Transcript Leasing - McGraw

21-0
CHAPTER
21
Introduction to
Corporate Finance
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Chapter Outline
21.1
21.2
21.3
21.4
21.5
21.6
21.7
21.8
21.9
21.10
21.11
Types of Leases
Accounting and Leasing
Taxes, the IRS, and Leases
The Cash Flows of Leasing
A Detour on Discounting and Debt Capacity with Corporate
Taxes
NPV Analysis of the Lease-versus-Buy Decision
Debt Displacement and Lease Valuation
Does Leasing Ever Pay: The Base Case
Reasons for Leasing
Some Unanswered Questions
Summary and Conclusions
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21.1 Types of Leases
The Basics
A lease is a contractual agreement between a lessee
and lessor.
The lessor owns the asset and for a fee allows the
lessee to use the asset.
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Buying versus Leasing
Buy
Lease
Firm U buys asset and uses asset;
financed by debt and equity.
Lessor buys asset, Firm U leases it.
Manufacturer
of asset
Manufacturer
of asset
Firm U
1.
2.
Uses asset
Owns asset
Equity
shareholders
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Lessor
Creditors
1.
Owns asset
2. Does not use asset
Equity
shareholders
Lessee (Firm U)
1.
Uses asset
2. Does not own asset
Creditors
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Operating Leases
Usually not fully amortized.
Usually require the lessor to maintain and
insure the asset.
Lessee enjoys a cancellation option.
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Financial Leases
The exact opposite of an operating lease.
1. Do not provide for maintenance or service by the
lessor.
2. Financial leases are fully amortized.
3. The lessee usually has a right to renew the lease at
expiry.
4. Generally, financial leases cannot be cancelled.
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Sale and Lease-Back
A particular type of financial lease.
Occurs when a company sells an asset it
already owns to another firm and
immediately leases it from them.
Two sets of cash flows occur:
The lessee receives cash today from the sale.
The lessee agrees to make periodic lease payments,
thereby retaining the use of the asset.
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Leveraged Leases
A leveraged lease is another type of financial
lease.
A three-sided arrangement between the lessee,
the lessor, and lenders.
The lessor owns the asset and for a fee allows the lessee to use
the asset.
The lessor borrows to partially finance the asset.
The lenders typically use a nonrecourse loan. This means that
the lessor is not obligated to the lender in case of a default by
the lessee.
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Leveraged Leases
Lessor buys asset, Firm U leases it.
Manufacturer
of asset
Lessor
1.
Owns asset
2. Does not use asset
Equity
shareholders
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Lessor borrows from lender to
partially finance purchase
The lenders typically use a
nonrecourse loan. This
means that the lessor is not
Lessee (Firm U) obligated to the lender in
case of a default by the
1. Uses asset
2. Does not own asset lessee
In the event of a default by
the lessor, the lender has a
first lien on the asset. Also
the lease payments are
Creditors
made directly to the lender
after a default.
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21-9
21.2 Accounting and Leasing
In the old days, leases led to off-balance-sheet
financing.
Today, leases are either classified as capital
leases or operating leases.
Operating leases do not appear on the balance sheet.
Capital leases appear on the balance sheet—the
present value of the lease payments appears on both
sides.
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Accounting and Leasing
Consider a firm with two assets: a truck and some land.
Balance Sheet
Truck is purchased with debt
Truck
$100,000
Land
$100,000
Total Assets
$200,000
Operating Lease
Truck
Land
$100,000
Total Assets
$100,000
Capital Lease
Assets leased
$100,000
$100,000
Land
$100,000
Total Assets
$200,000
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Debt
$100,000
Equity
$100,000
Total Debt & Equity
$200,000
Debt
Equity
$100,000
Total Debt & Equity
$100,000
Obligations under capital lease
Equity
Total Debt & Equity
$100,000
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21-11
Capital Lease
A lease must be capitalized if any one of the following is
met:
The present value of the lease payments is at least 90 percent
of the fair market value of the asset at the start of the lease.
The lease transfers ownership of the property to the lessee by
the end of the term of the lease.
The lease term is 75 percent or more of the estimated
economic life of the asset.
The lessee can buy the asset at a bargain price at expiry.
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21.3 Taxes, the IRS, and Leases
The 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 of ownership to a
party who can.
Naturally, the IRS seeks to limit this, especially if
the lease appears to be set up solely to avoid
taxes.
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21.3 Taxes, the IRS, and Leases
The lessee can deduct lease payments if the
lease is qualified by the IRS.
1. The term 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 of the lease 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 market
value of the asset.
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21.4 The Cash Flows of Leasing
Consider a firm, ClumZee Movers, that wishes to
acquire a delivery truck.
The truck is expected to reduce costs by $4,500 per
year.
The truck costs $25,000 and has a useful life of 5
years.
If the firm buys the truck, they will depreciate it
straight-line to zero.
They can lease it for 5 years from Tiger Leasing
with an annual lease payment of $6,250.
