee and lessor are located

in different countries.

• Usually leveraged, and motivated by differences between the tax regulations of different countries.

• Generally structured so that the lessor and lessee can both claim depreciation deductions on the same asset.

• Complex tax issues in Australia:

– Difficult for Australian lessor to participate in a CBL involving an offshore asset.

– Australian lessee can be involved in CBL provided there is a purchase option.

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Accounting for Leases• In Australia, AASB 117 ‘Leases’ provides that the

accounting treatment of a lease depends on whether it is classified as an operating or a finance lease.

• Operating leases are treated in the traditional way (lease rentals expensed and no recognition of any assets or liabilities).

• AASB 117 provides that a lease would normally be classified as a finance lease if:

– Substantially all of the risks and rewards associated with ownership of the leased asset are effectively transferred to the lessee.

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Accounting for Leases (cont.)• Where lease is a finance lease, lease asset and

liability equal to fair value of leased property or PV of lease payments must be recognised on balance sheet.

• The previous criteria are, however, only guidelines.

• The classification of a lease should depend on the economic substance of the transaction.

• However, lessors have made efforts to structure finance leases such that they are recognised as operating leases to avoid the need to recognise finance leases as assets or liabilities.

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Taxation Treatment of Leases• If a leased asset is used to generate taxable

income, the lease rentals paid by the lessee are an allowable tax deduction, provided that the lease is classified as a ‘genuine lease’ rather than an ‘instalment purchase arrangement’.

• While lease rentals are deductible, the lessee cannot deduct, for tax purposes, depreciation on the leased asset.

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Setting Lease Rentals

• Four steps:

– Calculate the present value of the cash flows from ownership of the asset.

– Calculate the required present value of the lease payments.

– Calculate the minimum after-tax lease payment.

– Calculate the minimum before-tax payment, given the tax rate tc.

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Evaluation of Finance Leases

• Should we compare:– Leasing with borrowing, or leasing with buying?

• Myers, Dill and Bautista (1976) (MDB) suggested analysing a finance lease in the context of its effect on the lessee’s capital structure.

• MDB emphasised that entering into a finance lease uses some of the lessee’s debt capacity.– Therefore, it follows that a finance lease should be

analysed by comparing it with debt.

• MDB method:– Leasing will be economically advantageous to a lessee if

the finance provided by leasing is greater than the liability incurred by leasing.

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Leasing Decisions and Investment Decisions

• In practice, the investment decision would normally be considered first and, if the project were profitable, the alternative of leasing the required assets would be evaluated.

• However, a project revealing a negative NPV should not necessarily be discarded, as the NPV of a lease can be large enough to ‘rescue’ an otherwise marginally unprofitable project.

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The Value of Leasing in Competitive Capital Markets• Suppose that all financiers and asset users

operate in a perfect capital market where the following conditions apply:

– Leasing involves no transactions costs.

– Information is costless and freely available.

– All parties are subject to the same tax laws and tax rates.

• Under these conditions, the cost of leasing an asset should be the same as the cost of buying it. The lease or buy decision should be a matter of indifference.

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The Value of Leasing in Competitive Capital Markets (cont.)• The popularity of leasing has varied over time.

It is particularly popular for some types of assets.

• This suggests that there are cases where asset users have a systematic preference for leasing or buying.

• For this to be so, there must be tax differences or imperfections that can make leasing advantageous in some cases.

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Establishing an Advantage for Leasing• To make leasing attractive to the user of an asset

without simultaneously making leasing unattractive to the lessor requires some departure from the perfect-market conditions.

• The symmetry between the positions of the two parties needs to be broken:

– Quantity discounts available to specialty lessors.

– Differences in tax positions of the parties.

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Taxes and the Size of Leasing Gains• The NPV of a lease to the lessee (NPVLES ) can be

expressed as:

• Similarly, the NPV to the lessor (NPVLOR ) will be:

DepPVLPVCNPVLES

** DepPVLPVCNPVLOR

where:

cost of the leased asset

( ) present value of the lease rentals

( ) present value of depreciation tax savings

C

PV L

PV Dep

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Taxes and the Size of Leasing Gains (cont.)• A lease can affect the present value of the

government’s tax receipts in two ways:

– The government gains, in that it can tax the lease rentals received by the lessor.

– The government loses, in that the lessor is able to claim deductions for depreciation on the leased asset.

• The net result is that the government can lose through deferral of tax receipts — this net loss by the government is why the lease is advantageous to the parties to the lease.

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Taxes and the Size of Leasing Gains (cont.)• Other things being equal, the government’s net

loss will be larger in present value terms if:

– Lessor’s tax rate is much greater than the lessee’s.

– Depreciation tax savings are received early.

– The term of the lease is long and the lease rentals are paid late.

– Interest rate is high.

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Leasing and the Imputation Tax System• Under the imputation tax system, any advantage

associated with deferring a company’s tax payments is likely to be small.

– This is because company tax is, from the point of view of resident shareholders, only a withholding tax (effective rate of company income tax is low).

– Hence, any tax advantage from leasing must also be small.

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Evaluation of Operating Leases• Short-term lease that allows lessee to obtain the

services provided by an asset, without directly bearing the risks of asset ownership.

• Operating leases are more complex than finance leases.

• Equivalent annual cost model can be used to evaluate operating leases where projects have different economic lives.

• The principle involved explains that — an operating lease is attractive to the lessee if the annual rental is less than the equivalent annual cost of buying and operating the asset.

• Care must be taken in applying this principle to ensure that the lease and buy alternatives are treated consistently.

