Transcript Introduction to Corporate Finance

Leasing
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The basic characteristics of leases
and how to differentiate between
operating and financial (or capital)
leases
The benefits and disadvantages of
leases
How the lease decision can be
evaluated using the discounted cash
flow valuation methods
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Asset-based
lending
Financial lease
Lessee
Lessor
Leveraged lease
Off-balance-sheet
financing
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Operating lease
Sale and leaseback
(SLB) agreement
Secured financing
Small and mediumsized enterprises
(SMEs)
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The decision to invest in an asset that has a long life is
a capital budgeting decision.
The decision to acquire is a separate decision from the
decision on the method of financing the acquisition
When these two decisions are combined, this is called
asset-based lending because the financing is tied
directly to a particular asset.
Examples of asset-based lending include:
◦ Secured loans
◦ Leases
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Lease is a contract under which a lessor, the
owner of the assets, gives right to use the asset
to a lessee, the user of the assets, for an agreed
period of time for a consideration called the
lease rentals.
Hence A lease contract is an agreement where the
owner conveys to the user the right to use an
asset in return for a number of specified
payments over an agreed period of time
Lessor is the owner of the asset
Lessee is the user of the asset
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Operating Lease
 A lease where some of the benefits of ownership do
not transfer to the lessee and remain with the lessor.
Financial (Capital) Lease
 A lease where essentially all the benefits of ownership
transfer to the lessee; also known as a capital or full
payout lease.
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Shot-term, cancelable lease agreements are
called operating lease.
Tourist renting a car, lease contracts for
computers, office equipments and hotel
rooms.
The Lessor is generally responsible for
maintenance and insurance.
Risk of obsolescence remains with the lessor.
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Long-term, non-cancelable lease contracts
are known as financial lease.
Examples are plant, machinery, land,
building, ships and aircrafts.
Amortize the cost of the asset over the
terms of the lease–Capital or Full pay-out
leases.
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Table 16-1 Operating versus Financial Leases
OPERATING
Lessee
FINANCIAL
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
Claim the
interest portion
of payments
received as
interest income
Depreciation
expense
(associated with
leased asset)
Cannot claim
Claim
Decompose
into interest
and principal
repayment, and
expense the
interest portion
Claim
Cannot claim
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Sometimes, a user may sell an (existing) asset
owned by him to the lessor (leasing company) and
lease it back from him. Such sale and lease back
arrangements may provide substantial tax
benefits.
In April 1989, Shipping Credit and Investment
Corporation of India purchased Great Eastern
Shipping Company bulk carrier, Jag Lata, for Rs
12.5 Cr and then leased it back to GESC on a 5
years lease, the rentals being Rs 28.13 Lakh per
month. The ships WDV was Rs 2.5 Cr.
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The lessee is deemed to own the asset and will
claim depreciation on the firm’s income
statement and record the value as an asset and
liability on the balance sheet.
Such leases usually:
Require the lessee to carry out maintenance
and insure the asset
 Provides the lessee with a fixed purchase option
 The lease agreement covers 75% of the economic
life of the asset
 Is structured so that the present value of lease
payments exceeds 90 % of the cost
 Involves fixed rental payments.
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• If a lease is NOT a capital lease, then it is an
operating lease
• Operating leases do not transfer to the lessee the
benefits of ownership
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• A three-way agreement among the lessee, the
lessor, and a third party lender in which the lessor
buys the asset with only a small down payment and
the lender supplies the financing
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Financial leases are included on the balance sheet
of the lessee
Operating leases are off-balance-sheet financing
for the lessee (included only in the notes to the
financial statements)
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Leasing is an alternative means of obtaining the use
of an asset. There are four main differences in the
cash flows for a company that leases an asset
instead of buying it:
1. It does not have to pay for the asset up front
2. 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 financial lease
3. It makes regular lease payments. If the lease is
an operating lease, then the full amount of the
lease payments is tax deductible; only the
interest portion is deductible for capital leases
4. Operating leases are not depreciated.
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IRR of Leasing Analysis
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Estimate incremental cash flows that result from
leasing
◦ Solve for the discount rate (IRR) that equates the
incremental cash flows with the initial value of the
asset. (This is the after-tax IRR or cost of leasing)
 If IRR of leasing > after-tax cost of borrowing (borrow
and buy the asset)
 If IRR of leasing < after-tax cost of borrowing (lease
the asset)
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NPV of Leasing Analysis
◦ Estimate incremental cash flows that result from
leasing
◦ Calculate NPV using after-tax cost of borrowing as
the discount rate.
 If NPV of leasing is
 If NPV of leasing
the asset)
–
(borrow and buy the asset)
+ after-tax cost of borrowing (lease
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The direct cash flow consequences are:
1. The purchase price of the asset is avoided.
2. The depreciation tax shield Is lost.
3. The after tax lease rentals are paid.
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The net present value of these cash flows
at after tax cost of debt should be
calculated. If it is positive lease is
beneficial.
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Cheaper financing
Reduce the risks of asset ownership
Implicit interest rates
Maintenance
Convenience
Flexibility
Capital budgeting restrictions
Financial statement effects
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In this chapter you have learned:
◦ That firms can gain the use of assets
through leasing rather than outright
ownership
◦ The general differences between
operating and financial leases
◦ How to evaluate a potential lease
decision using discounted cash flow
analysis
◦ The various reasons firms might have
for entering into lease arrangements
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