[PPT]Leasing - FacStaff Home Page for CBUfacstaff.cbu.edu/~spitts/Finance_327_427/chap026.ppt · Web view26 Leasing Key Concepts and Skills Understand basic lease terminology Understand

McGraw-Hill/IrwinMcGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2626Leasing

26-2

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

26-3

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

26-4

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

26-5

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

26-6

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

26-7

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

26-8

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

26-9

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

26-10

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)

26-11

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

26-12

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?

26-13

Work the Web Example

Many people have to choose between buying and leasing a car

Click on the web surfer to go to Kiplinger’s Go to Tools: Spending Tools 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.

26-14

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

26-15

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

26-16

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?

McGraw-Hill/IrwinMcGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

End of Chapter

26-18

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%