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Leases
What is a Lease?

A lease is a contract where the lessor agrees to
let the lessee use their asset in exchange for
compensation
 Lessee:
Needs the asset, pays a quasi-rent to the
lessor to use the asset
 Lessor: Owns the asset, lets the lessee use the asset
in exchange for a quasi-rent

Two types of leases: Operating & Financial
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Operating Lease

The lease payments are not enough to recoup
the full cost of the asset
 Generally
short-term contracts, and the lessor
expects to either sell the asset or renew the lease
The lessor maintains and insure the asset
 The lessee can return the asset and cancel the
lease at will
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Financial Leases

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Lease payments are enough to cover the
cost of the asset
The lessee maintenance and insures the
asset
Generally cannot be cancelled
The lessee usually has a right to renew the
lease at expiry
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Sale and Lease Back
A Special Financial Leases
 A firm sells an asset, and then leases it back
immediately

 Why
would a firm do this?
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Buy or Lease Decision
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ClumZee Movers, needs a truck, which will
reduce costs by $6,500/year.
The truck costs $25,000 and has a 5 yr life
If the firm buys the truck, they will use straightline depreciation to a zero salvage value.
ClumZee tax rate is 34%
Alternatively they can lease the truck from Tiger
Leasing for $8,250/year
Should Clumzee buy or lease the truck?
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Buy Cash flow
Year 0
Year 1 – 5
Initial Purchase
After Tax Op Saving
Dep. Tax Shield
Incremental CF
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Leasing Cash flow
Year 0
Year 1 – 5
Initial Purchase
After Tax Op Saving
After Tax Lease
Payments
Incremental CF
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Leasing minus Buying Cash Flows
 Year
0:
 Lease
CF____
 Buy CF _____
 Lease – Buy CF ______
 Year
1-5:
 Lease
CF____
 Buy CF _____
 Lease – Buy CF ______
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Leasing Incremental Cash Flows
Year 0
$25,000
Years 1-5
–$1,155 – $5,990 = –$7,145
• Should ClumZee lease the truck?
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Why discount at the debt rate?
A
lease payment is like the debt service
(interest payment) 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 debt rate
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NPV Analysis: Lease-v-Buy
Decision

