Transcript No Slide Title

Contemporary Financial Management
Chapter 19:
Leasing
© 2004 by Nelson, a division of Thomson Canada Limited
Introduction
 This chapter explores the reasons a firm might
choose to lease rather than borrow and buy
some of their assets.
 It examines the type of analysis that should go
into a lease versus borrow-and-purchase
decision to maximize shareholder wealth.
 It examines the costs and benefits to leasing
companies offering this type of financing.
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Concept of a Lease
 A lease is a contractual arrangement between
two parties:
 The Lessor – the owner of the asset, who
agrees to allow the lessee to use the asset for a
period of time, in return for a fixed payment
 The Lessee – the user of the asset, who
agrees to pay the Lessor for the use of the
asset
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Concept of a Lease
 Leases are most effective when done between a
high marginal tax lessor and a low marginal tax
lessee.
 The lessee passes to the lessor tax deductions
that the lessee cannot use.
 In return, the lessor passes some of the benefit
back to the lessee in the form of lower lease
payments.
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Lease Contract
 Leases
 An alternative to term financing
 A mechanism to transfer tax benefits
 Lessee
 Obtains use of an asset
 For a specific period of time
 In return for a series of payments to the lessor
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Types of Leases
 Operating Lease
 Sometimes called service or maintenance leases
 Term of the lease is less than the economic life
of the asset
 Usually cancelable by the lessee
 Lessor maintains and services the asset
 Lessor pays any tax and insurance
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Types of Leases
 Financial Lease
 Sometimes called a capital lease
 Initial term usually equal to the expected
economic life of the asset
 Not cancelable by the lessee
 Lessee responsible for maintenance, insurance
and property taxes
 May originate as a:
• Direct lease
• Sale and leaseback
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Direct Lease
 The lessee acquires the use of an asset it does
not own.
 The lessor may be the manufacturer or a
financial institution.
 If the lessor is a financial institution (F.I.), the
lessee provides all specifications to the F.I.,
which then purchases the asset and leases it to
the lessee.
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Sale and Leaseback
 A firm sells an asset to a lessor and immediately
enters into an agreement to lease it back.
 Benefits to the lessee include:
 Cash from the sale can be invested in other
assets.
 The lessee continues to use the asset, even
though it is now owned by somebody else.
 May be able to record a “gain on sale” if the
asset is sold at greater than its book value.
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Types of Leases
 Leveraged Lease
 Three-party lease involving a lessee, a lessor
and a financial institution (F.I.) or lender.
 The lessor and the F.I. jointly provide the funds
required to purchase the asset.
 All other terms are similar to a financial lease.
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Advantages to Leasing
 Flexible – fewer restrictive covenants
 Convenient
 Source of financing to the risky firm (since
ownership remains with the lessor)
 May avoid some risk of obsolescence
 Smoother earnings and earnings per share
 100% financing (but lease payments usually
occur at the beginning of the period)
 Enhance liquidity (sale & leaseback)
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Disadvantages to Leasing
 May be more expensive than borrowing
 Lessor retains the salvage value
 May be difficult to obtain approval for
modifications
 Often subject to a cancellation penalty
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Tax Considerations
 Annual lease payments are tax deductible for
the lessee if the CRA (Canada Revenue Agency)
agrees that the contract is truly a lease and not
just an installment loan called a lease.
 Reasons why CRA might disallow a lease
 Lessee has the right to acquire the asset at less
than fair market value
 Lessee required to buy the asset at the end of
the lease
 Lessee automatically obtains ownership at the
end of the lease
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Leases and Accounting Practices
 Canadian accounting standards are contained in
the CICA handbook.
 Firms are normally required to capitalize
financial leases.
 The capitalized value of a lease is equal to:
 Present value of the lease payments
 Discounted at the firm’s borrowing rate for a
secured loan with similar maturity
 Details must be disclosed in the Notes.
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Notes to the Financial Statements
 For Financial Leases, the Notes must contain, as
of the date of the Balance Sheet:
 Gross amount of assets leased by asset class
 Amount of accumulated lease amortization
 Future minimum lease payments in total for
each of the next five fiscal years
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Small Firms
 Reasons for leasing




