21 Leasing and Other Asset-Based Financing Corporate Financial Management 3e Emery Finnerty Stowe Modified for course use by Arnold R. Cowan.
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2121Leasing and Other
Asset-Based Financing
Corporate Financial Management 3e Emery Finnerty Stowe
Modified for course use by Arnold R. Cowan
2
Lease Financing
A lease is a rental agreement that extends for one year or longer.
The owner of the asset (the lessor) grants exclusive use of the asset to the lessee for a fixed period of time. In return, the lessee makes fixed periodic payments to
the lessor.
At termination, the lessee may have the option to either renew the lease or purchase the asset.
3
Types of Leases
Full-service lease Lessor responsible for maintenance, insurance,
and property taxes.
Net lease Lessee responsible for maintenance, insurance,
and property taxes.
4
Types of Leases
Operating lease short-term may be cancelable
Financial lease long-term similar to a loan agreement
6
Direct Lease
Lessee Manufacturer/ Lessor
Lease
Lessee LessorLease Sale of Asset Manufacturer/ Lessor
or
8
Leveraged Lease
LenderLien
Equity Investor
Lessee Lease
Single Purpose Leasing
Company
Manufacturer
Sale of A
sset
Equity
Loan
9
Synthetic Leases
Firms have used synthetic leases to get the use of assets but keep debt off their balance sheets.An unrelated financial institution invests some equity and sets up a special-purpose-entity that buys the assets and leases it to the firm under an operating lease.Since the Enron bankruptcy, firms have been reluctant to use synthetic leases.
10
Enron’s Murky Deals
Lending Group
Equity Investor
Enron
Partnership or Special Purpose Entity
Enron used outside partnerships to move assets
off its balance sheet and monetize assets. But the
company was deeply involved with funding
those partnerships.
Enron sells assets, gets debt off the balance
sheet and recognizes a gain on the sale.
Outside investors inject at least 3% of the
funding so that Enron doesn’t have to claim it
as a subsidiary.
1
3Enron provided some or all of the 3%.
Banks provided the other 97% of the
financing.
45Enron guarantees the loan. Sometimes with now-worthless Enron shares.
2
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Enron’s Partnerships
Reasons for setting up SPEs: By setting up partnerships, partly owned by
the company, Enron could draw in capital from outside investors.
If structured properly (the tax code requires that at least 3% of the partnership equity be obtained from outside investors), the partnerships could also be kept separate from Enron.
12
Enron’s Partnerships
As a result, any debt incurred by the partnership could be kept off the company's balance sheet. As an added bonus, Enron often recognized a gain on the sale of the assets.
13
Why did Enron want debt off their balance sheet?
The simple answer is that Enron feared that too much debt would damage its credit rating.
14
Why did Enron want debt off their balance sheet?
A more complex answer lies with agency costs. Enron executives headed and partly owned some of the partnerships, which provided a huge source of outside income for those involved. Enron’s former CFO, Andrew Fastow, made more
than $30 million from two partnerships that he ran.
If you were a shareholder in a SPE buying an asset from your employer, where would your loyalties lie?
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How Widespread Was This at Enron?
There were hundreds, and perhaps even thousands, of these partnerships.
The exact number isn't known.
In all, Enron had about 3,500 subsidiaries and affiliates, many of them limited partnerships and limited-liability companies, which are a sort of hybrid between corporations and partnerships.
16
How Did They Get Away With It?
The company and its board of directors claimed that allowing executives to be involved with the outside partnerships gave it the advantage of speed.
Enron claimed that it set up safeguards to protect itself, but in retrospect they were clearly inadequate.
17
Advantages of Leases
Efficient use of tax deductions and tax credits of ownershipReduced riskReduced cost of borrowingBankruptcy considerationsTapping new sources of fundsCircumventing restrictions debt covenants off-balance sheet financing
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Disadvantages of Leasing
Lessee forfeits tax deductions associated with asset ownership.
Lessee usually forgoes residual asset value.
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Valuing Financial Leases
Basic approach is similar to debt refunding.
Lease displaces debt.
Missed lease payments can result in the lessor claiming the asset. filing lawsuits. forcing firm into bankruptcy.
