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LEASE FINANCING

Firms generally own fixed assets and report them on their balance sheets, but it is the use of fixed assets that is important rather than their ownership. A lease provides for the use of an asset without having to own it. It is possible to lease virtually any kind of asset, and about one-third of all new equipment acquired by businesses in the US is financed through leasing. Lease decision is a financing decision, and not a capital budgeting decision. Thus, lease analysis is only conducted after the decision to acquire the asset has been made .

A

lease is a contractual agreement between two parties a lessee (user of the asset) and a

lessor (owner of the asset). The agreement establishes that the lessee has the right to use an

asset and in return must make periodic lease payments to the lessor, the owner of the asset. The lessor also receives the tax benefit of ownership through depreciation tax savings . Long term leasing is a method of financing, property, plant and equipment.

A

lease is comparable to debt financing (secured loan) because both subject the firm to a

series of contractual payments and failure to make those payments could lead to bankruptcy.

Since lease cash flows have approximately the same risk as debt cash flows, the appropriate discount rate in the analysis of leasing is the after-tax cost of debt.

The biggest group of lessors is equipment manufacturers like IBM, Xerox, GM, etc. In addition, there are many leasing companies who handle leasing arrangements.

MAJOR TYPES OF LEASES

1. OPERATING LEASES: These leases are short-term arrangements which provide both financing and maintenance services. Operating leases are typically employed when the asset has high risk of technological and economic obsolescence, which is absorbed by the lessor.

Terms of Operating Leases :

Lease period is short relative to the service life of the asset

Lessor maintains and services the leased asset

Lessee has the right to cancel the lease contract before the expiration date

Lease payments are not sufficient to recover the full cost of the asset.

2. CAPITAL OR FINANCIAL LEASES

There are two basic types of financial leases: (a) Direct Lease, and (b) Sale and Lease-back.

A direct lease requires the lessor to acquire the asset directly from the manufacturer or

vendor. In a sale and leaseback , a firm owning an asset sells it to a leasing company and simultaneously leases it back. The seller receives the purchase price but retains the use of

property in exchange for rental payments.

Terms of Financial Leases:

Not cancelable unless the lessee pays a cancellation penalty

Maintenance costs are borne by the lessee

Total lease payments exceed the purchase price of the asset (full-pay-out leases)

Fully amortized

Lease period approximates the service life of the asset

Financial leases are typically used to finance major capital expenditures. A capital lease must

be disclosed on the balance sheet if at least one of the following criteria is met:

The lease transfers asset ownership to the lessee at the end of the lease term.

The lessee can purchase the asset at a price below fair market value (bargain purchase price option) when the lease expires.

The lease term is 75% or more of the estimated economic life of the asset.

The PV of the lease payments is at least 90% of the fair market value of the asset at the start of lease.

3. LEVERAGED LEASES

A type of financial lease in which three parties are involved in the lease transaction: lessee,

lessor, and the lender. Leveraged leases are used to finance “big ticket” items such as planes,

or multi million dollar equipment or projects.

The lessor partially finances the asset by borrowing. The debt is secured by the equipment and is usually not guaranteed by the lessor (a non-recourse loan). The lessor receives the periodic lease payments and then makes payment on the debt.

MOTIVATIONS FOR LEASING

Reduce funding costs by transferring tax benefits: Leasing allows the transfer of tax benefit from those who need equipment but cannot take full advantage associated with

ownership to a party who can. Leasing is a device to reduce taxes. A firm that is unprofitable

or is expanding rapidly and generating large depreciation write-offs cannot immediately take full tax benefit of ownership. On the other hand, highly profitable companies such as GE gain the most tax benefit from owning the assets as a lessor.

*Solve the debt overhang problem and avoid under-investment in positive NPV projects: Many firms seek lease financing as an alternative to traditional bank financing to invest in positive NPV projects, especially when credit is tight. Primary reasons cited are:

less cash is required upfront; approval from lessors is quicker than from lenders; fewer restrictions are imposed.

Obtain 100% off-balance sheet financing: Leasing (operating and synthetic) provides 100% off-balance sheet financing. (dubious reason, not consistent with EMH)

*Improve GAAP earnings: Operating and synthetic leasing which share similar GAAP treatment can increase reported earnings because lease payments are typically less than the combination of interest expenses and depreciation charges under a purchase scenario. This is often cited as a key reason for leasing. (this is not consistent with the EMH view).

Shift residual asset risk: Assets that face rapid technological obsolescence are often leased. The risk is transferred to lessor who may be in a better position to bear this risk. The lessee also benefits by acquiring most advanced equipment.

