Types of leases

1
CHAPTER 14 Lease Financing

• Types of leases
• Tax Treatment of Leases
• Effects on financial statements
• Lessees analysis
• Lessors analysis
• Leveraged Leases
• Other issues in lease analysis

2
Importance of Leasing

• Over 30 percent of all new capital equipment is
  financed through lease arrangements.
• Currently leasing companies buy about 50 percent
  of all new commercial aircraft sold.

3
Who are the two parties to a lease transaction?

• The lessee, who uses the asset and makes the
  periodic lease, or rental payments.
• The lessor, who owns the asset and receives the
  rental payments
• Note that the lease decision is a financing
  decision for the lessee and an investment
  decision for the lessor.
• For the lessee, a lease is comparable to a loan.
  The cost of leasing is compared to the cost of
  borrowing.

4
Who provides leases?

• Independent leasing companies
• Equipment manufacturers such as IBM
• Finance companies like General Electric Credit
  Corporation
• Banks
• Individuals

5
What are the primary lease types?

• Operating lease
• Short-term and normally cancelable
• Maintenance usually included
• Financial Lease
• Long-term and normally noncancelable
• Maintenance usually not included
• Sale and Leaseback
• Combination Lease
• Leveraged Lease

6
Operating Leases

• Usually provide maintenance service.
• Are not fully amortized.
• Often contain a cancellation cause.
• Are for a short term relative to the assets
  life.
• Full service

7
Financial or Capital Leases

• Typically do not provide for maintenance service
• Are not cancelable
• Are fully amortized (the lessor receives rental
  payments equal to the full price of the leased
  equipment plus a return on invested capital)
• Lessee generally pays property taxes and
  insurance on the leased property

8
How are leases treated for tax purposes?

• Leases are classified by the IRS as either
  guideline (tax-oriented) or nonguideline.
• For a guideline lease, the entire lease payment
  is deductible to the lessee.
• For a nonguideline lease, only the imputed
  interest payment is deductible.
• Why should the IRS be concerned about lease
  provisions?

9
Main Provisions of Tax Guidelines

• Lease term must not exceed 80 percent of the
  estimated useful life of equipment
• Estimated residual value at the expiration of the
  lease must equal at least 20 percent of its value
  at the start of the lease
• Leased equipment must not be limited use
  property
• Lessee can be given an option to buy the asset
  only at its fair market value

10
What is the difference between a capital lease
and an operating lease?

• FASB Statement 13 sets forth the rules for
  capital and operating leases.
• Capital leases
• Run for at least 75 of the assets expected
  useful life.
• The present value of the lease payments is equal
  to or greater than 90 percent of the initial
  value of the asset.
• Are shown directly on the balance sheet.

11
Why is leasing sometimes referred to as
off-balance sheet financing?

• For accounting purposes, leases are classified as
  either capital or operating.
• Capital leases must be shown directly on the
  lessees balance sheet. If an asset is leased and
  the lease is not a capital lease, then the lease
  will not be shown on the balance sheet. It must
  be disclosed in the footnotes.
• As a result, financial ratios may not be
  comparable between a firm that leases and one
  that does not.

12
What impact does leasing have on a firms capital
structure?

• Leasing is a substitute for debt.
• As such, leasing uses up a firms debt capacity.
• Assume a firm has a 50/50 target capital
  structure. Half of its assets are leased. How
  should the remaining assets be financed?

13
Net Advantage to Leasing
Installed Cost of Asset - PV of After-Tax Lease
Payments -PV of Depreciation Tax Shield (Use
MACRS Depreciation) PV of After-Tax Operating
Cost Incurred if Owned but not if Leased - PV of
After-Tax Salvage Value or Residual Value Net
Advantage to Leasing (NAL)
14
Net Advantage to Leasing (NAL)

• When analyzing the NAL from the viewpoint of the
  lessee, choose leasing if the NAL is positive.
• You can also reverse all numbers from the
  previous slide and examine the lease from the
  viewpoint of the lessor. Then if the NAL is
  positive, you can write the lease.
• Given the appropriate tax rates and residual
  values, leasing can be beneficial for both the
  lessee and the lessor.

15
Problem The firm has decided to acquire some
new equipment.

• If leased
• Firm could obtain a 4-year lease on the
  equipment.
• Lease meets IRS guidelines to expense lease
  payments.
• An annual payment of 280,000 is payable at the
  beginning of each year. (Note lease payments are
  usually made at the beginning of the period.)

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• Other information
• Equipment cost 1,000,000.
• Could borrow at 10.
• Marginal tax rate 40.
• 3 year MACRS life.
• If company borrows and buys, 4-year maintenance
  contract costs 20,000 per year. Beginning of
  year payment.
• Residual value at t 4 100,000.

