Transcript Ch. 18 Lease Financing - California State University, San

Ch. 18 Lease Financing
• 1. Type of Leases
• Players in lease contract
- Lessors who owns the property
- Lessee who obtains use of the property in exchange for one or more
lease or rental.
1)
Operating leases: (1) lease contracts ordinarily requiring the lessor
to maintain and service the leased equipment, and the cost of the
maintenance is built into the lease payments. (2) In general,
rental payments under the leases contract are not sufficient for
the lessor to recover the full cost of the asset (not fully
amortized). But lessor can expect to recover the cost by
subsequent renewal leasing, by re-leasing the assets to another
lessee, or by selling the assets. (3) It contains a cancellation clause
that gives the lessee the right to cancel the lease contract before
expiration date.
• 2) Financial or capital leases – “net, net” lease
• The lessee selects the specific items and negotiate the
price with the manufacturer. Then the lessee arranges
to have the lessor buy the equipment from
manufacturer and simultaneously executes a lease
contract.
• (1) do not provide maintenance service, (2) are not
cancellable unless pay fully, and (3) are fully amortized
– rental payment including a full price of the leased
equipment and a return on invested capital) (4) lessee
must pay property tax and insurance.
• 3) Sale and lease back arrangements
• A firm that owns land, buildings or equipment
sells the property to another firm (e.g.
insurance, commercial bank, and specialized
leasing firms, financial arm of an industrial
firm, limited partner, or individual investors)
and simultaneously executes an agreement to
lease the property back for a stated period
under specific terms.
• The seller immediately receives the purchase
price and then the seller - lessee retains the
use of the property. Lease payments are just
sufficient to return the full purchase price and
a stated return on the lessor’s investment. It is
a special type of financial lease. The major
difference from financial lease is the assets are
not new but used ones. The lessor buys the
property from the user-lessee.
• 4) Combination leases
• Lease contract combines the features of operating
and financial leases, depending on terms. E.g)
financial lease with cancellation clause.
• 5) Synthetic leases.
• So popular in the mid- to late- 1990s when firms
found that it can be used to keep debt off their
balance sheet.
• Transaction: A firm that wanted to acquired an asset
– real estate – with debt would first establish a
special purpose entity, or SPE.
• SPE would obtain financing, typically 97% debt
(provided by financial institutions) and 3% equity (a
party other than the firm itself). SPE uses the funds
to acquire the property and the firm leases it from
SPE, generally for 3 to5 years.
• Because of the relatively short term of the lease, it
was deem to be an operating lease and did not have
to be capitalized and shown on the balance sheet.
• The firm that set up SPE is required to do one of
three things when the lease expires: (1) pay off the
SPE’s 97% loan, (2) refinance the loan at the current
interest rate, if the lender is willing to refinance at all
or (3) sell the asset and make up any shortfall
between the sale price and amount of loan.
• In 2003, due to abuse of synthetic lease (e.g. Enron
and Tyco cases), the FASB put it place rules that
require companies to report on their balance sheets
most SPEs and synthetic leases.
• 2. Tax effects
• The full amount of the lease payments is tax deductible
expense for the lessee provided the Internal Revenue Service
agrees that a particular contract is a genuine lease and not
simply a loan called a lease.
• The main provisions of tax guidelines complying with IRS
requirements (guideline, or tax-oriented lease);
• (1) lease term must not exceed 80% of the estimated useful
life of the equipment at the commencement of the lease
transaction. (2) residual value (not inflation adjusted) at the
expiration of the lease must be at least 20% of its vale at the
start of lease. (3) Neither the lessee nor any related party can
have the right to purchase the property at a predetermined
fixed price. However, the lessee can be given an option to buy
the asset at its fair market value.
• (4) Neither the lessee nor any related party can pay
or guarantee payment of any part of the leased
equipment. (5) The leased equipment must not be “
limited use” property, defined as equipment that can
be used only by the lessee or a related party at the
end of the lease.
• Non-tax oriented lease; the lessee (1) is the effective
owner of the leased property, (2) can depreciate it
for tax purposes, and (3) can deduct only the interest
portion of each lease payment.
• 3. Financial Statement Effects
• Leasing is often called off-balance sheet financing.
Reduced the firms’ debt ratios. It was illegally
abused.
• FASB 13 statement requires that firms entering into
financial (or capital) leases must restate their balance
sheet and report the leased asset as a fixed asset and
the present value of the future lease payments as a
liability. This process is called “capitalizing the lease.”
• It will make no big difference between debt financing
and lease in the financial statement.
