School of Business Administration University of Miami: Assigned Readings & Problems

Professor Jawad M.
Addoum FIN303: Spring 2013

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School of Business
Administration
University of Miami
Leasing
Corporate Financial Management
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Assigned Readings & Problems
Reading: EFS Chapter 21, Section 21.1-21.3
Homework: EFS Chapter 21
Questions/Challenging Questions: 1, 2, 3, 4, 5, 7, 11 (4
th
ed)
Problems: A4 (when text says residual value it means both
sales price & terminal book value), A7, B10, B11a, B12, B15
(4
th
ed)
Professor Jawad M. Addoum FIN303: Spring 2013
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Objectives
In this lecture you will learn:
What a lease is in general
What the three types of financial leases are
What the principle reasons are that firms choose to lease
rather than buy
How to calculate the Net Advantage of Leasing (NAL) as
compared to buying
How the possibility of leasing affects the capital budgeting
analysis
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Overview
A lease is a contractual agreement between a lessee and
lessor
A contract between two parties: the lessee (the user) and the
lessor (the owner)
The lessee first decides on the asset needed and then negotiates
a lease contract with the lessor
The lessee has the right to use the asset and in return she must
make periodic payments to the lessor
The principal lessors are Equipment Manufacturers (GMAC),
Commercial Banks, Finance Companies, and Leasing
Companies
From the lessees standpoint, long-term leasing is similar to
buying the equipment with a secured loan
The terms of the lease are comparable to what a banker might
arrange with a secured loan
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The principal benefit of long-term leasing is tax
reduction
Leasing allows the transfer of tax benefits from those who
need equipmentbut cannot take full advantage of the
tax benefits associated with ownershipto a party who
can
If corporate taxes were ever repealed, long-term
leasing would likely disappear!
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Types of Leases (Leasing Industry)
Operating Leases
The term of the operating lease is usually significantly less
than the economic life of the asset
Usually require the lessor to maintain and insure the leased
asset (a full-service lease)
Lessee has the option to cancel the lease prior to contract
expiration
n the past, the lessee received an
"operator along with the
equipment
Not necessarily the same as
operating leases in
accounting!
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Financial Leases
In general, the lessee may not cancel the lease. She must
make all payments or face the risk of bankruptcy
The lessee is responsible for maintenance or service (a net
lease)
Lessee has the right to renew the lease on expiration
Really an alternative method of financing a purchase!
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Types of Financial Leases
In a Direct Lease, the asset is typically new and the lessor is
either an independent lessor or the equipment manufacturer
If the lessor is an independent leasing company, it must buy the
asset from its manufacturer
Manufacturer
Lessor
Lessee
Buys Equipment
Leases
Equipment
Direct Lease with a Leasing Company
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9
Sale and Lease-Back of Property
A firm sells an asset it owns to a leasing company and
immediately leases it back
Lessee receives cash
Lessee continues to use the equipment but now makes
payments to a lessor
Leveraged Lease
Lessor puts up no more than 40-50% of the purchase price
The bulk of the remaining finance comes from creditors who
receive interest payments from the lessor
Lenders typically have no recourse (to the lessor) in the case of
default by the lessee
Lenders do however have a perfected first lien on the asset
In default, the lenders are entitled to seize the asset and any
subsequent lease payments are made directly to the lenders
Note, the lessor receives all the tax benefits (depreciation) from
ownership, not the lenders
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Shareholders Creditors
Provide Capital
Lessor
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The Lease vs. Buy Decision
How should a firm decide whether to lease or buy an asset?
We call this the Net Advantage of Leasing (NAL) to the
Lessee?
Calculation Method (Simplified)
Project the incremental after-tax cash flows with leasing
Project the incremental after-tax cash flows with buying using
secured debt
Calculate the difference between the lease and buy cash flows
Discount this difference at the firms after-tax cost of secured
debt to calculate the Net Advantage of Leasing (NAL)
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Example 1: GenTech is a firm that develops vaccines for
newly discovered diseases such as SARS. It relies heavily on
state-of the-art gene-splicing equipment and is considering
whether to lease or buy a new instrument that it needs. The
instrument costs $100,000 but will save the firm an additional
$60,000 per year through the reduction in outside lab costs.