Risk of a firm’s lease payments are similar to those of its interest and principal payments.
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Equivalent Ways to Analyze
Net Advantage to Leasing (NAL) approach: Lease if
NAL > 0.
The Internal Rate of Return (IRR) approach: Lease if
IRR of leasing < after-tax cost of debt financing.
21
Leases Analysis Example
The Emerson Co. needs the use of a special purpose stamping machine for the next 10 years.
The machine costs $6 million, has a life of 10 years, and a salvage value of $300,000.
Emerson can lease this machine from the General Supply Co. for 10 years, with annual year-end lease payments of $1.05 million. Emerson’s tax rate is 40%.
22
Leases Analysis Example
If Emerson were to buy the machine, it would finance 80% of the purchase price with a 11.5% secured installment loan, with the remainder being borrowed as unsecured installment debt at 14% interest.
The after-tax required return on the asset is 15%.
Evaluate this leasing opportunity.
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Leasing Displaces Borrowing
Suppose initially that the Emerson Co. has net assets worth $50 million, and a debt ratio of 50%. Compute the debt ratio if Emerson uses:
Conventional financing for the stamping machine.
Leases the stamping machine. How would the target debt ratio be restored?
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Leasing Displaces Borrowing
InitialCapitalization
Conventional DebtFinancial Lease Obligation
Total Debt
EquityTotal
$ 25 M
$ 0 M$25 M
$25 M$50 M
Debt Ratio 50%
25
Leasing Displaces Borrowing
ConventionalFinancing
Conventional DebtFinancial Lease Obligation
Total Debt
EquityTotal
$ 28 M
$ 0 M$25 M
$28 M$56 M
Debt Ratio 50%
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Leasing Displaces Borrowing
LeaseFinancing
Conventional DebtFinancial Lease Obligation
Total Debt
EquityTotal
$ 25 M
$ 6 M$31 M
$25 M$56 M
Debt Ratio 5 5.36%
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Leasing Displaces Borrowing
Debt RatioRestored
Conventional DebtFinancial Lease Obligation
Total Debt
EquityTotal
$ 22 M
$ 6 M$28 M
$28 M$56 M
Debt Ratio 50%
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Analyzing Leases
The Net Advantage to Leasing (NAL) equals the purchase price (P) minus the present value of the incremental after-tax cash flows (CFAT) associated with the lease.
NAL = P – PV(CFATs)
29
Analyzing Leases - the Discount Rate
The discount rate should be the lessee’s after-tax cost of similarly secured debt.Since the lease obligation is not overcollateralized, the secured debt rate should reflect this.Fully secured means the asset is worth more than 25% of the loan. $80M loan on $100M asset: $20/$80 = 25%
Use weighted average of secured and unsecured debt rates if necessary.
30
Analyzing Leases - the Cash Flows
Cost of asset (saving)
Lease payments (cost)
Incremental differences in operating and other expenses (cost or savings)
Depreciation tax shelter (foregone benefit)
Expected net residual value (foregone benefit)
Investment tax credits (foregone benefit)
Net Advantage to LeasingDt = year t depreciation deduction
Et= year t cash expense savings from leasing
ITC = investment tax credit, if available
CFt = lease payment in year tN = life of lease (in years)P = purchase price of assetr = asset’s after-tax required return
r′ = cost of debt (secured & unsecured)Salvage = net salvage valueT = lessee’s marginal income tax rate
'1
(1 )( )
(1 (1 ) ) (1 )
Nt t t
t Nt
T CF E TD SalvageNAL P ITC
T r r
Net Advantage to Leasing
We save paying the purchase price P.We lose the ITC and salvage value.We pay the lease payment CF; this may be partly offset by savings on operating and other cash expenses (E) and by tax deductibility.We lose the depreciation tax shield TD.Discount main cash flows at the after-tax cost of debt.
