Leasing

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Leasing
Chapter 22 Class 18 19
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Summary

• Lessor vs. Lessee
• types of leases
• tax accounting implications
• Prefer? buy or lease
• Do? Buy, lease, or reject both.
• NPV analysis NAL from 2 viewpoints

• Is leasing a zero-sum game?
• Can it be mutually beneficial(to both lessor and
  lessee)?

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Some Notation

• Lease rental agreement.
• Lessor individual who owns the property and
  rents it out.
• Lessee the user of the property.

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Lease Types

• Operating or service lease usually a short term
  cancelable lease. Service is normally
  responsibility of lessor.
• Financial or capital lease financing
  arrangement for lessee to buy equipment Generally
  longer term. Often non-cancelable. Lessee usually
  responsible for maintenance. Opposite of a
  service lease.
• Sale and leaseback owner of asset sells asset
  to another party and then leases it back.
• Leveraged lease lessor borrows money to
  purchase asset.

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Accounting and Leasing

• Operating leases off balance sheet perhaps only
  showing up as a footnote.
• Financial Leases (called capital leases in CICA
  rule 3065) PV of lease payments must be reported
  as debt obligation on lessees balance sheet.
• For accounting purpose, a lease is declared to be
  a financial lease if at least one of the
  following criteria is met
• The lease transfers ownership of the property to
  the lessee by the end of the term of the lease.
• The lessee has an option to purchase the asset at
  a price below fair market value.
• The leases term is 75 percent or more of the
  estimated economic life of the asset.
• The present value of the lease payments is at
  least 90 percent of the assets fair market value
  at the start of the lease.

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Operating leases Tax and Accounting Implications

• Lessor maintains ownership of asset and claims
  CCA tax shield.
• Lease is business expense for lessee.
• Leases are off balance sheet for lessee perhaps
  only showing up as a footnote.
• Not fully amortized-payments made by lessee are
  enough to cover the cost.
• Cancellation option

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Financial/Capital leaseTax and Accounting
Implications

• Lessee is responsible for maintenance
• Lease is treated as alternative financing
  arrangement asset is treated as if it were
  owned by lessee.
• PV of lease payments must be reported as debt
  obligation on lessees balance sheet.
• CCA is claimed by lessee, only interest portion
  of lease payment is tax deductible.
• Fully amortized
• No cancellation option
• Right to renew

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Buying versus Leasing
Buy
Lease
Firm U buys asset and uses asset financed by
debt and equity.
Lessor buys asset, Firm U leases it.
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Should a Firm Lease or Buy Some Considerations

• Potential lessees perspective.
• Good reasons for leasing
• Tax benefits.
• Increase flexibility ability to expand or shut
  down.
• Obsolescence risk.
• Reduction of uncertainty in salvage values.
• Not so good reasons for leasing
• Conservation of capital.
• Protection of debt capacity.
• Less restrictive than debt covenants.
• Impact on accounting income.

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NPV Analysis NALlessee or NALee

• Should the firm buy the asset or sign a
  (financial) lease?
• Look at incremental cash flows!
• Do not look at cash flows that accrue because
  firm has use of asset.
• As with every other budgeting decision, lease if
  the the present value of the benefits of leasing
  exceeds the cost of leasing
• NALee benefits to leasing cost of leasing
• Appropriate discount rate for NPV calculations is
  the after tax cost of debt. (leasing imposes same
  sort of commitment as does a long term debt
  contract).

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Calculating Cash Flows

• Benefit of leasing no immediate capital outlay
• Firm saves capital cost of leased assed CLAo
• Cost of leasing is the present value of the after
  tax lease expenses, which are made at the
  beginning of the year (an annuity due)

• loss of the present value of the CCA tax shields
  that would have accrued to the firm had the asset
  been purchased.

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NALee

• The net advantage to leasing is obtained as
• The NALee finds the cost of the asset (which is
  saved) minus the cost of leasing the asset (which
  includes both out of pocket and opportunity costs
  versus)
• If NALee is positive, leasing is preferred to
  buying.
• If NALee is negative, buying is preferred to
  leasing.

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Example 1

• Your company wants to purchase a new network file
  server for its wide area computer network. The
  server costs 24,000. At the end of 3 years, it
  will have a salvage value of 7,000.
• NPV of buying the machine is positive.
• Your options are to borrow the money at 10 or
  lease the machine. If you lease it, the payments
  will be 6,500 a year, payable at the beginning
  of each year. If you buy the server, you can
  apply a CCA rate of 30 per year. The tax rate is
  40. Assuming the asset pool remains open, should
  you buy or lease?
• What is the maximum acceptable lease payment?

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NALee Components

• NALee CLA (PVLPAT PVCCATS PVSV)
• CLA is Cost of Leased Asset
• PVLPAT is Present Value of Lease Payments after
  Tax
• PVCCATS is Present Value of CCA Tax Shields
• PVSV is Present Value of Salvage Value

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Example 1 Solution

• NALeeCLA-(PVLPATPVCCATSPVSV)
• NALee24,000 (11,0505,8155,877)
• NALee1,258 ergo, prefer to lease rather than
  buy, but should you lease?
• Need NPVinvest from Chapter 8. Problem states
  that NPVinvestgt0.
• OverallNPV NPVinvest NALee
• If NPVinvest1,000, OverallNPV2,258 ergo, should
  lease
• If NPVinvest -1,000, OverallNPV258 ergo, should
  lease
• If NPVinvest -2,000, OverallNPV-742 ergo,
  neither buy nor lease

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Example 1 Lessees Lmax

• What is the lessees maximum acceptable lease
  payment, Lmax?
• If NPVinvest gt 0, set NALee 0 and solve for L.
  Thats Lmax!
• If NPVinvest lt 0, set OverallNPV 0 and solve
  for L. Thats Lmax!
• Lmax 7,240 At L6,500, NALee gt 0 but at L
  7,240, NALee 0. If L gt 7,240, dont lease.