The machine may be depreciated over five years on a
straight-line schedule for tax purposes. Alternatively, the
instrument may be leased at $24,750 per year for five years.
GenTechs marginal tax rate is 34% and its cost of secured
debt pre-tax is 7.57575%. Should GenTech lease or buy the
instrument?
After-tax operating cost savings: (60,000)(1-0.34)=39,600
Depreciation: 100,000/5=20,000
Depreciation tax benefit (with purchase): 20,000(0.34)=6,800
After-tax cost of lease: 24,750(1-0.34)=16,335
After-tax cost of secured debt: 7.57575%(1-0.34)=5%
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13 Note: the Operating Cost Savings ($39,600 after tax) cancel out
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Implication: Buy dont lease!
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Discount Rate & Risk
Lease Payments
The riskiness of lease payments is nearly identical to that a bank would
assume if made a secured loan to the firm and the firm bought the
equipment
The bankers loan is collateralized by the equipment vs. the lessor owns
the equipment
The term of the bank loan should match the term of the lease
The appropriate level of risk for lease payments is therefore captured by
the firms cost of borrowing
Operating Cost Savings
The operating cost savings (or revenue increases) are identical whether
the equipment be leased or purchased
These cash flows net out in the NAL calculation
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Depreciation
The only other cash flow that must be discounted (for now) is the
depreciation tax benefits: common practice is to assume that these cash
flows are as risky as the lease payments
Therefore, the risk in the Net Advantage of Leasing calculation is
captured in the cost of borrowing (after-tax)!
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Debt Service Parity
Essentially, when we calculate an NAL we compare the
purchase price to the Equivalent Loan implied by the lease
payments (after tax) and the lost depreciation tax shields
If the Equivalent Loan is less than the purchase price of the
asset, leasing makes economic sense! (and the NAL>0)
In general, this approach of calculating an equivalent loan is
called Debt Service Parity and has many, many applications:
Leasing
Callable bond refunding
Assuming vs. calling target debt in an acquisition
See Appendix III for more discussion including why the
discount rate is taken after tax
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Symmetric Taxes
Every transaction has two sides. In Example 1, we
saw that the firm preferred to buy rather than
lease. What was the lessors valuation of the lease?
EXAMPLE 1 (Lessor): Assuming that lessor and lessee
tax rates are both 34%, the lessor cash flows are:
After-tax lease payments: (24,750)(1-0.34)=16,335
Depreciation tax benefit: 20,000(0.34)=6,800
Technical Note: For manufacturer lessors, depreciation would be
based on manufacturing costs
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The Lessor cash flows are identical in magnitude but opposite in sign!
NOTE: the benefit to the LESSOR is called the NPVL (Net Present Value o f Leasing)
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The NPV of the leasing deal for the Lessor (NPVL) is
the negative of the Net Advantage of Leasing
(NAL) for the Lessee!
Here, leasing is a zero-sum game and has no
economic value! The lease payment will be
determined by the payment that makes either
party just indifferent.
This result holds whenever:
Both parties are subject to the same interest and tax rates
Transactions costs are ignored
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Reasons for Leasing: Tax
Advantages
TAXES are the most important reason for long-term leasing. If
the corporate income tax were ever repealed, long-term
leasing would probably disappear!
Example 1 (Tax Differences): Suppose that the LESSEE in
Example 1 pays NO TAXES but the Lessor pays taxes at 34%. Is
there a reason for leasing? Can BOTH parties be better off?
The lease payments remain at $24,750
For the Lessee:
After-tax operating cost savings: (60,000)(1-0)=60,000
Depreciation tax benefit (with purchase): 20,000(0)=0
After-tax cost of lease: $24,750(1-0)= $24,750
After-tax cost of secured debt: 7.57575%(1-0)= 7.57575 %
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Therefore, the NAL for the Lessee is:
For the Lessor, we already saw
With different tax rates, both lessee and lessor may be
better off with leasing!
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Reasons for Leasing: Tax
Advantages
Wait, if both parties are better off, who is worse off? (Leasing is a
zero-sum game)
UNCLE SAM!
Tax-driven leasing transactions are nothing more than a reallocation of
wealth from the IRS to the private sector
Depreciation tax shields, which are of no value to the lessee, are passed
on the the lessor, who can use them!
