Chapter Outline

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Chapter Outline

• 21.1 Types of Leases
• 21.2 Accounting and Leasing
• 21.3 Taxes and Leases
• 21.4 The Cash Flows of Leasing
• 21.5 A Detour on Discounting and Debt Capacity
  with Corporate Taxes
• 21.6 NPV Analysis of the Lease-versus-Buy
  Decision
• 21.7 Debt Displacement and Lease Valuation
• 21.8 Does Leasing Ever Pay The Base Case
• 21.9 Reasons for Leasing
• 21.10 Some Unanswered Questions

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21.1 Types of Leases

• The Basics
• A lease is a contractual agreement between a
  lessee and lessor.
• The agreement establishes that the lessee has the
  right to use an asset and in return must make
  periodic payments to the lessor.
• The lessor is either the assets manufacturer or
  an independent leasing company.

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Operating Leases

• Usually not fully amortized. This means that the
  payments required under the terms of the lease
  are not enough to recover the full cost of the
  asset for the lessor.
• Usually require the lessor to maintain and insure
  the asset.
• Lessee enjoys a cancellation option. This option
  gives the lessee the right to cancel the lease
  contract before the expiration date.

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Financial Leases

• The exact opposite of an operating lease.
• Do not provide for maintenance or service by the
  lessor.
• Financial leases are fully amortized.
• The lessee usually has a right to renew the lease
  at expiry.
• Generally, financial leases cannot be cancelled,
  i.e., the lessee must make all payments or face
  the risk of bankruptcy.

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Sale and Lease-Back

• A particular type of financial lease.
• Occurs when a company sells an asset it already
  owns to another firm and immediately leases it
  from them.
• Two sets of cash flows occur
• The lessee receives cash today from the sale.
• The lessee agrees to make periodic lease
  payments, thereby retaining the use of the asset.

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Leveraged Leases

• A leveraged lease is another type of financial
  lease.
• A three-sided arrangement between the lessee, the
  lessor, and lenders.
• The lessor owns the asset and for a fee allows
  the lessee to use the asset.
• The lessor borrows to partially finance the
  asset.
• The lenders typically use a nonrecourse loan.
  This means that the lessor is not obligated to
  the lender in case of a default by the lessee.

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21.2 Accounting and Leasing

• In the old days, leases led to off-balance-sheet
  financing.
• In 1979, the Canadian Institute of Chartered
  Accountants implemented new rules for lease
  accounting according to which financial leases
  must be capitalized.
• Capital leases appear on the balance sheetthe
  present value of the lease payments appears on
  both sides.

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Accounting and Leasing

• Balance Sheet
• Truck is purchased with debt
• Truck 100,000 Debt 100,000
• Land 100,000 Equity 100,000
• Total Assets 200,000 Total Debt Equity
  200,000
• Operating Lease
• Truck Debt
• Land 100,000 Equity 100,000
• Total Assets 100,000 Total Debt Equity
  100,000
• Capital Lease
• Assets leased 100,000 Obligations under capital
  lease 100,000
• Land 100,000 Equity 100,000
• Total Assets 200,000 Total Debt
  Equity 200,000

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Capital Lease

• A lease must be capitalized if any one of the
  following is met
• The present value of the lease payments is at
  least 90-percent of the fair market value of the
  asset at the start of the lease.
• The lease transfers ownership of the property to
  the lessee by the end of the term of the lease.
• The lease term is 75-percent or more of the
  estimated economic life of the asset.
• The lessee can buy the asset at a bargain price
  at expiry.

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21.3 Taxes and Leases

• The principal benefit of long-term leasing is tax
  reduction.
• Leasing allows the transfer of tax benefits from
  those who need equipment but cannot take full
  advantage of the tax benefits of ownership to a
  party who can.
• If the CCRA (Canada Customs and Revenue Agency)
  detects one or more of the following, the lease
  will be disallowed.
• The lessee automatically acquires title to the
  property after payment of a specified amount in
  the form of rentals.
• The lessee is required to buy the property from
  the lessor.
• The lessee has the right during the lease to
  acquire the property at a price less than fair
  market value.

