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26
Leasing
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Key Concepts and Skills
Understand basic lease terminology
Understand the criteria for a capital lease vs. an
operating lease
Understand the typical incremental cash flows to
leasing
Be able to compute the net advantage to leasing
Understand the good reasons for leasing and
the dubious reasons for leasing
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Chapter Outline
Leases and Lease Types
Accounting and Leasing
Taxes, the IRS, and Leases
The Cash Flows from Leasing
Lease or Buy?
A Leasing Paradox
Reasons for Leasing
3
Lease Terminology
Lease contractual agreement for use of an asset in
return for a series of payments
Lessee user of an asset; makes payments
Lessor owner of the asset; receives payments
Direct lease lessor is the manufacturer
Captive finance company subsidiaries that lease
products for the manufacturer
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Types of Leases
Operating lease
Shorter-term lease
Lessor is responsible for insurance, taxes, and maintenance
Often cancelable
Financial lease (capital lease)
Longer-term lease
Lessee is responsible for insurance, taxes, and maintenance
Generally not cancelable
Specific capital leases
Tax-oriented
Leveraged
Sale and leaseback
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Lease Accounting
Leases are governed primarily by FASB 13
Financial leases are essentially treated as debt
financing
Present value of lease payments must be included
on the balance sheet as a liability
Same amount shown on the asset as the
capitalized value of leased assets
Operating leases are still off-balance-sheet
and do not have any impact on the balance
sheet itself
6
Criteria for a Capital Lease
If one of the following criteria is met, then the
lease is considered a capital lease and must be
shown on the balance sheet
Lease transfers ownership by the end of the lease
term
Lessee can purchase asset at below market price
Lease term is for 75 percent or more of the life of
the asset
Present value of lease payments is at least 90
percent of the fair market value at the start of the
lease
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Taxes
Lessee can deduct lease payments for income tax
purposes
Must be used for business purposes and not to avoid taxes
Term of lease is less than 80 percent of the economic life of
the asset
Should not include an option to acquire the asset at the end of
the lease at a below market price
Lease payments should not start high and then drop
dramatically
Must survive a profits test lessor should earn a fair return
Renewal options must be reasonable and consider fair market
value at the time of the renewal
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Incremental Cash Flows
Cash Flows from the Lessees point of view
After-tax lease payment (outflow)
Lease payment*(1 T)
Lost depreciation tax shield (outflow)
Depreciation * tax rate for each year
Initial cost of machine (inflow)
Inflow because we save the cost of purchasing the asset now
May have incremental maintenance, taxes, or
insurance
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Example: Lease Cash Flows
ABC, Inc. needs some new equipment. The equipment
would cost $100,000 if purchased, and would be
depreciated straight-line over 5 years. No salvage is
expected. Alternatively, the company can lease the
equipment for $25,000 per year. The marginal tax rate
is 40%.
What are the incremental cash flows?
After-tax lease payment = 25,000(1 - .4) = 15,000 (outflow years 1
- 5)
Lost depreciation tax shield = (100,000/5)*.4 = 8,000 (outflow
years 1 5)
Cost of machine = 100,000 (inflow year 0)
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Lease or Buy?
The company needs to determine whether it is
better off borrowing the money and buying the
asset, or leasing
Compute the NPV of the incremental cash flows
Appropriate discount rate is the after-tax cost of
debt since a lease is essentially the same risk as
a companys debt
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Net Advantage to Leasing
The net advantage to leasing (NAL) is the same
thing as the NPV of the incremental cash flows
If NAL > 0, the firm should lease
If NAL < 0, the firm should buy
Consider the previous example. Assume the
firms cost of debt is 10%.
After-tax cost of debt = 10(1 - .4) = 6%
NAL = 3,116
Should the firm buy or lease?
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Work the Web Example
Many people have to choose between buying and
leasing a car
Click on the web surfer to go to Kiplingers
Go to Tools: Spending Tools
Do the calculations for a $30,000 car, 5-year loan at 7% with
monthly payments, and a $3,000 down payment. The available
lease is for 3 years and requires a $550 per month payment
with a $1,000 security deposit and $1,000 other upfront costs.
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Good Reasons for Leasing
Taxes may be reduced
May reduce some uncertainty
May have lower transaction costs
May require fewer restrictive covenants
May encumber fewer assets than secured
borrowing
14
Dubious Reasons for Leasing
Balance sheet, especially leverage ratios, may look
better if the lease does not have to be accounted for on
the balance sheet
100% financing except that leases normally do require
either a down-payment or security deposit
Low cost some may try to compare the implied rate of
interest to other market rates, but this is not directly
comparable
15
Quick Quiz
What is the difference between a lessee and a lessor?
What is the difference between an operating lease and
a capital lease?
What are the requirements for a lease to be tax
deductible?
What are typical incremental cash flows and how do
you determine the net advantage to leasing?
What are some good reasons for leasing?
What are some dubious reasons for leasing?
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End of Chapter
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Comprehensive Problem
What is the net advantage to leasing for the
following project, and what decision should be
made?
Equipment would cost $250,000 if purchased
It would be depreciated straight-line to zero salvage
over 5 years.
Alternatively, it may be leased for $65,000/yr.
The firms after-tax cost of debt is 6%, and its tax rate
is 40%