How are the spoils of tax shields divided between lessee and lessor?
Negotiation!
Relative negotiating power decides how the parties share the wealth
Each party has a reservation value below which they will not participate
in the deal
If lease payments are set so low (high) that the lessor (lessee) has less
than a zero NPVL (NAL) from the leasing transaction, the deal is never
consummated
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CAUTION!! YOU CANT ASSUME THAT JUST BECAUSE THE LESSEE
HAS A LOWER TAX RATE, SHE SHOULD CHOOSE TO LEASE!!
The lessor could charge too high a lease payment
Its not hard to construct an example where the lease
alternative is preferred only if the lessee pays taxes!
Always make the lease-buy decision based on a complete
discounted cash flow analysis!
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Other Reasons for Leasing: Risk
The lessee does not own the equipment when the lease expires. At
this time the equipment is said to have RESIDUAL VALUE
There may be substantial uncertainty at the time the equipment is leased
as to what the residual value will be: One risk is obsolescence
Under a lease contract, the lessor bears this risk
If the lessee chooses not to lease and instead to buy the equipment,
she bears this residual value risk
A small, newly formed firm with principal stockholders who are poorly
diversified may benefit greatly from leasing
A large, publicly held financial institution may easily bear the risk of the
residual value
Moreover, holding many leases diversifies away much of the equipment-specific
residual value risk
PREDICTION: large, stable, publicly held corporations are less likely to
lease (all else equal)
General principle of efficiency: the party best able to bear a risk should do so!
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Other Reasons for Leasing:
Transactions Costs
When the need for equipment is short-term, substantial costs may be
incurred when ownership is transferred
Leasing an executive apartment short term clearly makes more sense
than buying a condominium for a consulting assignment
On the flip side, leasing generates agency costs
The lessee may misuse or overuse the assetshe has no concern for the
assets residual value
This cost is included, implicitly, in the lease payments
If too high, agency costs may eliminate this potential benefit of leasing
Monitoring and usage metrics and penalties may reduce agency costs.
Still, monitoring is expensive and some agency costs remain
The more sensitive the value of an asset to use and maintenance
decisions, the more likely the asset will be purchased
Car leasing works because mileage and maintenance can be cheaply
monitored
Leasing is beneficial for reasons of transactions costs when the costs of
purchase and resale exceed the monitoring and remaining agency costs
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Questionable/Bad Reasons for
Leasing
A Strong Balance Sheet
Since the lease liability is hidden with an operating lease (financial
accounting), the balance sheet of a firm with an operating lease looks
stronger
A clever financial manager could try to negotiate a lease contract the
does not meet the requirements for it to be booked
However, operating leases do appear in a firms annual report in the
notes. Therefore, assuming (semi-strong form) market efficiency, how
leases are classified should not affect firm value
Investors still figure their impact by reading the notes in the annual report
Higher Earnings and Higher ROA
In the early years of a lease, lease payments are less than the sum of
depreciation and interest expenses. Therefore, earnings are higher
Again, operating leases do not appear as assets on the balance sheet,
so assets are lower
ROA (Earnings/Assets) is therefore higher
Investors can see through this too!
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The Full Picture
The complete formula for the Net Advantage to
Leasing is:
P is Purchase Price
Residual is S-T(S-B
N
)
WACC is project cost of
capital
Lease PMT is the lease
payment
Expenses is the increase in
expenses with a leaseoften
a negative number!
D
t
is depreciation in year t if the
asset were purchased. (If
depreciation is not straightline,
this value changes year to
year!)
r is the pre-tax cost of 100%
debt financing
N is the length of the lease
ITC is the investment tax credit
(if any)
Note: The NPVL formula is just the negative of the NAL: NPVL = - NAL (but with the lessor's tax rate etc.)
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New Issue:
Lenders will not treat a loan as fully secured unless it is
overcollateralized
For example, the secured lender may fund 80% of the assets
value at the secured rate and leave the borrower to find
finance for the remaining 20% at an unsecured rate
Therefore, the rate for discounting lease payments and
depreciation tax shields is greater than the after-tax
secured loan rate
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A Full Example
EXAMPLE 3: North American Coal Company (NACCO) is considering
the purchase or lease of an electric shovel costing $10M. NACCO
would use each shovel for 10 years and expect the shovel to be
worth $500,000 at that time. The asset would require straight-line
depreciation over ten years to a terminal value of $500,000. A
finance company has offered to lease the shovel for annual
payments of $1.745M payable at the end of each of 10 years.