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21.4 The Cash Flows of Leasing

• Consider a firm, ClumZee Movers, that wishes to
  acquire a delivery truck.
• The truck is expected to reduce costs by 4,500
  per year.
• The truck costs 25,000 and has a useful life of
  five years.
• If the firm buys the truck, they will depreciate
  it straight-line to zero.
• They can lease it for five years from Tiger
  Leasing with an annual lease payment of 6,250.

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21.4 The Cash Flows of Leasing

• Cash Flows Buy
• Year 0 Years 1-5
• Cost of truck 25,000
• After-tax savings 4,500(1-.34) 2,970
• Depreciation Tax Shield 5,000(.34) 1,700
• 25,000 4,670

• Cash Flows Lease
• Year 0 Years 1-5
• Lease Payments 6,250(1-.34) 4,125
• After-tax savings 4,500(1-.34) 2,970
• 1,155

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21.4 The Cash Flows of Leasing

• Cash Flows Leasing Instead of Buying
• Year 0 Years 1-5
• 25,000 1,155 4,670 5,825
• Cash Flows Buying Instead of Leasing
• Year 0 Years 1-5
• 25,000 4,670 1,155 5,825
• However we wish to conceptualize this, we need to
  have an interest rate at which to discount the
  future cash flows.
• That rate is the after-tax rate on the firms
  secured debt.

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21.5 A Detour on Discounting and Debt Capacity
with Corporate Taxes

• Present Value of Riskless Cash Flows
• In a world with corporate taxes, firms should
  discount riskless cash flows at the after-tax
  riskless rate of interest.
• Optimal Debt Level and Riskless Cash Flows
• In a world with corporate taxes, one determines
  the increase in the firms optimal debt level by
  discounting a future guaranteed after-tax inflow
  at the after-tax riskless interest rate.

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21.6 NPV Analysis of the Lease-vs.-Buy Decision

• A lease payment is like the debt service on a
  secured bond issued by the lessee.
• In the real world, many companies discount both
  the depreciation tax shields and the lease
  payments at the after-tax interest rate on
  secured debt issued by the lessee.
• The various tax shields could be riskier than
  lease payments for two reasons
• The value of the CCA tax benefits depends on the
  firms ability to generate enough taxable income.
• The corporate tax rate may change.

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NPV Analysis of the Lease-vs.-Buy Decision
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21.7 Debt Displacement and Lease Valuation

• Considering the issues of debt displacement
  allows for a more intuitive understanding of the
  lease versus buy decision.
• Leases displace debtthis is a hidden cost of
  leasing. If a firm leases, it will not use as
  much regular debt as it would otherwise.
• The interest tax shield will be lost.

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21.7 Debt Displacement and Lease Valuation

• The debt displaced by leasing results in forgone
  interest tax shields on the debt that ClumZee
  movers didnt go into when they leased instead of
  bought the truck.
• Suppose ClumZee agrees to a lease payment of
  6,250 before tax. This payment would support a
  loan of 25,219.20 (see the next slide)
• In exchange for this, they get the use of a truck
  worth 25,000.
• Clearly the NPV is a negative 219.20, which
  agrees with our earlier calculations.

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21.7 Debt Displacement and Lease Valuation

• Suppose ClumZee agrees to a lease payment of
  6,250 before tax. This payment would support a
  loan of 25,219.20

Calculate the increase in debt capacity by
discounting the difference between the cash flows
of the purchase and the cash flows of the lease
by the after-tax interest rate.
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21.8 Does Leasing Ever Pay The Base Case

• In the above example, ClumZee Movers chose to
  buy, because the NPV of leasing was a negative
  219.20
• Note that this is the opposite of the NPV that
  Tiger Leasing would have

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21.9 Reasons for Leasing

• Good Reasons
• Taxes may be reduced by leasing.
• The lease contract may reduce certain types of
  uncertainty.
• Transactions costs can be higher for buying an
  asset and financing it with debt or equity than
  for leasing the asset.
• Bad Reasons
• Leasing and accounting income
• 100 financing

