By

Prof. Ken Lagman Yumang

Leasing
LEASING by KenYu
Learning the nuts and bolts
Important Terminologies
1. Leasing enables a firm to obtain the use of
certain fixed assets for which it must make a series
of contractual, periodic, tax-deductible payments.
2. Lessee is the receiver of the services under the
lease contract.
3. Lessor is the owner of the asset.
4. Lease is a rental agreement where the lessor
receives a series of fixed payments from the lessee
in return for the use of the leased asset.

LEASING by KenYu
Learning the nuts and bolts
Types of Leases
1. Operating Lease
often 5 years, or less
maintenance is provided by the lessor
cancelable at the option of the lessee, but
may be required to pay penalty
life of the leased assets are usually
LONGER than the term of the lease.
payments required are not sufficient to
recover the cost of the assets leased.

LEASING by KenYu
Learning the nuts and bolts
Types of Leases
2. Capital or Financial Lease
longer term than operating lease
maintenance is NOT provided by the lessor
non-cancelable
life of the leased asset is SHORTER than
the leased term
payments are sufficient to recover the cost
of the leased asset.

LEASING by KenYu
Learning the nuts and bolts
Types of Leases
2. Capital or Financial Lease
CAPITAL LEASES are leases that meet any one of the
following requirements:
The lease agreement transfers ownership to the lessee
before the lease expires.
The lessee can purchase the asset for a bargain price
when the lease expires.
The lease lasts for at least 75% of the assets estimated
economic life.
The present value of the lease payments is at least 90%
of the assets value.
Leasing
Financial Statement Effects
Operating Lease
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Leasing
Reasons for Leasing
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Leasing
Reasons for Leasing
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Evaluating an Operating Lease
Lessor Decision: At what amount should I lease?
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AMOUNTS ASSOCIATED TO OWNING A FIXED ASSET:
Initial Cost or the purchase price of the property
Operating, maintenance, administrative, and other
costs related to leasing the property
Tax shield on costs or the tax advantage from incurring
operating, maintenance, administrative and other costs
(Costs x Tax Rate)
Depreciation tax shield or the tax advantage from
owning depreciable assets. (Depreciation Expense x
Tax Rate)
Evaluating an Operating Lease
Lessor Decision: At what amount should I lease?
LEASING by KenYu
Problem Illustration:
Manila is pushing for the a casino project similar to what
we see in Vegas and Macau. You see this as an
opportunity to do business. VIP transportation, based
on your marketing research, is feasible. You are
targeting to lease limousines to the casino.
Evaluating an Operating Lease
Lessor Decision: At what amount should I lease?
LEASING by KenYu
Problem Illustration:
Suppose you can buy a new limo for $75,000, and lease
it out for 7 years. Lease-related operating,
maintenance, and other costs are estemated to be
$12,000 per year. Your WACC is 7%. The limo is
depreciated 20%, 32%, 19.20%, 11.52%, 11.52%, and
5.76% on years 1, 2, 3, 4, 5, and 6, respectively. The
limo will have no salvage value at the end of its life. At
how much should you charge the casino under an
operating lease contract? (PV of Costs? Breakeven Rent?)
Evaluating an Operating Lease
Lessor Decision: At what amount should I lease?
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Compute for the PV of cash flows, using PV formulas
(Initial Cost, Operating Costs, Tax Shields on Costs and Depreciation)
Compute for the periodic Break-Even Rent after tax
Compute for the periodic Break-Even Rent before tax
Evaluating an Operating Lease
Our friends from TVM #MissKoSila
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Present Value of 1
Present Value of an Ordidary Annuity
Present Value of an Annuity Due
Evaluating an Operating Lease
Sanity Check:
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Tents for big events are now in demand.
Suppose you can import tents for $3,000 each
and you plan to lease each for 5 years. You
expect to incur operating and other costs of
$400 per year. Tents are depreciated using
the straight line method. Your cost of capital is
9%, and the tax rate is 35%. What would your
periodic operating lease before tax to
breakeven?
Evaluating a Financial Lease
Lessee Decision: Should I borrow and buy, or lease?
LEASING by KenYu
Things to consider:
If you buy, you will have to borrow to finance the
purchase. Therefore, the cost of capital is the COST OF
DEBT. But remember that the cost of debt comes with a
tax shield. Hence, the cost of capital is the AFTER TAX
COST OF DEBT.
To evaluate a financial lease, estimate the cash flows and
compute for the NPV of the lease.
DECISION: NPV is POSITIVE ! Lease
NPV is NEGATIVE ! Buy

Evaluating a Financial Lease
Lessee Decision: Should I borrow and buy, or lease?
LEASING by KenYu
Things to consider:
If you buy, you will have to borrow to finance the
purchase. Therefore, the cost of capital is the COST OF
DEBT. But remember that the cost of debt comes with a
tax shield. Hence, the cost of capital is the AFTER TAX
COST OF DEBT.
To evaluate a financial lease, estimate the cash flows and
compute for the NPV of the lease.
DECISION: NPV is POSITIVE ! Lease
NPV is NEGATIVE ! Buy

Evaluating a Financial Lease
Lessee Decision: Should I borrow and buy, or lease?
LEASING by KenYu
Problem Illustration:
Victory Liner requires new buses for its expansion. The
operating manager wants to buy new buses for $100,000
each, with an eight-year life to be depreciated 20%, 32%,
19.20%, 11.52%, 11.52%, 5.76%, and 0% on years 1, 2, 3, 4, 5,
6, and 7, respectively. The bus salesman offers an eight-year
financial lease contract at $16,900 per year. Victory Liners
borrowing rate is 10% per annum, and has a 35% corporate
tax rate. Should Victory Liner buy or lease the buses?

Evaluating a Financial Lease
Lessee Decision: Should I borrow and buy, or lease?
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Cash flow consequences of the financial lease contract:
LESSEE saves the cost of the buying the asset
Loss of depreciation benefit of owning the bus
Lease payment is due at the start of each year
Lease payments are tax deductible
LESSEE shoulders maintenance expenses. But
this can be ignored since in either case (lease or
buy), this will be shouldered by the lessee.

Evaluating a Financial Lease
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Compute for the NPV of cash flows, using the
AFTER-TAX cost of debt.
Refer to the decision criteria.
Lessee Decision: Should I borrow and buy, or lease?
Evaluating a Financial Lease
Sanity Check:
LEASING by KenYu
Philippine Airlines (PAL) is considering the addition of
a new Boeing 747 to its fleet. It costs $180 million to
purchase. PAL can lease the aircraft for 7 years with
annual lease payment of $25 million. The aircraft
will be depreciated using straight-line method, with
no salvage value. If PAL would buy the aircraft, the
purchase will be finance by a long-term loan with 8%
annual interest rate. PAL pays 30% corporate tax
rate. Should PAL lease or buy the Boeing 747?
LEASING
References:
Gitman
Brealey
Brigham
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