Leases have lower expected bankruptcy costs than secured debt, i.e., they receive more favorable treatment in bankruptcy proceedings.

Other often cited reasons, include:

Short-term leases are convenient as maintenance is provided and the cancellation option is valuable.

If the life of the project is in doubt, it may be better to use an operating lease.

Avoid restrictive debt covenants and flotation costs.

Competition among leasing companies force them to pass on some of the benefits to lessees in the form of low lease payments. Because of competition, assets with large residual values are not necessarily more suitable for buying than leasing, as sometimes argued.

DISADVANTAGES OF LEASING

Leasing is often more expensive than ownership, i.e., the effective interest cost of leasing are often higher compared to borrowing.

The lessee gives up the benefit of salvage value which is particularly significant in real estate. Similarly, the lessee gives up the tax benefit of ownership (the asset’s depreciation tax shield)

Financial leases may not be cancelled without a substantial penalty.

Approval for improvement in leased real estates may be difficult to obtain.

ACCOUNTING AND LEASING

Before 1976, leasing was frequently called off balance sheet financing . A firm could arrange to use an asset through lease and not disclose the asset or the lease contract on the balance sheet. The Financial Accounting Standard (FAS) 13 sets out the criteria to determine if a lease is financial or operating. All financial leases are required to be capitalized.

LEASE ANALYSIS: Net Advantage to Leasing (NAL)

Lease-buy analysis from the lessee's perspective compares leasing to the alternative of borrow- buy by computing the net advantage to leasing (NAL) which is an NPV-type analysis. If the NAL is positive, it is cheaper for the lessee to lease the asset than to borrow and buy it. It is easy to see from equation below how each item affects the attractiveness of leasing. For example, a larger lease payment, depreciation tax shield, or estimated salvage value reduce the NAL.

NAL

=

IO

where

n

t = 0

L

t

(1

T

c

)

(1

+ K

d

)

t

n

1

t =

T

c

Dep .

t

(1

+ K

d

)

t

+

 

M

t

(1

T

c

)

NSV

n

1

(1

+ K

d

)

t

(1

+ K

d

)

n

n

t

=

IO

=

Initial outlay (installed cost) avoided when asset is leased

L t (1 - T c )

=

After-tax lease payment

T c Dep t

=

Depreciation tax shield

M t (1 - T c )

=

After-tax maintenance or operating costs incurred if owned

NSV n

=

but not if asset is leased Net (after-tax) salvage value

K d (1 - T c )

=

After-tax cost of secured debt

The lease decision can also be analyzed using the IRR approach. The IRR of the lease is the after-tax cost rate of the lease. The asset should be leased if the IRR of the lease is less than the after-tax cost of debt .

Lessor Analysis: The lessor views the lease as an investment and compares its return with alternative investments with similar risk. If the lesssor's NPV is positive or the IRR is greater than the after-tax return on a comparable investment, then the lease should be written.

Sample Problem:

You work for a nuclear research laboratory that is contemplating leasing a diagnostic scanner (leasing is common practice with expensive, high-tech equipment). The scanner costs $4,500,000, and would be depreciated straight-line to zero over four years. Because of the radiation contamination, it will actually be completely valueless in four years. You can lease it for $1,350,000 per year for four years under an operating lease arrangement. Assume the tax rate is 35 percent. You can borrow at 8% before taxes. Should you lease or buy?

Lease Analysis Example - Chapter 21

asset cost

4,500,000

interest on secured debt

8.00%

5.20%

Rb after-tax

lease payments

1,350,000

end of period

maintenance cost

0

tax rate

35%

salvage value

20,000

S/L

1

2

3

4

depreciation %

25.00%

25.00%

25.00%

25.00%

annual dep.

$1,125,000

$1,125,000

$1,125,000

$1,125,000

Year

0

1

2

3

4

asset cost

4,500,000

after-tax lease payment

-877,500.00

-877,500.00

-877,500.00

-877,500.00

depreciation tax shield

-393,750.00

-393,750.00

-393,750.00

-393,750.00

after-tax maint. costs

0

0

0

0

net salvage value

Net Cash Flow

4,500,000

-1,271,250

-1,271,250

-1,271,250

-1,271,250

PV of net cash flows

PV of NSV

NAL Lessor Perspective: If we assume that the lessor has the same tax rate and same cost of debt (and no other benefit), NAV to the lessor is negative

13,074.

$13,074

0

13,074

Since the NAL is positive, lease the asset.