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Prepared by Prepared by Ken Hartviksen Ken Hartviksen INTRODUCTION TO INTRODUCTION TO CORPORATE FINANCE CORPORATE FINANCE Laurence Booth Laurence Booth W. Sean W. Sean Cleary Cleary Chapter 16 – Leasing Chapter 16 – Leasing
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Page 1: Chapter 16 - Leasing

Prepared byPrepared byKen HartviksenKen Hartviksen

INTRODUCTION TOINTRODUCTION TO CORPORATE FINANCECORPORATE FINANCELaurence Booth Laurence Booth •• W. Sean Cleary W. Sean Cleary

Chapter 16 – LeasingChapter 16 – Leasing

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CHAPTER 16CHAPTER 16 LeasingLeasing

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Lecture AgendaLecture Agenda

• Learning ObjectivesLearning Objectives• Important TermsImportant Terms• Leasing ArrangementsLeasing Arrangements• Accounting for LeasesAccounting for Leases• Evaluating the Lease Evaluating the Lease

DecisionDecision• Motivation for LeasingMotivation for Leasing• Summary and Summary and

ConclusionsConclusions– Concept Review QuestionsConcept Review Questions

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Learning ObjectivesLearning Objectives

You should understand:You should understand:

• The basic characteristics of The basic characteristics of leases and how to differentiate leases and how to differentiate between operating and financial between operating and financial (or capital) leases(or capital) leases

• The accounting treatment of both The accounting treatment of both operating and financial leasesoperating and financial leases

• The benefits and disadvantages The benefits and disadvantages of leasesof leases

• How the lease decision can be How the lease decision can be evaluated using the discounted evaluated using the discounted cash flow valuation methods.cash flow valuation methods.

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Important Chapter TermsImportant Chapter Terms

• Asset-based lendingAsset-based lending• Captive finance Captive finance

companiescompanies• Financial leaseFinancial lease• LesseeLessee• LessorLessor• Leveraged leaseLeveraged lease• Off-balance-sheet Off-balance-sheet

financingfinancing

• Operating leaseOperating lease• Sale and leaseback Sale and leaseback

(SLB) agreement(SLB) agreement• Secured financingSecured financing• Small and medium-sized Small and medium-sized

enterprises (SMEs)enterprises (SMEs)

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Introduction to Leasing ArrangementsIntroduction to Leasing Arrangements

LeasingLeasing

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Leasing ArrangementsLeasing ArrangementsIntroductionIntroduction

• The decision to invest in an asset that has a long life is The decision to invest in an asset that has a long life is a capital budgeting decision.a capital budgeting decision.

• The The decision decision to acquireto acquire is a separate decision from the is a separate decision from the decision on the decision on the method of financingmethod of financing the acquisition. the acquisition.

• When these two decisions are combined, this is called When these two decisions are combined, this is called asset-based lending asset-based lending because the financing is tied because the financing is tied directly to a particular asset.directly to a particular asset.

• Examples of asset-based lending include:Examples of asset-based lending include:– Secured loansSecured loans– Conditional sales contractsConditional sales contracts– LeasesLeases

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Leasing ArrangementsLeasing ArrangementsThe Institutional FrameworkThe Institutional Framework

• Canadian Finance and Leasing Association (CFLA) Canadian Finance and Leasing Association (CFLA) acts as the trade association for asset-based lendersacts as the trade association for asset-based lenders– 160 members160 members– Represents three group of financial companies:Represents three group of financial companies:

1.1. Independent asset-based finance companiesIndependent asset-based finance companies– Involved in machinery and equipment financing with 60% of customers Involved in machinery and equipment financing with 60% of customers

begin SMEs.begin SMEs.– 40% of the assets financed are transportation equipment (buses, 40% of the assets financed are transportation equipment (buses,

trucks, trailers or office equipment)trucks, trailers or office equipment)

2.2. Captive finance companies of major manufacturers (eg. GMC Captive finance companies of major manufacturers (eg. GMC Finance and Ford Credit Canada) where 1/3 of all new vehicles Finance and Ford Credit Canada) where 1/3 of all new vehicles are leased. are leased.

3.3. Chartered banksChartered banks– Chartered banks are not allowed to lease consumer household Chartered banks are not allowed to lease consumer household

property and are therefore focussed on leasing commercial property and are therefore focussed on leasing commercial transportation equipment and real property such as land and buildingstransportation equipment and real property such as land and buildings

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LeaseLeaseWhat is it?What is it?

A lease contract is an agreement where the owner A lease contract is an agreement where the owner conveys to the user the right to use an asset in return conveys to the user the right to use an asset in return for a number of specified payments over an agreed for a number of specified payments over an agreed period of time. period of time.