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Evaluation of Operating Leases (Cont.)• Operating lease is more costly than buying an

asset that is needed for extended period.

• However, operating leases can be less costly than buying an asset in the following circumstances:

– Operating lease can be cheaper if lessors can take advantage of cost savings that are not available to the lessee.

– Operating leases provide options that are valuable to the lessee and, in some cases, the option to cancel a lease can be the most effective way of obtaining a benefit, such as the risk that an asset is no longer needed due to decline in demand.

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Possible Advantages of Leasing• Company taxation:

– Advantages may arise from the deferral of taxes.

– Firms with lower marginal tax rates use leasing more than firms with high marginal tax rates, found by Graham, Lemmon and Schallheim (1998) for US.

– Cross-border leases take advantage of the differences between the tax environments in different countries.

– Possible advantages where lessors are able to choose between different accounting methods to calculate their taxable income.

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Possible Advantages of Leasing (cont.)

• Conservation of capital:

– By leasing, a company can conserve its capital for investment elsewhere.

– However, there are problems with this argument.

• ‘Off-balance sheet’ finance:

– Because in the past lessees have not been required to report their lease obligation on the balance sheet, they can use leasing to increase their access to debt.

– However, AASB 117 now requires the capitalisation of finance lease obligations, which means that any potential ‘off-balance sheet’ advantage for leasing should no longer be available.

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Possible Advantages of Leasing (cont.)• Cost of capital:

– If the lessor’s cost of capital is lower (higher) than that of the potential lessee, the existence of competitive capital markets will result in leasing (buying) being preferred to buying (leasing).

– The circumstances when the cost of capital of the lessor and lessee will differ depending on the risks associated with using the asset.

– Miller and Upton (1976) — cost of capital for leasing and buying should be the same, otherwise one would dominate the other in marketplace.

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Possible Advantages of Leasing (cont.)

• Transaction cost:

– If a lessee defaults, the lessor, as owner of the asset, can immediately repossess it.

– However, a secured lender is likely to face considerable delay and greater costs because it may be necessary for the defaulting borrower to be liquidated.

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Possible Advantages of Leasing (cont.)• Agency costs:

– Leasing and debt are not perfect substitutes as they can differ in terms of incentive effects and control of agency costs.

– Remuneration packages can create incentive to lease rather than purchase — impact on ROI, to which pay packages may be linked — Smith and Wakeman (1985).

– If manager has large equity stake in company, he/she may prefer to lease assets to reduce personal exposure to specific asset risk — Mehran, Taggart and Yermack (1999).

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Leasing Policy

• Why does a business lease some assets while purchasing other similar assets?

• Sensitivity to use and maintenance decisions:

– A lessee does not have a right to the salvage value of an asset at the end of the lease.

– Therefore, there is less incentive to care for and maintain assets that are leased rather than owned.

– Therefore, lessors set lease rentals on the basis of expected levels of abuse.

– Consequently, assets that are sensitive to use and maintenance decisions will tend to be purchased.

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Leasing Policy (cont.)• Specialised assets:

– There is an incentive to buy, rather than lease, specialised (or company-specific) assets.

– The residual value of such assets tends to be disputed between lessor and lessee, i.e. lessor places lower residual value on asset than lessee.

– This leads to unacceptably high lease payments, making outright purchase relatively more attractive to potential lessee.

• Flexibility and transaction costs:– An operating lease is likely to involve lower costs than

purchasing an asset and then selling it.

– Leasing may also involve lower search costs and costs of assessing quality.

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Leasing Policy (cont.)• Comparative advantage in asset disposal:

– Three potential sources of comparative advantage in asset disposal by a lessor:

Lower search, information and transaction costs associated with the lessor providing a specialised market for used assets.

Reduced repair and maintenance costs for current machines from reusing components of previously leased machines.

Reduced production costs resulting from reusing components of previously leased machines in the production of new machines.

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Chattel Mortgages and Hire Purchase• Chattel mortgages and hire purchase

agreements are similar to finance leases.

• Chattel mortgage (CM)

– User purchases goods and financier registers charge over goods as security.

– Loan secured over movable property rather than real estate.

• Hire purchase (HP)

– Financier purchases asset and hires it to user for agreed period.

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Chattel Mortgages and Hire Purchase (cont.)• In the case of a CM or HP agreement, user will be

required to make a series of payments or instalments to the financier for an agreed period.

• An HP agreement will either commit the user to buy the asset or give the user an option to buy it.

• In the case of HP, the user, rather than the financier, will be entitled to claim deductions for depreciation.

• During 2005–06, CM and HP agreements made up 65% of the Australian equipment finance market.

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Chattel Mortgages and Hire Purchase (cont.)• Equipment finance and the GST:

– CM and HP agreements and leasing are treated differently under GST.

– CM are treated as a loan (financial supply):

GST applies only to cost of asset; no GST on loan or loan repayments.

– Lease rentals are subject to GST.

– HP agreements can be split into financial supply and asset purchase components:

No GST on financial supply component; GST applies only to cost of asset.

– If GST input credits can be claimed, the GST differences between CM and HP agreements and leasing are not relevant.

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Summary• Reasons for leasing differ between types of lease.

• Operating lease — separates risk of ownership from use of leased asset.

• Finance lease — risk of ownership on lessee and lease is an alternative method of finance, reducing transaction costs of obtaining finance.

• Leasing can be driven by tax benefits — changes in tax rules, government charges and GST treatment can have important effects on leasing arrangements and their popularity.

• Leasing is more common for general or marketable assets.

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