Data are from the Mini Case.
17
Time Line After-Tax Cost of Owning (In
Thousands)
0 1
2 3 4 AT loan
pmt -60 -60 -60 -1,060 Dep shld 132 180 60 28 Ma
int -20 -20 -20 -20 Tax sav 8 8 8 8 RV 100
Tax -40 NCF -12 60 108 -12 -972
Methodology preferred by textbook.
18

• Note the depreciation shield in each year equals
  the depreciation expense times the lessees tax
  rate. For Year 1, the depreciation shield is
  330,000(0.40) 132,000.
• The present value of the cost of owning cash
  flows, when discounted at 6, is -639,267.

19
Time Line After-Tax Cost of Leasing (In
Thousands)
0 1
2 3 4 Lease
pmt -280 -280 -280 -280 Tax sav 112 112 112 112
NCF -168 -168 -168 -168 PV cost of leasing
_at_ 6 -617,066. Use the BGN Button on your
calculator.
20
Why use 6 as the discount rate?

• Leasing is similar to debt financing.
• The cash flows have relatively low risk most are
  fixed by contract.
• Therefore, the firms 10 cost of debt is
  considered the risk-free rate for the firm.
• The tax shield of interest payments must be
  recognized, so the discount rate is 10(1-T)
  10(1- 0.4) 6.0

21
What is the Net Advantage to Leasing (NAL)?

• NAL PV cost of owning - PV cost of leasing
  639,267 - 617,066 22,201. (Methodology
  preferred by text)
• A positive NAL indicates that leasing is less
  expensive than borrowing and buying, so the firm
  should lease the equipment.

22
Some Comments About Net Advantage to Leasing (NAL)

• We will use NAL in the problems at the end of the
  chapter.
• You can determine the Net Present Value for the
  Lessor by calculating the reverse of the NAL.
  Thus, you can use NAL for both the Lessee and the
  Lessor.
• We will not use IRR analysis for leasing in
  Finance 404.
• Please review your leasing materials from Finance
  312.

23

• Note that we have assumed the company will not
  continue to use the asset after the lease
  expires. The project life is the same as the term
  of the lease.
• If the firm planned to continue using the asset
  after the lease, it would have to buy it at the
  residual value, which would be an outflow in the
  lease cash flows. If the firm was in that
  situation, they would have to consider the entire
  residual value.

24
Assume that the RV could be 0 or 200,000, with
an expected value of 100,000. How could this
risk be reflected?

• The discount rate applied to the residual value
  inflow (a positive CF) should be increased to
  account for the increased risk.
• All other cash flows should be discounted at the
  original 6 rate.

More
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• If the residual value were included as an outflow
  (a negative CF) in the cost of leasing cash
  flows, the increased risk would be reflected by
  applying a lower discount rate to the residual
  value cash flow.
• Again, all other cash flows have relatively low
  risk, and hence would be discounted at the 6
  rate.

26
What effect would increased uncertainty about
the residual value have on the lease versus buy
decision if the firm does not plan to continue to
use the asset?

• The lessor, not the lessee, owns the equipment
  when the lease expires.
• The residual value risk is passed from the lessee
  to the lessor.
• Increased residual value risk makes the lease
  more attractive to the lessee.

27
From the lessors standpoint, how should one
analyze the lease transaction?

• To the lessor, writing the lease is an
  investment. You can use the NAL method.
• The lessor should compare the return on the lease
  with returns available on alternative investments
  of similar risk. This rate most likely would be
  different than the rate used by the lessee. If
  the NPV gt 0, then the lease should be written.

28
Assume the following data for the lessor firm

• All information given in the previous example for
  the lessee applies except
• 300,000 lease (rental) payment
• Maintenance of 20,000 per year payable at
  beginning of year.

29
Time Line Lessors Analysis (In Thousands)
0 1 2
3 4 Cost -1,000 Dep shld
132 180 60 28 Maint -20 -20 -20 -20 Tax
sav 8 8 8 8 Lse pmt 300 300 300 300 Tax
-120 -120 -120 -120 RV 100 RV
tax -40 NCF -832 300 348 228 88
30

• The NPV of the net cash flows, when discounted at
  6, is 21,875.
• The IRR is 7.35.
• Should the lessor write the lease? Why?
• You can use Goal Seeking in EXCEL to set a lease
  payment amount, given a desired return. Go to
  Tools first, then Goal Seeking.

31
Find the lessors NPV if the lease payment were
280,000.

• With lease payments of 280,000, the lessors
  cash flows would be equal, but opposite in sign
  to the lessees.
• Thus, lessors NPV -22,201.
• If all inputs are symmetrical, leasing is a
  zero-sum game.
• If lessors and lessees tax rates differed, so
  would the NPVs. The key to leasing revolves about
  taxes and/or residual value.