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A Tax Arbitrage

• Suppose ClumZee movers is actually in the 25 tax
  bracket and Tiger Leasing is in the 34 tax
  bracket. If Tiger reduces the lease payment to
  6,200, can both firms have a positive NPV?
• Cash Flows Tiger Leasing
• Year 0 Years 1-5
• Cost of truck 25,000
• Depreciation Tax Shield 5,000(.34) 1,700
• Lease Payments 6,200(1 .34) 4,092
• 25,000 5,792
• NPV 76.33
• Cash Flows ClumZee Movers Leasing Instead of
  Buying
• Year 0 Years 1-5
• Cost of truck we didnt buy 25,000
• Lost Depreciation Tax Shield 5,000(.25)
  1,250
• After-Tax Lease Payments 6,200(1 .25)
  4,650
• 25,000 5,900
• NPV -543.91

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Reservations and Negotiations

• What is the smallest lease payment that Tiger
  Leasing will accept? Set their NPV to zero and
  solve for Lmin
• Cash Flows Tiger Leasing
• Year 0 Years 1-5
• Cost of truck -25,000
• Depreciation Tax Shield 5,000(.34) 1,700
• Lease Payments Lmin (1 .34) Lmin .66
• -25,000 1,700 Lmin .66

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Reservations and Negotiations

• What is the highest lease payment that ClumZee
  Movers can pay? Set their NPV to zero and solve
  for Lmax
• Cash Flows ClumZee Movers Leasing Instead of
  Buying
• Year 0 Years 1-5
• Cost of truck we didnt buy 25,000
• Lost Depreciation Tax Shield 5,000(.25)
  1,250
• After-Tax Lease Payments Lmax( 1
  .25) .75 Lmax
• 25,000 1,250 .75 Lmax

No lease is possible Lmin gt Lmax
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21.10 Some Unanswered Questions

• Are the Uses of Leases and of Debt Complementary?
• Why are Leases offered by Both Manufacturers and
  Third Party Lessors?
• For manufacturer lessors, the basis for
  determining capital cost allowance is the
  manufacturers cost.
• For third party lessors, the basis is the sale
  price that the lessor paid to the manufacturer.
• Why are Some Assets Leased More than Others?
• The more sensitive is the value of an asset to
  use and maintenance decisions, the more likely it
  is that the asset will be purchased instead of
  leased.

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21.11 Summary and Conclusions

• There are three ways to value a lease.
• Use the real-world convention of discounting the
  incremental after-tax cash flows at the lessors
  after-tax rate on secured debt.
• Calculate the increase in debt capacity by
  discounting the difference between the cash flows
  of the purchase and the cash flows of the lease
  by the after-tax interest rate. The increase in
  debt capacity from a purchase is compared to the
  extra outflow at year 0 from a purchase.
• Use APV (presented in the appendix to this
  chapter).
• They all yield the same answer.
• The easiest way is the least intuitive.

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Appendix 21A APV Approach to Leasing

• APV All-Equity Value Financing NPV

Calculations shown on the following slides will
show that for the latest Clumzee Movers example
(tax rate is 25) APV 591.38 1,135.30 APV
543.91 Which is the same value as the easier
NPV analysis.
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Appendix 21A APV Approach to Leasing

• APV All-Equity Value Financing NPV
• To find the all-equity value, discount the cash
  flows at the pre-tax interest rate. The after-tax
  rate was 5 which implies a pretax rate of
• 6.66 5/(1-.25).

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Appendix 21A APV Approach to Leasing

• APV All-Equity Value Financing NPV
• The NPV of the financing is the forgone interest
  tax shields on the debt that ClumZee movers
  didnt go into when they leased instead of bought
  the truck.
• ClumZee agreed to a lease payment of 5,900.
• This payment would support a loan of 25,543.91

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Appendix 21A APV Approach to Leasing
The lost interest tax shield associated with this
additional debt capacity of 25,543.91 has a
present value of 1,135.30
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21.7 Debt Displacement and Lease Valuation
The lost interest tax shield associated with this
additional debt capacity of 25,219.20 has a
present value of