'1
(1 )( )
(1 (1 ) ) (1 )
Nt t t
t Nt
T CF E TD SalvageNAL P ITC
T r r
33
Net Advantage to Leasing
For the Emerson Co., P = $6 million CFt = $1.05 million per year for 10 years
Dt = ($6,000,000 - $300,000) / 10 = $570,000 per year for 10 years
Et = 0, ITC = 0 r = 15% r′ = 80%(11.5%) + 20%(14%) = 12.0%
34
Net Advantage to Leasing
'1
(1 )( )
(1 (1 ) ) (1 )
Nt t t
t Nt
T CF E TD SalvageNAL P ITC
T r r
10
10
1 )15.1(
000,300$
)12.0)40.01(1(
000,570$4.0)05.1)($40.1(6$
t
t
mmNAL
068,45$NAL
35
The IRR Approach
For Emerson’s leasing opportunity, the IRR is 7.58%.
The after-tax cost of debt financing is
12%×(1– 0.40) = 7.20%.
Since the IRR (the cost of lease financing) is greater than the after-tax cost of debt financing, Emerson should not lease the machine.
36
Break-Even Lease Payments
The break-even lease payments can be computed by setting the NAL to zero.
In the case of Emerson’s lease, the annual break-even payments are $1,039,206. Since the lease contract calls for payments of
$1,050,000; the leasing alternative is not preferred.
37
NPV of Lease to the Lessor
In a perfect market with no tax, leasing is a zero-sum game. The NPV of the lease to the lessor will be
- (NAL to the lessee).
If lessee and lessor have the same marginal income tax rates, leasing is still a zero sum game in an otherwise perfect market.
38
NPV of Lease to the Lessor
where T′ = lessor’s marginal income tax rate.
' '
Lessor ' '1
(1 )( )
(1 (1 ) ) (1 )
Nt t t
t Nt
T CF E T D SalvageNAL P ITC
T r r
39
NPV of Lease to the Lessor
10
10
1Lessor )15.1(
000,300$
)12.0)40.01(1(
000,570$4.0)05.1)($40.1(6$
t
t
mmNAL
068,45$Lessor NAL
' '
Lessor ' '1
(1 )( )
(1 (1 ) ) (1 )
Nt t t
t Nt
T CF E T D SalvageNAL P ITC
T r r
40
Effect of Tax Asymmetries
Suppose lessee’s (Emerson’s) tax rate is zero. Also assume that the before-tax required return on the asset for the lessee is 17.50%.
The NAL to Emerson is then $7,460.
The NPV to the lessor is still $45,068.
Thus, both parties gain from the leasing arrangement.
41
Tax Treatment of Financial Leases
IRS has guidelines for distinguishing between true leases and installment sales agreements. secured loans.
If lessor meets these guidelines: lessor can claim tax deductions and credits of
asset ownership. lessee can deduct full amount of lease payment
for tax purposes.
42
IRS Guidelines for Financial Leases
Term of lease < 80% of asset’s useful life.Lessor must maintain an equity investment of at least 10% of asset’s original cost.Exercise price of the purchase option must equal the asset’s fair market value at the time the option is exercised.Lessee does not pay any portion of the asset’s purchase price.Lessor must hold title to the property.
43
Accounting Treatment of Financial Leases
SFAS 13 requires lessees to capitalize all leases that meet any one of the following: Lease transfers ownership of asset to lessee before
the lease expires. Lessee has option to purchase asset at a bargain
price. Term of lease is greater than or equal to 75% of
assets useful economic life. PV of lease payments is ≥ 90% of asset value.
44
Project Financing
Desirable when Project can stand alone as an economic unit. Project will generate enough revenue (net of
operating costs) to service project debt.
Examples: Mines & mineral processing facilities Pipelines Oil refineries Paper mills
45
Project Financing Arrangements
Completion undertaking
Purchase, throughput, or tolling agreements
Cash deficiency agreements
46
Advantages and Disadvantages of Project Financing
Advantages Risk sharing Expanded debt capacity Lower cost of debt
Disadvantages Significant transaction costs and legal fees Complex contractual agreements Lenders require a higher yield premium
47
Limited Partnership Financing
Another form of tax-oriented financing.Allows the firm to “sell” the tax deductions and credits associated with asset ownership to the limited partners.Income (or loss) for tax purposes flows through to the partners.Limited partners are passive investors.General partner operates the limited partnership and has unlimited liability.
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