• If one or more of following conditions exist, a lease is
classified as a financial or capital lease;
• (1) ownership of the property is effectively transferred from
the lessor to the lessee.
• (2) the lessee can purchase the property at less than its true
market value when the lease expires.
• (3) The lease runs for a period equal to or greater than 75% of
the asset’s life.
• (4) Present Value of the lease payment is equal to or greater
than 90% of the initial value of the asset.
• Failure to make financial or capital lease
payment can bankrupt a firm. Thus lease
should be regarded as debt for capital
structure purpose. It would influence costs of
debt and equity.
• Operating leases are required to be disclosed
at footbnote.
4. Evaluation lease
• A lease is comparable to a loan in the sense
that the firm is required to make a specific
series of payments and a failure to meet these
payments could result in bankruptcy. The
analysis should compare the cost of leasing
with cost of debt financing regardless of how
the asset purchase is actually financed.
• After tax cost of debt is used as a discount
rate.
•
•
•
E.g) Lewis Securities Inc. has decided to acquire a new market data and quotation system for
its Richmond home office. The system receives current market prices and other information
from several on-line data services, then either displays the information on a screen or stores
it for later retrieval by the firm's brokers. The system also permits customers to call up
current quotes on terminals in the lobby.
The equipment costs $1,000,000, and, if it were purchased, Lewis could obtain a term loan
for the full purchase price at a 10 percent interest rate. Although the equipment has a sixyear useful life, it is classified as a special-purpose computer, so it falls into the MACRS 3-year
class. If the system were purchased, a 4-year maintenance contract could be obtained at a
cost of $20,000 per year, payable at the beginning of each year. The equipment would be
sold after 4 years, and the best estimate of its residual value at that time is $200,000.
However, since real-time display system technology is changing rapidly, the actual residual
value is uncertain.
As an alternative to the borrow-and-buy plan, the equipment manufacturer informed Lewis
that Consolidated Leasing would be willing to write a 4-year guideline lease on the
equipment, including maintenance, for payments of $260,000 at the beginning of each year.
Lewis's marginal federal-plus-state tax rate is 40 percent. You have been asked to analyze the
lease-versus-purchase decision, and in the process to answer the following questions:
1) Lessee’s point of view
NPV LEASE ANALYSIS
Year =
0
1
2
3
4
Cost of Owning
Equipment cost
Loan amount
($1,000)
$1,000
Interest expense
Tax savings from interest
($100)
($100)
($100)
($100)
40
40
40
40
Principal repayment
($1,000)
After tax loan payment
($60)
($60)
($60)
($1,060)
Depreciation shield
$132
$180
$60
$28
($20)
($20)
($20)
($20)
$8
$8
$8
$8
Maintenance
Tax savings on maintenance
Residual value
$200
Tax on residual value
Net cash flow
PV ownership cost @ 6%
$0
($80)
($12)
($591.741)
$60
$108
($12)
($912)
Year =
0
1
2
3
4
Cost of Leasing
Lease payment
Tax savings from lease
Net cash flow
PV of leasing @ 6%
($260)
($260)
($260)
($260)
$104
$104
$104
$104
($156)
($156)
($156)
($156)
($572.990)
Cost Comparison
PV ownership cost @ 6%
($591.741)
PV of leasing @ 6%
($572.990)
Net Advantage to Leasing
$18.751
$0
2) Lessor’s point of view
e.g) Assume that the lease payments were actually $280,000 per
year, that Consolidated Leasing is also in the 40 percent tax
bracket, and that it also forecasts a $200,000 residual value.
Also, to furnish the maintenance support, Consolidated would
have to purchase a maintenance contract from the manufacturer
at the same $20,000 annual cost, again paid in advance.
Consolidated Leasing can obtain an expected 10 percent pre-tax
return on investments of similar risk. What would
Consolidated's NPV and IRR of leasing be under these
conditions?
Lease payment =
$280
Lessor's tax rate =
40%
Lessor's pre-tax interest rate =
After-tax discount rate =
10%
6.00%
Year =
0
1
2
3
4
Cost of Owning
Equipment cost
($1,000)
Depreciation shield
Maintenance
($20)
Tax savings on maintenance
Lease payment
Tax on lease payment
$132
$180
$60
($20)
($20)
($20)
$8
$8
$8
$8
$280
$280
$280
$280
($112)
($112)
($112)
($112)
Residual value
$28
$200
Tax on residual value
Net cash flow
($80)
($844)
PV @ 6%
IRR
$25.325
7.46%
$288
$336
$216
$148