Types of leases

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CHAPTER 21 Lease Financing

• Types of leases
• Tax treatment of leases
• Effects on financial statements
• Lessees analysis
• Lessors analysis
• Other issues in lease analysis

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Who are the two parties to a lease transaction?

• The lessee, who uses the asset and makes the
  lease, or rental, payments.
• The lessor, who owns the asset and receives the
  rental payments.
• Note that the lease decision is a financing
  decision for the lessee and an investment
  decision for the lessor.

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Lease Terms

• Operating Leases (aka Service Leases)
• Include operating and service costs as part of
  lease
• Cancellable by lessee
• Not fully amortized (value of lease payments less
  than value of equipment)
• Lease is for less than the life of the equipment
• Examples
• Autos, copiers, computers

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Lease Terms

• Capital or Financial Leases
• Source of financing
• Lessee generally agrees to purchase equipment and
  then arranges lease agreement with bank or
  leasing company (direct lease)
• Not cancellable, fully amortized, generally no
  service provided
• Sale and lease-back arrangement
• Equipment is purchased from lessee
• Leveraged lease
• Lessor borrows portion of money required to buy
  asset. Doesnt affect lessee.

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Why Lease?

• Sensible Reasons for Leasing
• Short-term leases are convenient
• Cancellation options are valuable
• Maintenance is provided
• In certain circumstances
• Standardization leads to low costs
• Leasing is a cheap way of financing

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Why Lease?

• Sensible Reasons for Leasing
• Tax shields can be used
• Lessor may be able to take advantage of tax
  shields and pass value back to lessee

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Why Lease?

• Dubious Reasons for Leasing
• Leasing avoids capital expenditure controls
• Leasing should be viewed as a capital expenditure
• Leasing preserves capital
• Leasing does not require a cash outlay
• Borrowing does not require a cash outlay either

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Accounting for Leases

• Capital leases (financial leases)
• Must be represented on balance sheet and, hence,
  offset by a liability
• Lease agreement transfers ownership to lessee
  before lease expires
• Lessee can purchase asset for a bargain price
  before lease expires
• Least lasts for at least 75 of assets economic
  life
• Present value of lease payments is at least 90
  of the assets value

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Accounting for Leases

• Operating Leases
• Do not meet any of the four criteria for capital
  leases
• Only represented as an expense
• Any advantage to a lease being off-balance
  sheet?

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Leasing Theory

• Standard Assumption
• Leasing and debt are perfect substitutes
• An increase in leasing will be associated with a
  corresponding drop in the amount of debt
• Use after tax cost of debt to discount value of
  leases

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Leasing Theory

• MM view
• Who cares?
• Lease, lend, equity it doesnt matter to firm
  value
• Is there an optimal level of debt?
• Standard assumption assumes that there is some
  optimal level of debt and that leasing
  substitutes for debt

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Leasing Theory

• What has been found in the finance literature?
• Leasing and debt are shown to be complementary
• More leasing more debt
• Why?

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Lease Valuation

• Valuation from the lessors perspective
• How much should we charge to break even?
• Cash outflows
• Initial cost of equipment
• Maintenance costs (where applicable)
• Cash inflows
• Depreciation tax shield
• After-tax lease payments

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Lease Valuation

• Valuation from the lessors perspective
• Discount rate
• Cash-flows are discounted at the WACC of the
  lessor
• Given that lessors are generally banks or other
  financial institutions, they generally rely
  heavily on debt
• Find value of lease payment that makes NPV zero
• Similar to finding equivalent annual cost

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Lease Valuation

• Valuation from lessees perspective
• Should we lease?
• Trade off the costs of leasing with the cost of
  buying
• Assume initially we dont have cash outflow for
  asset
• Lose depreciation tax shield, have to make lease
  payment, may or may not pay maintenance, dont
  get salvage value
• Discount at the after-tax cost of debt
• Substitution between lease and debt financing

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Financial Leases
Example Greymare Bus Lines is considering a
lease. Your operating manager wants to buy a new
bus for 100,000. The bus has an 8 year life.
The bus salesperson says she will lease Greymare
the bus for 8 years at 16,900 per year, but
Greymare assumes all operating and maintenance
costs. The companys tax rate is 35 and its
cost of debt is 10. The bus will be depreciated
using a five year MACRS schedule. Should
Greymare buy or lease the bus?
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Financial Leases
Greymare Bus Lines Balance Sheet without
lease Equivalent lease balance sheet
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Financial Leases
Example - cont Greymare Bus Lines can borrow at
10, thus the value of the lease should be
discounted at 6.5 or .10 x (1-.35). The NPV
result will tell us if Greymore should lease or
buy the bus.
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Financial Leases
Cash flow consequences of the lease contract to
Greymare
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Financial Leases
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Financial Leases
Example - cont Greymare Bus Lines lease cash
flows can also be thought of as loan equivalent
cash flows.
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Financial Leases
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Loan Equivalent

• If you can devise a borrowing plan that gives the
  same cash flow as the lease in every future
  period but a higher immediate cash flow
• Borrow

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Evaluating a Lease Cash Flows

• Howe Construction needs the use of some equipment
  for 5 years. The equipment costs 5 million, has
  a life of 5 years, and no salvage value. Howe
  uses straight line depreciation, and has a 40
  tax rate. Instead of purchasing the equipment,
  Howe is considering leasing it. The Goode Co.
  will lease the equipment to Howe for 1.4 million
  per year. Compute the incremental cash flows from
  leasing the equipment.

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Cash Flows from Leasing
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NPV of Lease

• Assume that the pre-tax cost of secured debt for
  the Howe Co. is 10.
• The after-tax cost is 10(1-0.40) 6.

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Lease or Purchase?

• Cash flows were computed as leasing over
  purchasing.
• The NPV of these cash flows is -223,331.
• This is the Net Advantage to Leasing, or NAL.
• Purchase the asset!

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The Equivalent Loan

• How much can the firm borrow (by issuing
  conventional, amortized secured debt) such that
  the future cash flows of the loan equal those of
  the leasing alternative?
• The firm can borrow 5,223,331.
• Future cash flows are the same under both the
  leasing and the borrowing alternative.
• But, the firm can borrow 223,331 more. Hence do
  not lease.

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Equivalent Loan Cash Flows
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Lessors Point of View
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NPV of Leasing from the Lessors Viewpoint

• Assume the lessor has a WACC of 6.

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Two Sides of the Same Coin!

• Lessors NPV 223,331
• Lessees NPV -223,331
• With symmetric taxes and financing costs, leasing
  is a zero sum game!
• What is the most that the lessee can pay to make
  it indifferent between leasing and borrowing?
• Pre-tax lease payments 1,311,637
• At this level of payments, lessors NPV is also
  zero.

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Where do Gains from Leasing Come From?

• Suppose Lessors tax rate is 40 (same as
  before).
• Minimum lease payments required 1,311,637
• Suppose lessees tax rate is 20 (lt lessors tax
  rate).
• Maximum lease payments 1,315,353.
• Negotiate a lease payment between these two
  values.
• If lease payment 1,313,500 then lessors NPV
  4,709 and lessees NPV 5,918.