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Discount the incremental lease cash flows
ClumZee’s pre tax debt rate is 7.6%
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The after tax rate is 5% → 0.076 * (1-0.34)
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Given: Leasing v Buy Example
Xomox Corp needs a new pipe machine to meet it’s
demands (Tax Rate =34%, uses straight line depreciation)
IBMC makes such a machine for $10,000, with an
expected life of 5 years, no salvage value
This machine will save Xomox $6,000 in manufacturing costs
Friendly Leasing Corp will lease the same machine to Xomox for
$2,500 for 5 years
What are the incremental cash flows?
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Given: Lease v Buy Cash Flows
Year 0
1
2
Buy
3
4
5
Op Savings After Tax
$3,960
$3,960
$3,960
$3,960
$3,960
Dep Tax Benefit
$680
$680
$680
$680
$680
$4,640
$4,640
$4,640
$4,640
$4,640
Costs
Total
-$10,000
-$10,000
Lease
Payments
-$2,500
-$2,500
-$2,500
-$2,500
-$2,500
$850
$850
$850
$850
$850
Op Savings After Tax
$3,960
$3,960
$3,960
$3,960
$3,960
Total
$2,310
$2,310
$2,310
$2,310
$2,310
Tax Benefit
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Given: Lease – Buy Cash Flows
Year 0
1
2
3
4
5
-$2,500 -$2,500
-$2,500
-$2,500
-$2,500
$850
$850
$850
$850
-$680
-$680
-$680
Lease
Payments
Payment’s Tax
Benefit
$850
Buy
Cost -$10,000
Lost Dep Tax Shield
Total
-$680
-$680
$10,000 -$2,330 -$2,330 -$2,330 -$2,330 -$2,330
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Given: Discounting the Difference
Xomox can borrow at 7.57575%, taxes are 34%
So the after tax discount rate is 5%
0.0757575 * (1-.34) = 0.05
Year 0
1
2
3
Cash Flow $10,000 -$2,330 -$2,330 -$2,330
Discount
CF
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-$87.68
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-$2,330
Xomox prefers to buy
Alternative Lease Evaluation Method: Debt
Displacement
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Since leases replace conventional debt, compare how
much the company could borrow
Suppose ClumZee leases the truck for $8,250/year
 Incremental
cost is the payment + lost tax shield
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The Lessor’s Cash Flows
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The NPV for Tiger is the exact opposite
Year 0
Truck
Year 1
-25,000
Dep Tax Shield
5,000*(1-.34)= 1,700
Lease Payment
8,250*(1-.34) = 5,445
-$25,000
$7,145
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Good Reasons to Lease
1.
Taxes can be reduced:
-Corporations are in different tax brackets
2.
Reduces uncertainty (kind of)
-Residual Value: the value of the asset at expiration
-Leasing allows the person best able to bear the risk,
to bear the risk
3.
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Transactions costs can be higher for buying
an asset and financing it with debt or equity
than for leasing the asset.
Bad Reasons to Lease
1.
Manipulation of Accounting Numbers
-Reduces the liabilities of the balance sheet
-Improves the firm’s ROA
2.
3.
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Avoid Capital Expenditure Controls
Possible to use Leases as Off-Balance Sheet
Financing
Taxes, the IRS, and Leases
A 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
(Depreciation) to a party who can.
 The IRS tries to limit this
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Taxes, the IRS, and Leases
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The lessee can deduct lease payments if the lease is
qualified by the IRS.
1.
2.
3.
4.
5.
6.
The lease must be less than 30 years.
There can be no bargain purchase option.
The lease should not have a schedule of payments that is
very high at the start and low thereafter.
The lease payments must provide the lessor with a fair
market rate of return.
The lease should not limit the lessee’s right to issue debt
or pay dividends.
Renewal options must be reasonable and reflect fair the
market value of the asset.
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Tax Arbitrage
ClumZee’s tax rate is 25%
 Tiger Leasing’s tax rate is 34%
 If the lease payments drop to $8,200, can the
lease happen?
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A Tax Arbitrage: Clumzee
Cash Flows ClumZee Movers: Leasing Instead of Buying
Year 0
Years 1-5
Cost of truck we didn’t buy $25,000
Lost Depreciation Tax Shield
5,000×(.25) = –$1,250
After-Tax Lease Payments
8,200×(1 –.25) = –$6,150
$25,000
–$7,400
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A Tax Arbitrage: Tiger
Cash Flows: Tiger Leasing
Year 0
Cost of truck
–$25,000
Dep Tax Shield
Lease Payments
–$25,000
Years 1-5
5,000×(.34) = $1,700
8,200×(1–.34)= $5,412
$7,112
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Is a Lease Possible?
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We need to determine each firm’s break even
payment
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ClumZee Leasing’s Breakeven Payment
 Solve
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for a 0 NPV payment
N = 5, I/Y = 5.7, PV=25,000, PMT = ?, FV = 0
 Subtract
the Dep Tax Shield to get the
after tax lease payment
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Tiger Leasing’s Breakeven Payment
 Solve

for a 0 NPV payment
N = 5, I/Y = 5, PV=25,000, PMT = ?, FV = 0
 Subtract
the Dep Tax Shield to get the
after tax lease payment
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Is a Lease Possible?
The most that ClumZee movers can afford to
pay is:
 The least that Tiger Leasing can accept is:
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Salvage Value
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For the purpose of this class we will ignore the
effects of salvage value, beyond how it
impacts depreciation
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Quick Quiz
Compare operating and financing leases.
 Explain why tax rates affect the lease vs. buy
decision.
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