LessorLessor is the owner of the asset is the owner of the asset

LesseeLessee is the user of the asset is the user of the asset

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Types of LeasesTypes of Leases

LeasingLeasing

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LeasingLeasingTypes of LeasesTypes of Leases

Operating LeaseOperating Lease• A lease where some of the benefits of ownership do not A lease where some of the benefits of ownership do not

transfer to the lessee and remain with the lessor. transfer to the lessee and remain with the lessor.

Financial (Capital) LeaseFinancial (Capital) Lease• A lease where essentially all the benefits of ownership A lease where essentially all the benefits of ownership

transfer to the lessee; also known as a capital or full payout transfer to the lessee; also known as a capital or full payout lease.lease.

(See Table 16 -1 on the following slide for the distinguishing features between (See Table 16 -1 on the following slide for the distinguishing features between the two types of leases) the two types of leases)

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Types of LeasesTypes of LeasesOperating versus Financial LeasesOperating versus Financial Leases

Lessee Lessor Lessee Lessor

Asset Not on balance

sheet (B/S); disclose in footnotes

Report on B/S Report on B/S Not on B/S

Lease payments Expense the

full amount as rental expense

Claim as rental

income

Decompose

into interest and principal repayment, and expense the interest portion

Claim the

interest portion of payments received as interest income

Depreciation

expense (associated with leased asset)

Cannot claim Claim Claim Cannot claim

Table 16-1 Operating versus Financial Leases

OPERATING FINANCIAL

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Conditional Sales AgreementConditional Sales AgreementWhat is it? CRA PerspectiveWhat is it? CRA Perspective

According to CRA a conditional sales agreement exists if one of According to CRA a conditional sales agreement exists if one of the following occurs:the following occurs:

• The lessee automatically acquires ownership at some pointThe lessee automatically acquires ownership at some point• The lessee is required to buy the asset at some point or guarantee The lessee is required to buy the asset at some point or guarantee

that the lessor gets a certain value for itthat the lessor gets a certain value for it• The lessee has the right to buy the asset at some point for The lessee has the right to buy the asset at some point for

substantially less than the likely fair market valuesubstantially less than the likely fair market value• The lessee has the right to buy the asset at a price that would cause The lessee has the right to buy the asset at a price that would cause

a reasonable person to conclude that they will buy it.a reasonable person to conclude that they will buy it.

CRA’s interest in this issue is that it must determine which party CRA’s interest in this issue is that it must determine which party to the contract has the legal right to claim CCA for tax purposes. to the contract has the legal right to claim CCA for tax purposes. If any of the other above conditions are satisfied, CRA regards If any of the other above conditions are satisfied, CRA regards the user (lessee) as having the right to claim CCA.the user (lessee) as having the right to claim CCA.

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Financial/Capital/Full Payout LeaseFinancial/Capital/Full Payout LeaseWhat is it? Accounting PerspectiveWhat is it? Accounting Perspective

According to the CICA all of the benefits of ownership transfer to According to the CICA all of the benefits of ownership transfer to the lessee with these lease agreements.the lessee with these lease agreements.

The lessee is deemed to own the asset and will claim The lessee is deemed to own the asset and will claim depreciation on the firm’s income statement and record the depreciation on the firm’s income statement and record the value as an asset and liability on the balance sheet.value as an asset and liability on the balance sheet.

Such leases usually:Such leases usually:

• Require the lessee to carry out maintenance and insure the assetRequire the lessee to carry out maintenance and insure the asset• Provides the lessee with a fixed purchase optionProvides the lessee with a fixed purchase option• The lease agreement covers 75% of the economic life of the assetThe lease agreement covers 75% of the economic life of the asset• Is structured so that the present value of lease payments exceeds Is structured so that the present value of lease payments exceeds

90 % of the cost90 % of the cost• Involves fixed rental payments.Involves fixed rental payments.

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Operating LeaseOperating LeaseWhat is it? Accounting PerspectiveWhat is it? Accounting Perspective

If it is NOT a capital lease, then it is an operating If it is NOT a capital lease, then it is an operating lease.lease.

Operating leases do not transfer to the lessee the benefits of Operating leases do not transfer to the lessee the benefits of ownership (ability to deduct CCA).ownership (ability to deduct CCA).

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Sale and Leaseback AgreementSale and Leaseback AgreementWhat is it?What is it?

An agreement in which the owner of an asset sells it to another An agreement in which the owner of an asset sells it to another party and then leases the asset back.party and then leases the asset back.

Popular type of lease for organizations in low tax brackets Popular type of lease for organizations in low tax brackets because they are unable to use the tax shield offered by CCA.because they are unable to use the tax shield offered by CCA.