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Example 2

• Nukem Inc. is contemplating leasing a diagnostic
  scanner.
• The scanner costs 800,000 and it qualifies for a
  30 CCA rate. It is valueless after 4 years.
• NPVinvest -35,000
• You can lease it for 250,000, payable at the
  start of each year for 4 years. The firms
  after-tax cost of debt is 10, and its tax rate
  is 35. Should the firm lease or buy? What is
  the maximum acceptable lease?

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Example 2 Solution

• NALee CLA-(PVLPATPVCCATSPVSV)
• NALee 800K-(566.6K200.45K0)
• NALee 32.95K thus prefer to lease rather than
  buy
• OverallNPV NPVinvest NALee
• OverallNPV -35K 32.95K -2.05K
• Conclusion Although prefer to lease rather than
  buy, but should neither lease nor buy!

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Example 2 Whats Lmax?

• Set OverallNPV 0 since NPVinvestlt0
• Set -35K NALee 0 and solve for L NALee,
  specifically PVLPAT, contains unknown L
• Solve 599.55K 2.27L 35K for L.
• Lmax 248,700. If L gt 248,700, Nukem should
  not lease.

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Lessors Perspective NALor

• What is the present value of cash flows that are
  received by the lessor?
• Lessor pays for cost of asset CLA0.
• Lessor earns present value of after tax lease
  L(1-t) which is received at the beginning of
  every year.
• Lessor receives present value of CCA tax shield
  on leased asset.
• Is NALor -NALee (leasing a zero-sum game)?

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NALor

• Net Advantage of Leasing from the lessors
  perspective
• NALor -CLA (PVLPATPVCCATSPVSV)
• NALee -NALor only if lessor and lessee face the
  same before-tax cost of debt (Kb), tax rate (T),
  cost of the lease asset (CLA) and salvage value
  (SV).
• Under these conditions, weve got ourselves a
  zero sum game. If the lease is attractive to one
  party, it is not attractive to the other party.
  The only feasible lease payment is that which
  makes both NALs equal zero!

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Setting Lease Rates Example 3

• Acme Leasing leases network file servers. The
  server costs 24,000. It will be obsolete in 3
  years with no salvage value.
• Acmes after-tax required return on debt
  instruments is 10. A CCA rate of 30 per year
  applies to the network file server.
• Since Acme leases out many servers, the asset
  pool remains open.
• If the tax rate is 40, what is the minimum lease
  payment that Acme will charge or Lmin?

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Example 3 Lessors Lmin

• Set NALor 0, solve for L
• NALor -CLA (PVLPATPVCCATSPVSV)
• PVLPAT contains the unknown L
• 0 -17.127K 1.641L implies L 10.437K
• Lmin 10,437 is the lessors minimum acceptable
  lease rate. If L lt 10,437, the lessor will not
  find the lease acceptable.

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How Can Leasing Be Mutually Beneficial to Both
Parties?

• Leasing can be mutually beneficial (positive
  NALs for both lessor and lessee) if the lessor
• Pays a higher rate of tax than the lessee
• Can borrow funds at a lower cost than the lessee
• Can buy the asset at a lower price
• Can sell the asset at a higher salvage value

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Break Even Lease Example 4

• An asset costs 173.74. The CCA rate is 20. The
  assets useful life is 2 years. The lease
  contract requires payment at start of each year.
  NPVinvest is positive.
• There is no salvage value. The corporate tax rate
  is 40. The before-tax cost of debt is 10.
• a) For what range of lease payments does the
  lease have a positive NPV for both parties?
• b) Answer the same question but this time assume
  that the cost of the asset to the lessor is only
  100.00 as the lessor obtains a quantity discount
  from the manufacturer of the asset.

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Example 4 Part a.) Solution

• As lessor and lessee face the same situation, we
  have a zero-sum game.
• There is no L that will make both NALs positive.
  
• The L that makes both NALs 0 is obtained by
  setting NALee or NALor 0 then solving for L.
• 0 173.74 1.166L 51.95
• L 104.45 is both the lessors Lmin and the
  lessees Lmax

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Example 4 Part b.) Solution

• Lessor now pays only 100 for the asset must
  recalculate the lessors Lmin
• NALor -1001.166L29.90
• NALor 0 implies L60.12
• Lessees Lmax 104.45 vs. Lessors Lmin 60.12
• Thus, 60.12 lt L lt 104.45

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Example 5

• A piece of equipment with a CCA rate of 30 costs
  300,000 with a 5 year useful life and no salvage
  value.
• The annual operating cash flows are expected to
  be 150,000 per year.
• The firms cost of capital is 16, and its tax
  rate is 40. The lease rate payable in advance is
  90,000 per year for 5 years. The after tax cost
  of borrowing is 9.
• Should the project be undertaken if the only way
  to acquire the right to use the asset is via a
  lease (the asset cannot be purchase)?

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Example 5 Solution (in 000s)

• NALee CLA (PVLPAT PVCCATS)
• NALee 300228.9588.5-17.45
• Conclusion Better to buy than to lease.
• But asset cant be bought.
• If lease rather than do nothing, achieve
  OverallNPV.
• OverallNPV NPVinvest NALee
• NPVinvest calculated in Chapter 8.
• NPVinvest -300294.68672.862667.55
• OverallNPV67.55-17.4550.1 thus better to lease
  rather than do nothing.