Transcript Leasing - Belmont University

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
• 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-balancesheet” 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 – tC)
• 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,
insurance, or salvage value
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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 $26,300
per year. The marginal tax rate is 40%.
• What are the incremental cash flows?
• After-tax lease payment = 26,300(1 - .4) = 15,780 (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%
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• NAL = $100,000 - $15,780(PVIFA6%,5)
•
- $8,000(PVIFA6%,5)
• NAL = -$170.01
• Do not lease the machine
• What is NAL to lessor?
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Differential taxes
•
•
•
•
•
Lessee pays no tax
Return = 10%
NAL = $100,000 - $26,300(PVIFA10%,5)
NAL = $302.31
Lease the machine
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Maximum Lease Payment
• NAL = $0
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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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