SLBs can mean that part of the tax savings can be transferred SLBs can mean that part of the tax savings can be transferred back to the seller in the form of lower lease payments, reducing back to the seller in the form of lower lease payments, reducing the cost of the asset.the cost of the asset.

1989 federal budget significantly reduced the benefits from such 1989 federal budget significantly reduced the benefits from such agreements by forcing the lessor to deduct depreciation on agreements by forcing the lessor to deduct depreciation on leased assets only from income derived from leasing.leased assets only from income derived from leasing.

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Leveraged LeaseLeveraged LeaseWhat is it?What is it?

A three-way agreement among the lessee, the lessor, A three-way agreement among the lessee, the lessor, and a third party lender in which the lessor buys the and a third party lender in which the lessor buys the asset with only a small down payment and the lender asset with only a small down payment and the lender supplies the financing.supplies the financing.

Popular in U.S. because lessor puts up only a portion of the Popular in U.S. because lessor puts up only a portion of the asset purchase price, but receives all of the tax benefits of asset purchase price, but receives all of the tax benefits of ownership.ownership.

Not popular in Canada because CRA restricts use of CCA to Not popular in Canada because CRA restricts use of CCA to the party at risk, and CCA deductions cannot be carried over the party at risk, and CCA deductions cannot be carried over to offset taxes on other income.to offset taxes on other income.

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Accounting for LeasesAccounting for Leases

LeasesLeases

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Accounting for LeasesAccounting for LeasesAccounting for LeasesAccounting for Leases

Financial leases are included on the balance Financial leases are included on the balance sheet of the lessee.sheet of the lessee.– Present value of all lease payments is recorded on Present value of all lease payments is recorded on

the right-hand side of the Balance Sheetthe right-hand side of the Balance Sheet– The same amount is recorded as an asset on the The same amount is recorded as an asset on the

left-hand side of the balance.left-hand side of the balance.

Operating leases are off-balance-sheet Operating leases are off-balance-sheet financing for the lessee (included only in the financing for the lessee (included only in the notes to the financial statements).notes to the financial statements).

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Accounting for LeasesAccounting for LeasesFinancial Statement Effects of Lease ClassificationFinancial Statement Effects of Lease Classification

Capital/Financial/Full Payout Leases:Capital/Financial/Full Payout Leases:Income EffectsIncome Effects

1.1. Net income will generally be lower for capital leases in the Net income will generally be lower for capital leases in the early years and higher in the later years.early years and higher in the later years.

2.2. CFO will be higher with capital leases. CCA may be deducted CFO will be higher with capital leases. CCA may be deducted in measuring Net Income after tax, however, CCA is added in measuring Net Income after tax, however, CCA is added back when determing CFO. Capital/ financial leases expense back when determing CFO. Capital/ financial leases expense only the interest portion of the payments in determining EBT.only the interest portion of the payments in determining EBT.

Balance Sheet EffectsBalance Sheet Effects

1.1. Lower current ratios, higher debt and leverage ratios, lower Lower current ratios, higher debt and leverage ratios, lower asset turnover and lower profitability ratios (especially in the asset turnover and lower profitability ratios (especially in the early years of asset life)early years of asset life)

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Accounting for LeasesAccounting for LeasesFinancial Statement Effects of Lease ClassificationFinancial Statement Effects of Lease Classification

Operating Leases:Operating Leases:Income EffectsIncome Effects

1.1. Net income will generally be higher for operating leases in the Net income will generally be higher for operating leases in the early years and lower in the later years because interest early years and lower in the later years because interest expense charged for the financial lease declines as the liability expense charged for the financial lease declines as the liability is amortized by the lease payments.is amortized by the lease payments.

2.2. CFO will be lower with operating leases since the full lease CFO will be lower with operating leases since the full lease payment is subtracted from CFO, unlike financial leases where payment is subtracted from CFO, unlike financial leases where only the interest portion of the payments is subtracted.only the interest portion of the payments is subtracted.

Balance Sheet EffectsBalance Sheet Effects

1.1. Higher current ratios, lower debt and leverage ratios, higher Higher current ratios, lower debt and leverage ratios, higher asset turnover and higher profitability ratios (especially in the asset turnover and higher profitability ratios (especially in the early years of asset life)early years of asset life)

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Evaluating the Lease DecisionEvaluating the Lease Decision

LeasingLeasing

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Evaluating the Lease DecisionEvaluating the Lease DecisionLease Versus BuyLease Versus Buy

• Leasing is an alternative means of obtaining the use Leasing is an alternative means of obtaining the use of an asset.of an asset.

