CONTEMPORARY FINANCIAL MANAGEMENT

Chapter 19:

Leasing

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.14

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:

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Present Value Cost of Leasing

Present Value Cost of Owning

against

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.

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( )

( )

= −

= −

=

Debt DebtAfter-tax PreTax

k k 1 T

0.10 1 0.4

6%

LEASE VERSUS BUY: SOLUTION

Step 1: Determined installed cost of the asset

Given as $50,000

Step 2: Calculation present value of lease payments

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( ) ( )

( ) ( )−

÷ ÷

− ÷= = ÷

-n

LeasePayments

6

1 - 1 + kPV = C 1 + k

k

1 1.0610,000 1.06 $52,123.64

0.06

LEASE VERSUS BUY: SOLUTION

Step 3: Determine present value of tax shield due to lease

payments

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( ) ( )

( ) ( ) −

÷ ÷

− ÷= ÷

=

-n

Tax ShieldDue to LeasePayments

6

1 - 1 + kPV = C T

k

1 1.0610,000 0.40

0.06

$19,669.29

LEASE VERSUS BUY: SOLUTION

Step 4: Determine present value of tax shield due to CCA

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( ) ( )

÷ ÷

= ÷ ÷+ =

Tax ShieldDue toCCA

dT 1 + 0.5kPV = UCC

d + k 1 + k

0.30 0.40 1.0350,000

0.30 0.06 1.06

$16,194.97

LEASE VERSUS BUY: SOLUTION

Step 5: Determine present value of operating costs

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( ) ( )

( ) ( ) −

÷ ÷

− ÷= − ÷

=

-n

OperatingCosts

6

1 - 1 + kPV = Annual Cost 1 - T

k

1 1.06750 1 0.4

.06

$2,212.80

LEASE VERSUS BUY: SOLUTION

Step 6: Determine present value of salvage

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( )

( )=

=

Salvage n

6

SalvagePV =

1 + k

2,000

1.06

$1,409.92

LEASE VERSUS BUY: SOLUTION

Step 7: Determine present value of CCA tax shield lost due to

salvage

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( ) ( )

÷

= ÷+ =

CCA TaxShield LostDue to Salvage

dTPV = Salvage

d + k

0.30 0.402,000

0.30 0.06

$470

LEASE VERSUS BUY: SOLUTION

Step 8: Calculate net advantage to leasing

Step 1: $50,000.00 Step 2: ($52,123.64) Step 3: $19,660.29 Step 4: ($16,194.97) Step 5: $2,212.80 Step 6: ($1,409.92) Step 7: $470.00

$2,623.5627

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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