Chapter 19 Lease Financing

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Chapter 19Lease Financing
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Lease

• A lease is a contract that allows an individual
  or a firm to make economic use of an asset for a
  stated period of time without obtaining ownership
  interest in it.

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Lease Contract

• Lessee
• Obtains use of an asset
• Specific period of time
• Ownership to lessor
• Agrees to make a series of payments to lessor
• Leases
• Alternative to term financing
• Arrangements to transfer tax benefits

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Providers of Lease Financing

• Equipment Manufacturers
• Finance Companies such as GE Credit
• Banks
• Independent Leasing Companies

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Classes of Leases

• Operating lease Service lease Maintenance
  lease
• Maintenance and insurance included
• Financial lease
• Noncancellable
• Lessee responsible for
• Maintenance
• Insurance
• Property taxes
• Direct lease
• Sale and leaseback
• Leveraged lease

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Operating Lease

• An Operating Lease is an agreement for period to
  period use of an asset.
• Maintenance and insurance are usually included in
  the lease
• The lease is cancelable.

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Financial or Capital Lease

• A financial or capital lease is noncancelable.
• Lessee is responsible for maintenance, insurance
  and property taxes.
• Can renew at expiration
• Types of Financial Leases
• Direct Lease -- the lessee acquires the use of an
  asset it has not owned.
• Sale and Leaseback -- The lessor purchases the
  asset from the lessee and then leases it back to
  the lessee.
• Leveraged Lease Three-party financial lease

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Leveraged Lease

• A leveraged lease is a three-party financial
  lease consisting of the lessee who acquires the
  use of the asset, the lessor who holds an equity
  interest in the asset (at least 20), and a
  lender (or lenders) who finance the purchase of
  the asset by the lessor.
• 85 of the value of all financial leases
• Cash flows to the lessor might be nonnormal. -
  - (negative, positive, negative, positive)

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Leveraged Lease - continued

• Advantages to Lessor
• Tax benefits from MACRS depreciation
• Tax benefits from interest paid to lender
• Lease income
• Put up only 20 to 50 of the asset
• Limited exposure
• Salvage value

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Leveraged Lease - continued

• Advantages to Lessee
• Low effective interest rate
• Cant use tax benefits and pass them on
• Use of the asset
• Advantages to Lender(s)
• Good return
• First lien on the asset
• Assignment of the lease rental payments

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Advantages to Leasing

• Lower payments because tax benefits accrue to
  lessor
• Lease agreements tend to be more flexible
• Lessor is able to obtain a higher salvage value
• Piecemeal Financing
• Convenient
• Avoid some risk of obsolescence
• Smoother earnings and EPS
• Lessor can maintain equipment more efficiently

Key
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Advantages to Leasing - continued

• Liquidity in the case of Sale and Leaseback
• For small or marginally profitable firms, leases
  may be the only source of financing available.
• Leasing may provide divisional/plant managers
  some flexibility in acquiring assets

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Disadvantages to Leasing

• More expensive for profitable firms
• Salvage value goes to lessor
• Difficult to get approval for modifications on
  leased real estate
• May not be canceled without penalty

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Tax and Accounting Considerations

• Recognized by IRS as a lease
• Remaining useful life must be greater than 1 year
  or 20 of cost of property
• May not exceed 30 years
• Reasonable ROI
• Renewal options
• Purchase options but at arms length
• Lessor must provide 20 equity in leveraged
  leases
• Property valuable only to the lessee cant be
  leased
• Lease contract disallowed for tax purposes if
  lease is set up purely to speed up tax deductions.

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Financial Accounting Standards Board ( FASB
13)Requires that financial leases be capitalized

• Liability to the PV of the lease payments
• Discounted at the firms borrowing rate
• Secured loan
• Similar maturity
• Report asset value
• Footnotes - Full Disclosure
• Financial leases
• Operating leases

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Financial Accounting Standards Board ( FASB
13) - continued

• Present Value of lease payments must be at least
  90 of fair market value
• Lease term is 75 of the estimated economic life
  of the asset

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Small Firms

• Reasons for leasing
• Fewer restrictive covenants
• Less cash required "up front"
• Better protection against obsolescence
• Quicker approvals
• Expensive reasons
• High effective interest cost if a profitable firm
• Loss of tax benefits
• Loss of salvage value

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Lease Payments

• Lessors required payment Three-step process
• Step 1 Compute the lessors amount to be
  amortized
• Initial outlay
• Less PV of after-tax salvage
• Less PV of depreciation tax
  shelter
• Equals Amount to be amortized
• Step 2 Compute after-tax lease income required
• Amount to be amortized PV of after-tax
  lease payment - Use your BGN button on your
  calculator if lease payments are at the beginning
  of the year.
• Step 3 Compute before-tax lease payment

After-tax lease income required
Lease Payment

1 - lessors marginal tax rate
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Lease Vs Borrowing to Buy

• You have already made the decision in that the
  investment project has a positive NPV.
• Compute the NAL
• If NAL is positive cheaper to lease
• If NAL is negative cheaper to borrow and own

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Net Advantage to Leasing (NAL)

• Calculations
• Installed cost of asset
• Less PV of after-tax lease payments
• Use your BGN button, if applicable and discount
  at the after-tax cost of Debt
• Less PV of depr tax shield (use MACRS)
• Plus Present value of after-tax operating costs
  incurred if owned but not if leased
• Less PV of Salvage value (Discount at the
  lessees weighted cost of capital)
• Equals Net Advantage to Leasing (to lessee)

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Net Advantage to Leasing

• The present value of the after-tax lease payment
  is calculated by using the after-tax marginal
  cost of borrowing.
• The annual depreciation tax shield is the
  depreciation times the lessees marginal tax
  rate. Use MACRS depreciation. Use the after-tax
  marginal cost of borrowing to calculate the
  present value of the depreciation tax shield.

More
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• The installed cost is the purchase price plus
  installation and shipping charges.
• If leased, some operating costs (such as property
  tax payments, insurance, etc.) may be paid by the
  lessor. Discount the savings at the after-tax
  marginal cost of borrowing.
• The salvage value belongs to the lessor and
  should be discounted at the after-tax cost of
  capital to reflect its uncertainty.

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Lease Analysis from the Lessors Perspective

• Use the Net Advantage to Leasing (NAL) approach
  except that all the positive items are now
  negative (such as the Installed Cost of the
  Asset. All the negative items (such as After-Tax
  Lease Payments) are now negative.
• Leasing can be beneficial to both the lessor and
  the lessee depending on different tax rates and
  perhaps different salvage values.

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Lease Financing - Conclusion

• Types of Leases
• Operating Lease
• Financial Lease
• Direct Lease
• Sale and Leaseback
• Leveraged Lease
• Tax Considerations
• FASB 13
• Lease Payments
• Net Advantage to Leasing