• There are four main differences in the cash flows for There are four main differences in the cash flows for a company that leases an asset instead of buying it:a company that leases an asset instead of buying it:1.1. It does not have to pay for the asset up frontIt does not have to pay for the asset up front

2.2. It does not get to sell the asset when it is finished with it, if it is It does not get to sell the asset when it is finished with it, if it is an operating lease, or if title is not transferred through a an operating lease, or if title is not transferred through a financial leasefinancial lease

3.3. It makes regular lease payments. If the lease is an operating It makes regular lease payments. If the lease is an operating lease, then the full amount of the lease payments is tax lease, then the full amount of the lease payments is tax deductible; only the interest portion is deductible for capital deductible; only the interest portion is deductible for capital leasesleases

4.4. Operating leases are not depreciated.Operating leases are not depreciated.

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Evaluating the Lease DecisionEvaluating the Lease DecisionLease Versus Buy Evaluative FrameworksLease Versus Buy Evaluative Frameworks

IRR of Leasing AnalysisIRR of Leasing Analysis– Estimate incremental cash flows that result from Estimate incremental cash flows that result from

leasingleasing– Solve for the discount rate (IRR) that equates the Solve for the discount rate (IRR) that equates the

incremental cash flows with the initial value of the incremental cash flows with the initial value of the asset. (This is the asset. (This is the after-tax IRRafter-tax IRR or cost of leasing) or cost of leasing)

• If IRR of leasing > after-tax cost of borrowing (borrow and If IRR of leasing > after-tax cost of borrowing (borrow and buy the asset)buy the asset)

• If IRR of leasing < after-tax cost of borrowing (lease the If IRR of leasing < after-tax cost of borrowing (lease the asset)asset)

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Evaluating the Lease DecisionEvaluating the Lease DecisionLease Versus Buy Evaluative FrameworksLease Versus Buy Evaluative Frameworks

NPV of Leasing AnalysisNPV of Leasing Analysis– Estimate incremental cash flows that result from Estimate incremental cash flows that result from

leasingleasing– Calculate NPV using after-tax cost of borrowing as Calculate NPV using after-tax cost of borrowing as

the discount rate.the discount rate.• If NPV of leasing is If NPV of leasing is - - (borrow and buy the asset)(borrow and buy the asset)

• If NPV of leasing If NPV of leasing ++ after-tax cost of borrowing (lease the after-tax cost of borrowing (lease the asset)asset)

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Motivations for Lease FinancingMotivations for Lease Financing

LeasingLeasing

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Motivation for LeasingMotivation for Leasing

1.1. Cheaper financing (which party can make Cheaper financing (which party can make better use of the CCA tax shield/)better use of the CCA tax shield/)

2.2. Reduce the risks of asset ownershipReduce the risks of asset ownership

3.3. Implicit interest ratesImplicit interest rates

4.4. MaintenanceMaintenance

5.5. ConvenienceConvenience

6.6. FlexibilityFlexibility

7.7. Capital budgeting restrictionsCapital budgeting restrictions

8.8. Financial statement effectsFinancial statement effects

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Summary and ConclusionsSummary and Conclusions

In this chapter you have learned:In this chapter you have learned:– That firms can gain the use of assets through That firms can gain the use of assets through

leasing rather than outright ownershipleasing rather than outright ownership

– The general differences between operating and The general differences between operating and financial leasesfinancial leases

– How to evaluate a potential lease decision using How to evaluate a potential lease decision using discounted cash flow analysisdiscounted cash flow analysis

– The various reasons firms might have for The various reasons firms might have for entering into lease arrangementsentering into lease arrangements

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Concept Review QuestionsConcept Review Questions

LeasingLeasing

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Concept Review Question 1 Concept Review Question 1 Operating versus Capital LeasesOperating versus Capital Leases

What is the difference between an operating What is the difference between an operating and a capital lease.and a capital lease.

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CopyrightCopyright

Copyright © 2007 John Wiley & Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights Sons Canada, Ltd. All rights reserved. Reproduction or reserved. Reproduction or translation of this work beyond that translation of this work beyond that permitted by Access Copyright (the permitted by Access Copyright (the Canadian copyright licensing Canadian copyright licensing agency) is unlawful. Requests for agency) is unlawful. Requests for further information should be further information should be addressed to the Permissions addressed to the Permissions Department, John Wiley & Sons Department, John Wiley & Sons Canada, Ltd.Canada, Ltd. The purchaser may The purchaser may make back-up copies for his or her make back-up copies for his or her own use only and not for distribution own use only and not for distribution or resale.or resale. The author and the The author and the publisher assume no responsibility publisher assume no responsibility for errors, omissions, or damages for errors, omissions, or damages caused by the use of these files or caused by the use of these files or programs or from the use of the programs or from the use of the information contained herein.information contained herein.