Chapter 27 Leasing McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 27

Leasing

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills

• Understand basic lease terminology• Understand the criteria for a capital lease

vs. an operating lease• Understand the typical incremental cash

flows to leasing• Be able to compute the net advantage to

leasing• Understand the good reasons for leasing

and the dubious reasons for leasing

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Chapter Outline

• Leases and Lease Types

• Accounting and Leasing

• Taxes, the IRS, and Leases

• The Cash Flows from Leasing

• Lease or Buy?

• A Leasing Paradox

• Reasons for Leasing

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Lease Terminology

• Lease – contractual agreement for use of an asset in return for a series of payments

• Lessee – user of an asset; makes payments• Lessor – owner of the asset; receives payments• Direct lease – lessor is the manufacturer• Captive finance company – subsidiaries that

lease products for the manufacturer

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Types of Leases• Operating lease

– Shorter-term lease– Lessor is responsible for insurance, taxes, and

maintenance– Often cancelable

• Financial lease (capital lease)– Longer-term lease– Lessee is responsible for insurance, taxes, and

maintenance– Generally not cancelable– Specific capital leases

• Tax-oriented• Leveraged• Sale and leaseback

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Lease Accounting• Leases are governed primarily by FASB 13• Financial leases are essentially treated as

debt financing– Present value of lease payments must be

included on the balance sheet as a liability– Same amount shown on the asset as the

“capitalized value of leased assets”

• Operating leases are still “off-balance-sheet” and do not have any impact on the balance sheet itself

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Criteria for a Capital Lease• If one of the following criteria is met, then

the lease is considered a capital lease and must be shown on the balance sheet– Lease transfers ownership by the end of the

lease term– Lessee can purchase asset at below market

price– Lease term is for 75 percent or more of the life

of the asset– Present value of lease payments is at least 90

percent of the fair market value at the start of the lease

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Taxes• Lessee can deduct lease payments for income tax

purposes– Must be used for business purposes and not to avoid

taxes– Term of lease is less than 80 percent of the economic life

of the asset– Should not include an option to acquire the asset at the

end of the lease at a below market price– Lease payments should not start high and then drop

dramatically– Must survive a profits test – lessor should earn a fair

return– Renewal options must be reasonable and consider fair

market value at the time of the renewal

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Incremental Cash Flows

• Cash Flows from the Lessee’s point of view– After-tax lease payment (outflow)

• Lease payment*(1 – T)

– Lost depreciation tax shield (outflow)• Depreciation * tax rate for each year

– Initial cost of machine (inflow)• Inflow because we save the cost of purchasing the asset

now

– May have incremental maintenance, taxes, or insurance

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Example: Lease Cash Flows

• ABC, Inc. needs some new equipment. The equipment would cost $100,000 if purchased and would be depreciated straight-line over 5 years. No salvage is expected. Alternatively, the company can lease the equipment for $25,000 per year. The marginal tax rate is 40%.– What are the incremental cash flows?

• After-tax lease payment = 25,000(1 - .4) = 15,000 (outflow years 1 - 5)

• Lost depreciation tax shield = (100,000/5)*.4 = 8,000 (outflow years 1 – 5)

• Cost of machine = 100,000 (inflow year 0)

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Lease or Buy?

• The company needs to determine whether it is better off borrowing the money and buying the asset, or leasing

• Compute the NPV of the incremental cash flows

• Appropriate discount rate is the after-tax cost of debt since a lease is essentially the same risk as a company’s debt

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Net Advantage to Leasing

• The net advantage to leasing (NAL) is the same thing as the NPV of the incremental cash flows– If NAL > 0, the firm should lease– If NAL < 0, the firm should buy

• Consider the previous example. Assume the firm’s cost of debt is 10%.– After-tax cost of debt = 10(1 - .4) = 6%– NAL = $3,116

• Should the firm buy or lease?

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Work the Web Example• Many people must choose between buying and

leasing a car• Click on the web surfer to go to Kiplinger’s

– Go to Tools & Calculators: Cars– Do the calculations for a $30,000 car, 5-year loan at 7%

with monthly payments, and a $3,000 down payment. The available lease is for 3 years and requires a $550 per month payment with a $1,000 security deposit and $1,000 other upfront costs.

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Good Reasons for Leasing

• Taxes may be reduced

• May reduce some uncertainty

• May have lower transaction costs

• May require fewer restrictive covenants

• May encumber fewer assets than secured borrowing

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Dubious Reasons for Leasing

• Balance sheet, especially leverage ratios, may look better if the lease does not have to be accounted for on the balance sheet

• 100% financing – except that leases normally do require either a down-payment or security deposit

• Low cost – some may try to compare the “implied” rate of interest to other market rates, but this is not directly comparable

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Quick Quiz• What is the difference between a lessee and a

lessor?• What is the difference between an operating

lease and a capital lease?• What are the requirements for a lease to be tax

deductible?• What are typical incremental cash flows, and how

do you determine the net advantage to leasing?• What are some good reasons for leasing?• What are some dubious reasons for leasing?

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Ethics Issues• Suppose a manager chooses to lease an

asset (operating lease) rather than buy, simply to keep the asset off-balance sheet and thereby avoid reporting the liability?– Although this may be legal, is there any ethical

implication?– Are investors able to effectively monitor and

analyze such activity?

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Comprehensive Problem

• What is the net advantage to leasing for the following project, and what decision should be made?– Equipment would cost $250,000 if purchased– It would be depreciated straight-line to zero

salvage over 5 years.– Alternatively, it may be leased for $65,000/yr.– The firm’s after-tax cost of debt is 6%, and its

tax rate is 40%

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End of Chapter

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