32
Advantages to both the lessor and the lessee

• Conditions are often such that leasing can
  provide benefits to both parties.
• This situation arises because of differentials
  in
• Tax rates
• Estimated residual values
• The ability to bear the residual value risk

33
What impact would a cancellation clause have on
the leases riskinessFrom the lessees
standpoint? From the lessors standpoint?

• A cancellation clause would lower the risk of the
  lease to the lessee but raise the lessors risk.
• To account for this, the lessor would increase
  the annual lease payment or else impose a penalty
  for early cancellation.

34
Now assume that the lessor can leverage the lease.

• The lessor can borrow 500,000 of the 1,000,000
  purchase price with a four-year loan at 10.
• Only interest is paid until maturity in 4 years,
  when the full principal is due.

35
Time Line Leveraged Lease (In Thousands)
0 1 2
3 4 Lse CF -832 300 348 228 88
Loan 500 AT Int -30 -30 -30 -30 Prin
pmt -500 NCF -332 270 318 198 -442
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Leveraged Lease (Continued)

• The NPV of the leveraged lease, when discounted
  at 6, is 21,875.
• Note that the NPV is unchanged (See Slide 31).
  This is because the loan cost is the same as the
  discount rate.
• However, the 21,875 leveraged NPV requires an
  investment of only 500,000, as opposed to
  1,000,000 with the unleveraged lease. Or you can
  view it as an net outlay of 332,000 vs.
  832,000.

(More...)
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• Thus, with a 1 million investment, the lessor
  could finance two such leases and obtain double
  the amount of NPV 2(21,875) 43,750 in
  profit.
• With the leveraged lease, we get two IRRs
  -3.5 and 29.6. The MIRR of the leveraged
  lease is about 6.
• However, leveraging increases the risk to the
  lessor, so the decision to leverage involves a
  risk/return tradeoff.

38
Leveraged Lease

• A leveraged lease is a three-party financial
  lease consisting of the lessee who acquires the
  use of the asset, the lessor who holds an equity
  interest in the asset (at least 20), and a
  lender (or lenders) who finance the purchase of
  the asset by the lessor.
• 85 of the value of all financial leases
• Cash flows to the lessor might be nonnormal. -
  - (negative, positive, negative, positive)

39
Leveraged Lease - continued

• Advantages to Lessor
• Tax benefits from MACRS depreciation
• Tax benefits from interest paid to lender
• Lease income
• Put up only 20 to 50 of the asset
• Limited exposure
• Salvage value

40
Leveraged Lease - continued

• Advantages to Lessee
• Low effective interest rate
• Cant use tax benefits and pass them on
• Use of the asset
• Advantages to Lender(s)
• Good return
• First lien on the asset
• Assignment of the lease rental payments

41
Other Issues in Lease Analysis

• Do higher residual values make leasing less
  attractive to the lessee?
• Is lease financing more available or better
  than debt financing?
• Is the lease analysis presented in this chapter
  applicable to real estate leases? To auto leases?
• Would spreadsheet models be useful in lease
  analysis?

More
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• What impact do tax laws have on the
  attractiveness of leasing?
• Tax rate differentials between the lessee and the
  lessor
• Alternative minimum tax (AMT)
• Lessors often have a more favorable position than
  lenders should the lessee actually go bankrupt.
• Lessors that specialize in certain types of
  equipment may be in a better position to dispose
  of repossessed equipment than banks or other
  lenders.
• Perhaps the lessor can maintain the leased
  equipment more efficiently than the lessee.

43
Numerical analysis often indicate that owning is
less costly than leasing. Why, then, is leasing
so popular?

• Provision of maintenance services
• Risk reduction for the lessee
• Project life
• Residual life
• Operating Risk
• Portfolio risk reduction enables lessor to better
  bear these risks.
• Leasing provides operating flexibility.

44
Feedback Effects on Capital Budgeting

• If the cost of leasing is less than the cost of
  debt, it is possible that leasing might make a
  previously rejected project acceptable.
• If all projects could be leased, the firm should
  use the cost of leasing in place of the cost of
  debt when calculating the cost of
  capital.

45

• If only one project can be leased, the true NPV
  of the project (if leased) is the NPV based on
  the regular cost of capital plus the leases
  NAL.
• If neither of the two extreme positions hold, no
  simple rule can be used to incorporate feedback
  effects.

46
Conclusion

• Types of Leases
• Tax-Oriented Lease
• Accounting Treatment of Leases
• Net Advantage to Leasing
• Leveraged Leasing
• Other Issues in Leasing