Less cash required upfront
Better protection against obsolescence
Quicker approvals
Fewer restrictive covenants
 Expensive reasons
 High interest cost
 Loss of tax benefits
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Lease Versus Buy Analysis
 Compare the incremental cost or benefit of
leasing versus borrowing and buying the asset.
 The Net Advantage to Leasing (NAL) compares:
Present Value
Cost of
Leasing
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Present Value
Cost of
Owning
Net Advantage to Leasing Calculation
1. Installed cost of the asset
Less
2. Present value of lease payments
Plus
3. Present value of tax shield from lease
payments
Less
4. Present value of tax shield due to CCA
Plus
5. Present value of operating costs
incurred due to ownership
Less
6. Present value of salvage
Plus
7. Present value of the tax shield due to
CCA that is lost due to salvage
8. Net advantage to leasing
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Lease Versus Buy Example
 A company is deciding whether to lease or buy a
new truck. The truck can be purchased for
$50,000 or leased for a 6-year period for
$10,000/year (due at the beginning of each
year). The firm can borrow at 10%. If
purchased, the firm will incur insurance and
maintenance costs of $750 per year. The truck
has a CCA rate of 30%. Salvage value in six
years is expected to be $2,000. The firm’s
marginal tax rate is 40% and its after-tax cost
of capital is 15%.
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Lease Versus Buy: Solution
 Calculate the firm’s after-tax cost of debt, which
will be used as the discount rate.
kDebt
After-tax
 kDebt
PreTax
1  T 
 0.10 1  0.4 
 6%
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Lease Versus Buy: Solution
 Step 1:
 Determined installed cost of the asset
 Given as $50,000
 Step 2:
 Calculation present value of lease payments
 1 - 1 + k -n 
 1 + k 
PVLease = C 


k
Payments


 1  1.06 6 
 1.06   $52,123.64
 10, 000 


0.06


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Lease Versus Buy: Solution
 Step 3:
 Determine present value of tax shield due to
lease payments
 1 - 1 + k -n 

PVTax Shield = C  T  


k
Due to Lease


Payments
 1  1.06 6 

 10, 000  0.40  


0.06


 $19, 669.29
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Lease Versus Buy: Solution
 Step 4:
 Determine present value of tax shield due to
CCA
PVTax Shield
Due to
CCA
 dT   1 + 0.5k 
= UCC 


d + k  1 + k 
  0.30   0.40    1.03 
 50, 000 


0.30

0.06
1.06



 $16,194.97
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© 2004 by Nelson, a division of Thomson Canada Limited
Lease Versus Buy: Solution
 Step 5:
 Determine present value of operating costs
PVOperating
Costs
 1 - 1 + k -n 

= Annual Cost 1 - T  


k


 1  1.06 6 

 750 1  0.4  


.06


 $2,212.80
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Lease Versus Buy: Solution
 Step 6:
 Determine present value of salvage
PVSalvage =

Salvage
1 + k 
n
2,000
1.06 
6
 $1, 409.92
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Lease Versus Buy: Solution
 Step 7:
 Determine present value of CCA tax shield lost
due to salvage
 dT 
PVCCA Tax
= Salvage 

d
+
k
Shield Lost


Due to Salvage
  0.30   0.40  
 2, 000 

 0.30  0.06 
 $470
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Lease Versus Buy: Solution
 Step 8:
 Calculate net advantage to leasing







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Step
Step
Step
Step
Step
Step
Step
1:
2:
3:
4:
5:
6:
7:
$50,000.00
($52,123.64)
$19,660.29
($16,194.97)
$2,212.80
($1,409.92)
$470.00
$2,623.56
© 2004 by Nelson, a division of Thomson Canada Limited
The net advantage to
leasing is $2,623.56,
based on the set of
assumptions provided.
This would change if any
of assumptions are
changed.
Major Points
 Leasing is an alternative to borrowing and
purchasing an asset.
 Leasing is most effective when the lessor has a
high marginal tax rate and the lessee has a low
marginal tax rate.
 Leasing may also be advantageous for small,
riskier firms that would otherwise have a hard
time acquiring the assets they need.
 Leasing is not cost free and it should only be
done after a complete analysis of the costs and
benefits.
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© 2004 by Nelson, a division of Thomson Canada Limited