Leasing from the Lessees Perspective

Define a symmetric lease as one where any cash inflow or benefit to the
lessor is an equal outflow or disadvantage to the lessee, and vice versa. The
lessor is a financial institution [or acting like one], and, as such, a potential lease
is a project subject to NPV analysis. In a symmetric lease, the lessors NPV =
NAL for the lessee. In a well-working market, where both lessee and lessor are
fully informed and financially astute, the terms of the lease would be such that
NPV = NAL = 0. This means the lessor earns its required rate of return on the
lease and the lessee pays its marginal cost of leasing capital. If the terms of the
lease are set so that NPV > 0, then the lessee would not agree to accept it. If the
terms of the lease are such that NAL > 0, then the lessor would not offer it.
In considering the NPV and the NAL, an analyst considers the lease
payments, the SVNOT and depreciation tax shields, any inherent maintenance
contract, etc. contained in the lease contract. In a well-working market, the
pricing of the lease includes such factors. After one finds the NAL, one has
already included the fact that the lessee has no ending equity buildup. To say
that here is a lease with a positive NAL, but we should view it with skepticism
because we are losing the residual value is double counting.
Frequently, leasing is compared to borrowing to buy the asset. The
comparison is appropriate, but too narrow. One should compare leasing to all
other competing forms of financing. Using the NAL does this, requiring no
special modifications for a specific alternative type of financing.
Alleged Advantages and Disadvantages of Leasing
[Non-cancelable operating lease; lessees perspective]
1. loss of depreciation tax shields true, but not a disadvantage, because
its built into the pricing
2. loss of residual value [SVNOT] true, but not a disadvantage, because
its built into the pricing.
3. payments are fully deductible for tax purposes true, but not a
substantive advantage. If one borrows to buy the asset, one makes
periodic payments comprised of interest and principal. Only the interest
portion yields a tax deduction. But the owner also gets deductions
depreciation. The sum of the principal payments that is not tax deductible
is roughly equal to the sum of depreciation deductions. Therefore, the
equivalent of the entire debt service payment is tax deductible, just as the
entire lease payment is tax deductible. There is a possibility of some
small advantage or disadvantage to leasing because of this comparison.
Given the nature of accelerated depreciation schedules, the likelihood is a
negligible disadvantage to leasing.

4. 100% financing the comparison is that borrowing often requires a

downpayment or other equity infusion. Nevertheless, leases nearly
always require upfront payments, such as first lease payment, security
deposits, administration fees, last three lease payments, etc. This
allegation of advantage is false.
5. reduces obsolescence risk if a company buys an asset, and it
subsequently becomes obsolete, the company can salvage the asset at
its diminished market value. If the company leases the asset and it
subsequently becomes obsolete, the company must pay off the lease or
cancel with penalties specified by the contract or continue to use the
inferior asset. This allegation of advantage is false. This canard perhaps
arose in that some short-term cancelable leases could be dropped when
the asset became obsolete. Even for these short-term leases, if lessee
and lessor agree on the likelihood and severity of obsolescence at the
time for effecting the lease, the potential costs of obsolescence would be
built into the pricing. The seemingly more interesting case is the
cancelable lease where the prospective lessee and lessor disagree about
the likelihood and costs of obsolescence. If the lessee thinks the costs
will be lower than what the lessor opines, then it will be unwilling to sign
the lease on the basis of what the lessor will demand. If the lessee thinks
the cost will be higher, then both parties think the deal is advantageous to
them and disadvantageous to the other they can make a deal. The
actual ex post advantage will go to the party whose a priori opinion about
the costs of potential obsolescence was closest to correct. Despite the
appearance that this is a tossup at time of signing the lease, the
advantage (disadvantage) probably is to the lessor (lessee). At the
extreme, the lessee involves itself in a one-time transaction for this asset
and has no experience in estimating its useful economic life and its
potential for obsolescence. The lessor has had many transactions
concerning this kind of asset and should be skilled in estimating those
factors.
6. off-the-balance sheet financing operating leases do not appear on the
balance sheet, but they do appear in the notes to the financial statements.
Off-the-balance sheet financing could be advantageous only if somehow
lenders would charge lower interest rates for future loans or investment
analysts would rank the stock higher than it should be. These groups of
people are not fools who dont look at the notes to financial statements.
While the premise is correct, the fact that operating leases do not appear
on the balance sheet is not an advantage.
7. saves debt capacity this one is very similar to #6 above. I agree that
excess debt capacity must have some value, because all options have
positive value. Excess debt capacity gives the company the option to
borrow more. When lenders examine a companys creditworthiness, they

