1 Leases. What is a Lease? A lease is a contract where the lessor agrees to let the lessee use their asset in exchange for compensation Lessee: Needs.

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Leases

What is a Lease?

A lease is a contract where the lessor agrees to let the lessee use their asset in exchange for compensationLessee: Needs the asset, pays a quasi-rent to the

lessor to use the assetLessor: Owns the asset, lets the lessee use the asset

in exchange for a quasi-rent Two types of leases: Operating & Financial

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Operating Lease The lease payments are not enough to recoup

the full cost of the assetGenerally short-term contracts, and the lessor

expects to either sell the asset or renew the lease The lessor maintains and insure the asset The lessee can return the asset and cancel the

lease at will

Financial Leases

Lease payments are enough to cover the cost of the asset

The lessee maintenance and insures the asset

Generally cannot be cancelled The lessee usually has a right to renew the

lease at expiry

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Sale and Lease Back A Special Financial Leases A firm sells an asset, and then leases it back

immediatelyWhy would a firm do this?

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Buy or Lease Decision ClumZee Movers, needs a truck, which will

reduce costs by $6,500/year. The truck costs $25,000 and has a 5 yr life If the firm buys the truck, they will use straight-

line depreciation to a zero salvage value. ClumZee tax rate is 34% Alternatively they can lease the truck from Tiger

Leasing for $8,250/year Should Clumzee buy or lease the truck?

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Buy Cash flow

Year 0 Year 1 – 5

Initial Purchase

After Tax Op Saving

Dep. Tax Shield

Incremental CF

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Leasing Cash flow

Year 0 Year 1 – 5

Initial Purchase

After Tax Op Saving

After Tax Lease Payments

Incremental CF

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Leasing minus Buying Cash Flows

Year 0:Lease CF____Buy CF _____Lease – Buy CF ______

Year 1-5:Lease CF____Buy CF _____Lease – Buy CF ______

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Leasing Incremental Cash FlowsYear 0 Years 1-5

$25,000 –$1,155 – $5,990 = –$7,145

• Should ClumZee lease the truck?

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Why discount at the debt rate?

A lease payment is like the debt service (interest payment) 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 debt rate

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NPV Analysis: Lease-v-Buy Decision Discount the incremental lease cash flows ClumZee’s pre tax debt rate is 7.6%

The after tax rate is 5% → 0.076 * (1-0.34)

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Given: Leasing v Buy Example

Xomox Corp needs a new pipe machine to meet it’s demands (Tax Rate =34%, uses straight line depreciation)

IBMC makes such a machine for $10,000, with an expected life of 5 years, no salvage value

This machine will save Xomox $6,000 in manufacturing costs

Friendly Leasing Corp will lease the same machine to Xomox for $2,500 for 5 years

What are the incremental cash flows?

Given: Lease v Buy Cash FlowsYear 0 1 2 3 4 5

Buy

Costs -$10,000

Op Savings After Tax $3,960 $3,960 $3,960 $3,960 $3,960

Dep Tax Benefit $680 $680 $680 $680 $680

Total -$10,000 $4,640 $4,640 $4,640 $4,640 $4,640

LeasePayments -$2,500 -$2,500 -$2,500 -$2,500 -$2,500

Tax Benefit $850 $850 $850 $850 $850

Op Savings After Tax $3,960 $3,960 $3,960 $3,960 $3,960

Total $2,310 $2,310 $2,310 $2,310 $2,310

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Given: Lease – Buy Cash Flows

Year 0 1 2 3 4 5

Lease

Payments -$2,500 -$2,500 -$2,500 -$2,500 -$2,500

Payment’s Tax Benefit

$850 $850 $850 $850 $850

Buy

Cost -$10,000

Lost Dep Tax Shield -$680 -$680 -$680 -$680 -$680

Total $10,000 -$2,330 -$2,330 -$2,330 -$2,330 -$2,330

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Given: Discounting the DifferenceXomox can borrow at 7.57575%, taxes are 34%So the after tax discount rate is 5%

0.0757575 * (1-.34) = 0.05

Year 0 1 2 3 4

Cash Flow $10,000 -$2,330 -$2,330 -$2,330 -$2,330

Discount CF -$87.68 Xomox prefers to buy

Alternative Lease Evaluation Method: Debt Displacement Since leases replace conventional debt, compare how

much the company could borrow Suppose ClumZee leases the truck for $8,250/year

Incremental cost is the payment + lost tax shield

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The Lessor’s Cash Flows

The NPV for Tiger is the exact opposite

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Year 0 Year 1

Truck -25,000

Dep Tax Shield 5,000*(1-.34)= 1,700

Lease Payment 8,250*(1-.34) = 5,445

-$25,000 $7,145

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Good Reasons to Lease1. Taxes can be reduced:

-Corporations are in different tax brackets

2. Reduces uncertainty (kind of)-Residual Value: the value of the asset at expiration-Leasing allows the person best able to bear the risk,

to bear the risk

3. Transactions costs can be higher for buying an asset and financing it with debt or equity than for leasing the asset.

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Bad Reasons to Lease

1. Manipulation of Accounting Numbers-Reduces the liabilities of the balance sheet

-Improves the firm’s ROA

2. Avoid Capital Expenditure Controls

3. Possible to use Leases as Off-Balance Sheet Financing

Taxes, the IRS, and Leases

A 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 (Depreciation) to a party who can.

The IRS tries to limit this

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Taxes, the IRS, and Leases The lessee can deduct lease payments if the lease is qualified by the IRS.

1. The lease must be less than 30 years.

2. There can be no bargain purchase option.

3. The lease should not have a schedule of payments that is very high at the start and low thereafter.

4. The lease payments must provide the lessor with a fair market rate of return.

5. The lease should not limit the lessee’s right to issue debt or pay dividends.

6. Renewal options must be reasonable and reflect fair the market value of the asset.

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Tax Arbitrage

ClumZee’s tax rate is 25% Tiger Leasing’s tax rate is 34% If the lease payments drop to $8,200, can the

lease happen?

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A Tax Arbitrage: Clumzee

Cash Flows ClumZee Movers: Leasing Instead of Buying

Year 0 Years 1-5Cost of truck we didn’t buy $25,000Lost Depreciation Tax Shield 5,000×(.25) = –$1,250After-Tax Lease Payments 8,200×(1 –.25) = –$6,150

$25,000 –$7,400

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A Tax Arbitrage: Tiger

Cash Flows: Tiger LeasingYear 0 Years 1-5

Cost of truck –$25,000Dep Tax Shield 5,000×(.34) = $1,700Lease Payments 8,200×(1–.34)= $5,412

–$25,000 $7,112

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Is a Lease Possible?

We need to determine each firm’s break even payment

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ClumZee Leasing’s Breakeven Payment Solve for a 0 NPV payment N = 5, I/Y = 5.7, PV=25,000, PMT = ?, FV = 0

Subtract the Dep Tax Shield to get the after tax lease payment

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Tiger Leasing’s Breakeven Payment Solve for a 0 NPV payment N = 5, I/Y = 5, PV=25,000, PMT = ?, FV = 0

Subtract the Dep Tax Shield to get the after tax lease payment

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Is a Lease Possible?

The most that ClumZee movers can afford to pay is:

The least that Tiger Leasing can accept is:

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Salvage Value

For the purpose of this class we will ignore the effects of salvage value, beyond how it impacts depreciation

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Quick Quiz

Compare operating and financing leases. Explain why tax rates affect the lease vs. buy

decision.

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