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21.4 The Cash Flows of Leasing
Cash Flows: Buy
Cost of truck
After-tax savings
Depreciation Tax Shield
Year 0
–$25,000
–$25,000
Years 1-5
4,500×(1-.34) = $2,970
5,000×(.34) =
$1,700
$4,670
Cash Flows: Lease
Year 0
Lease Payments
After-tax savings
Years 1-5
–6,250×(1-.34) = –$4,125
4,500×(1-.34) = $2,970
–$1,155
Cash Flows: Leasing Instead of Buying
Year 0
$25,000
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Years 1-5
–$1,155 – $4,670 = $5,825
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21.4 The Cash Flows of Leasing
Cash Flows: Leasing Instead of Buying
Year 0
$25,000
Years 1-5
–$1,155 – $4,670 = –$5,825
Cash Flows: Buying Instead of Leasing
Year 0
–$25,000
Years 1-5
$4,670 –$1,155 = $5,825
However we wish to conceptualize this, we need
to have an interest rate at which to discount the
future cash flows.
That rate is the after-tax rate on the firm’s secured
debt.
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21.5 A Detour on Discounting and Debt
Capacity with Corporate Taxes
Present Value of Riskless Cash Flows
In a world with corporate taxes, firms should
discount riskless cash flows at the after-tax riskless
rate of interest.
Optimal Debt Level and Riskless Cash
Flows
In a world with corporate taxes, one determines the
increase in the firm’s optimal debt level by
discounting a future guaranteed after-tax inflow at the
after-tax riskless interest rate.
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21.6 NPV Analysis of the
Lease-vs.-Buy Decision
A lease payment is like the debt service 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 interest rate
on secured debt issued by the lessee.
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NPV Analysis of the Lease-vs.-Buy Decision
There is a simple method for evaluating leases: discount all
cash flows at the after-tax interest rate on secured debt issued
by the lessee. Suppose that rate is 5 percent.
NPV Leasing Instead of Buying
Year 0
Years 1-5
$25,000
–$1,155 – $4,670 = – $5,825
CF0
$25,000
CF1
–$5,825
F1
5
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I
NPV
5
–$219.20
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NPV Analysis of the Lease-vs.-Buy Decision
There is a simple method for evaluating leases: discount all
cash flows at the after-tax interest rate on secured debt issued
by the lessee. Suppose that rate is 5 percent.
NPV Buying Instead of Leasing
Year 0
Years 1-5
– $25,000
$4,670 – $1,155 = $5,825
CF0
–$25,000
CF1
$5,825
F1
5
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NPV
5
$219.20
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21-21
21.7 Debt Displacement and
Lease Valuation
Considering the issues of debt displacement
allows for a more intuitive understanding of
the lease versus buy decision.
Leases displace debt—this is a hidden cost
of leasing. If a firm leases, it will not use as
much regular debt as it would otherwise.
The interest tax shield will be lost.
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21.7 Debt Displacement and Lease Valuation
The debt displaced by leasing results in forgone interest
tax shields on the debt that ClumZee movers didn’t go
into when they leased instead of bought the truck.
Suppose ClumZee agrees to a lease payment of $6,250
before tax. This payment would support a loan of
$25,219.20 (see the next slide)
In exchange for this, they get the use of a truck worth
$25,000.
Clearly the NPV is a negative $219.20, which agrees
with our earlier calculations.
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21.7 Debt Displacement and Lease Valuation
Suppose ClumZee agrees to a lease payment of $6,250 before tax.
This payment would support a loan of $25,219.20
Calculate the increase in debt capacity by discounting the difference
between the cash flows of the purchase and the cash flows of the
lease by the after-tax interest rate.
After-Tax Lease Payments
–6,250×(1 –.34) = –$4,125
Forgone Depreciation Tax Shield
–5,000×(.34) = –$1,700
–$5,825
N
I/Yr
5
5
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PV
PMT
FV
$25,219.20
–$5,825
0
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21.7 Debt Displacement and Lease Valuation
Suppose ClumZee agrees to a lease payment of $6,250 before tax.
This payment would support a loan of $25,219.20
Year
Outstanding Loan Balance
0
$25,219
1
2
3
4
5
$20,655
$15,862
$10,831
$5,547
$0.00
$1,910
$1,565
$1,202
$821
$420
Tax Deduction on interest
$650
$532
$409
$279
$143
After-tax Interest Expense
$1,261
$1,033
$793
$542
$277
Interest
Extra Cash that purchasing
firm generates over leasing
firm
$5,825
$5,825
$5,825
$5,825
$5,825
$1,260.96 = $25,219.20 0.05
$20,655.16 = $25,219.20 - [$5,825. - $1,260.96 ]
After-Tax Lease Payments
Forgone Depreciation Tax Shield
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–6,250×(1 –.34) = –$4,125
–5,000×(.34) =
–$1,700
–$5,825
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21.8 Does Leasing Ever Pay: The Base Case
In the above example, ClumZee Movers chose to buy, because the
NPV of leasing was a negative $219.20
Note that this is the opposite of the NPV that Tiger Leasing would
have:
Cash Flows: Tiger Leasing
Year 0
Cost of truck
Depreciation Tax Shield
Lease Payments
Years 1–5
–$25,000
–$25,000
CF0
–$25,000
CF1
$5,825
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5,000×(.34) =
$1,700
6,250×(1-.34) = $4,125
$5,825
I
F1
5
NPV
5
$219.20
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21-26
21.9 Reasons for Leasing
Good Reasons
Taxes may be reduced by leasing.