consider all its fixed financial cash flow obligations, including debt service
and lease payments. Thus, lease payments from a new contract would
be a factor that decreases any excess debt capacity just as additional
debt service payments would. This allegation of an advantage is false.
8. junior type of financing I saw this claim in a magazine section
advertising leasing. Junior financing that is, subordinated debt has
some attraction in that it serves as quasi-equity. The assets purchased
with subordinated debt can serve as collateral for future debt financing.
Subordinated borrowing is not true equity, because a default on the junior
debt leads to financial distress. Nevertheless, leasing is not junior
financing. Because the financier owns the asset, the lessor can more
easily get satisfaction in a case of the lessees financial distress and/or
bankruptcy. Leasing is, in fact, a very senior kind of financing. This
allegation of an advantage is false.
9. sometimes includes maintenance only a minority of leases require the
lessor to provide maintenance. Often the lessee must pay for and certify
that appropriate maintenance is occurring. Nonetheless, some leases
provide maintenance. This factor is not an advantage per se, because
the cost of providing the maintenance should be built into the pricing of
the lease. The maintenance provision, ceteris paribus, would be a neutral
provision. Yet in some special circumstances, maintenance provisions
could be a true leasing advantage. If the lessor is also the assets
manufacturer, it may be able to provide maintenance that is superior to
other sources. If the lessor has economy of scale in maintenance, it may
choose to implicitly price the maintenance into the lease at a cost high
enough to realize a profit but low enough to undercut the cost of
maintenance from other sources. In other words, it could design a lease
where both NPV > 0 and NAL > 0.
10. availability finally, we come to a true, substantive advantage of leasing.
Among small businesses, this is the primary driver in leasing. Because
the legal title remains with the financing entity, a lease reduces the risk of
financial distress to the lessor. A formal bankruptcy very frequently leads
to liquidation for small businesses. The lessor can more easily recover its
asset in such a liquidation than a lender can foreclose on a mortgaged
asset. A small business with limited creditworthiness can obtain the use
of an asset via leasing, where it would not have the financing available for
that asset via debt. The factor of availability is the primary reason for the
thriving leasing business in the United States.
11. tax asymmetries sometimes make possible leases where NPV>0 and
NAL>0 this is a factor in many leases in major corporations. When
both parties to a lease gain, the transaction is likely to happen. Because
of the myriad of Federal and state tax laws, there are many kinds of tax

asymmetry. The three that are the most common and likely to have the
most effect are as follows.
a. Income tax rate asymmetry the lessor and lessee have different
marginal income tax rates. The classic case is where the lessee
has a low tax rate (for example, a not-for-profit corporation has a
zero tax rate) and the lessor is at the full corporate tax rate. The
lessee finds the depreciation tax shields worthless, but they are
very valuable to the lessor. Despite the appeal of this argument,
one can frequently find cases in which there is no possible lease
payment schedule where NAL > 0 for the low-tax-rate lessee in
conjunction with NPV > 0 for the high-tax-rate lessor. Also
surprisingly, one can find cases where the lease contract is such
that NAL > 0 for a high-tax-rate lessee and NPV > 0 for a low-taxrate lessor.
b. Sales tax asymmetry in most States, the lessee avoids the
upfront sales tax for purchase, but commits to the present value of
sales tax payments subsumed by the lease payments. In some
situations, this is a saving. The lessor passes any sales tax
payments on to the government.
c. Downpayment tax shield asymmetry when the lease requires a
downpayment, especially in the case of vehicle leases, the lessee
can immediately expense the entire downpayment. The
downpayment usually goes to a dealer, who would get such a
payment or more in a purchase. Thus, neither the dealer nor the
lessor receives or loses any tax shield.
12. fewer restrictive covenants and covenants that are less restrictive
compared to debt financing, leasing usually has fewer restrictive
covenants, and those covenants are likely to be less restrictive. This is a
true advantage of leasing.
13. less operating flexibility in terms of termination this actual disadvantage
of leasing might be thought of as the truth about #5 above. One of the
valuable real options that exists in nearly as assets is the option to
salvage the asset before the end of its useful life or the end of the project.
If the firm leases the asset, it can terminate it only at the leases end.
14. sophisticated lessors can sometimes bilk nave lessees a lease is
always an involved contract and some are extremely complex. A leasing
company is expert at constructing and analyzing leases, but a potential
lessee may be signing its first lease. The sophistication in leasing is likely
to very much favor the lessor. A lessee, eager to have use of the asset,
might sign a lease designed such that the NAL is negative, and the NPV
to the lessor is a large positive value. This is a true disadvantage of
leasing.