The lease contract may reduce certain types of
uncertainty.
Transactions costs can be higher for buying an asset
and financing it with debt or equity than for leasing
the asset.
Bad Reasons
Accounting
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A Tax Arbitrage
Suppose ClumZee movers is actually in the 25% tax bracket and Tiger Leasing
is in the 34% tax bracket. If Tiger reduces the lease payment to $6,200, can
both firms have a positive NPV?
Cash Flows: Tiger Leasing
Cost of truck
Depreciation Tax Shield
Lease Payments
Year 0
–$25,000
Years 1-5
5,000×(.34) =
6,200×(1 –.34) =
–$25,000
$1,700
$4,092
$5,792
NPV = 76.33
Cash Flows ClumZee Movers: Leasing Instead of Buying
Cost of truck we didn’t buy
Lost Depreciation Tax Shield
After-Tax Lease Payments
Year 0
$25,000
Years 1-5
5,000×(.25) =
6,200×(1 –.25) =
$25,000
–$1,250
–$4,650
–$5,900
NPV = -$543.91
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Tiger Leasing’s Break-even Payment
What is the smallest lease payment that Tiger Leasing will
accept? Set their NPV to zero and solve for $Lmin:
Cash Flows: Tiger Leasing
Cost of truck
Depreciation Tax Shield
Lease Payments
Year 0
-$25,000
Years 1-5
5,000×(.34) =
$1,700
$Lmin × (1 –.34) =
$Lmin × (1 –.34)
$1,700 + $Lmin × (1 –.34)
-$25,000
NPV = 0 = -$25,000 +
5
.66  Lmin + $1,700
 (1.05)t
t =1
5
5
Lmin =
$1 + $1,700
$25,000 = .66  Lmin 
(1.05)t
t
(
1
.
05
)
=
t 1
t =1
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$25,000 -
5
700
$(11.,05
)
t =1
t
5
$1
.66  
t
t =1 (1.05)
Lmin = $6,173.29
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Tiger Leasing’s Break-even Payment
Step one is to find the after-tax cost of the truck.
Step two is to find the after-tax payment required.
Step One
Step Two
CF0
−25,000
N
5
CF1
$1,700
I/Yr
5
F1
5
PV
− $17,639.89
I
5
PMT
$4,074.37
NPV
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−$17,639.89
FV
0
This is $6,173.29
on a pre-tax basis.
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ClumZee Mover’s Break-even Payment
What is the highest lease payment that ClumZee Movers
can pay? Set their NPV to zero and solve for $Lmax:
Cash Flows ClumZee Movers: Leasing Instead of Buying
Year 0
Cost of truck we didn’t buy $25,000
Lost Depreciation Tax Shield
After-Tax Lease Payments
$25,000
Years 1-5
5,000×(.25) =
– $1,250
– $Lmax×( 1 –.25) = .75× Lmax
– 1,250 – .75× Lmax
.75  Lmax + $1,250
NPV = 0 = $25,000 - 
t
(1.05)
t =1
5
.75  Lmax
$1,250
+
$25,000 = 

t
t
(1.05)
t =1
t =1 (1.05)
5
5
No lease is possible: Lmin > Lmax
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Lmax =
$25,000 -
5
250
$(11.,05
)
t
t =1
5
(1..75
05)
t =1
t
Lmax = $6,032.49
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ClumZee Mover’s Break-even Payment
Step one is to find the after-tax cost of the truck.
Step two is to find the after-tax payment required.
Step One
Step Two
CF0
−25,000
N
5
CF1
$1,250
I/Yr
5
F1
5
PV
− $19,588.15
I
5
PMT
$4,524.37
NPV
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−$19,588.15
FV
0
This is $6,032.49
on a pre-tax basis.
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21-32
The most that ClumZee movers can afford to pay
is
$6,032.49
The least that Tiger Leasing can accept is
$6,173.29
So there won’t be a lease in this case.
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21.10 Some Unanswered Questions
Are the Uses of Leases and of Debt
Complementary?
Why are Leases offered by Both
Manufacturers and Third Party Lessors?
Why are Some Assets Leased More than
Others?
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21.11 Summary and Conclusions
There are three ways to value a lease.
Use the real-world convention of discounting the incremental
after-tax cash flows at the lessors after-tax rate on secured debt.
2. Calculate the increase in debt capacity by discounting the
difference between the cash flows of the purchase and the cash
flows of the lease by the after-tax interest rate. The increase in debt
capacity from a purchase is compared to the extra outflow at year
0 from a purchase.
3. Use APV (presented in the appendix to this chapter).
1.
They all yield the same answer.
The easiest way is the least intuitive.
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