Alternatively, NACCO could purchase the shovel
Like any real world firm, NACCO cannot borrow 100% of the purchase
through a secured loan. The secured lender will lend 80% of the assets
value at the secured rate of 11.5%. The remaining 20%, if borrowed, must
be financed at an unsecured rate of 14%. The cost of 100% debt
financing is therefore:
12%=(0.80)(11.5%)+(0.20)(14%)
The projects WACC is 15%
Depreciation is straight line implying D
t
=$950,000 (=10,000,000-
500,000)/10)
NACC pays taxes at a 40% rate implying T D
t
= $380,000 (=0.40(950,000))
There is no ITC or additional expenses with the lease (Expenses=0)
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CALCULATOR SOLUTON
PMT = (10.40)(1,745,000)+380,000 NAL = 10,000,000500,000/(1.15)
10
9,930,644
= 1,427,000 = 54,237
N = 10
FV = 0
= (10.40)0.12 = 7.2%
PV 9,930,644
PMT
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Is Leasing Economically Feasible?
Lets rewrite the net advantage of leasing as:
Let NAL(PMT
BE,Lessee
)=0 define the Lessees Breakeven Lease payment
Lets also write the NPV of leasing for the lessor as:
Let NPVL(PMT
BE,Lessor
)=0 define the Lessors Breakeven Lease payment
A mutually profitable leasing opportunity exists when:
PMT
BE
,
Lessor
< PMT
BE
,
Lessee
Technical Notes: We are assuming that the WACC for the lessee and lessor are the same. What
does this imply? We are also ignoring Expense and ITC
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More Reality: Payment Timing
Most leases require lease payments in advance
Our formula for the Net Advantage of Leasing
changes to:
Note: The NPVL formula is just the negative of the NAL: NPVL = - NAL (but with the lessor's tax rate etc.)
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Leasing and Capital Budgeting
Leasing and Capital Budgeting decision interact with each other
It is possible for a project to have a negative NPV but a sufficiently
positive NAL such that the project becomes economically feasible!
An approximate formula is:
Calculation Method
Perform a standard NPV analysis of a project
If NPV>0 definitely proceed with the project, but still see whether there is
an advantage to lease financingwhether NAL>0
If NPV<0 dont give up immediately. Calculate the NAL. If NPV+NAL>0
proceed with the project using lease financing
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Major points to remember
As always, know how to work the assigned homework problems as well as the
types of numerical examples in the notes
What is a lease in general?
What is financial lease? What is an operating lease?
What are three types of financial leases? Describe them.
What is the correct discount rate for valuing a leasing opportunity?
What are the principle reasons firms choose to lease rather than buy?
In perfect capital markets, does leasing matter? Why?
What are some bad/questionable reasons firms lease?
How can a firm calculate the Net Advantage of Leasing (NAL) as compared
to buying?
How does the timing of lease payments affect the calculation of NAL?
How does the possibility of leasing affect the capital budgeting analysis?
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In-class Problem
C&S, Inc. an international builder of high-rise office buildings, must
choose whether to lease or buy a new construction crane. The
crane costs $1.5 M and has a 7-year useful life. In 7 years, the crane
could be scrapped for $200,000 after tax. C&S could buy the crane
with 100% bank finance secured by the crane at a loan rate of 11%.
Alternatively, SF Leasing, Inc. has offered to lease the crane to C&S
for 7 years for an annual payment of $250,000 paid in arrears. The
crane may be depreciated for tax purposes on a straight-line basis
over 7 years to a $200,000 terminal value. There are no expense
differences between leasing and buying (E=0). If the lessees
(C&Ss) marginal tax rate is 40% and its WACC is 18%,
What is the net advantage to leasing (NAL)?
What is the NAL if the lease payments are in advance?
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APPENDIX I: Types of Leases
(Financial Accounting)
Statement of Financial Accounting Standards No. 13 ( FAS 13)
creates two classes of Leases: Capital Leases and Operating Leases
Capital Leases
Appear on the firms balance sheet
The present value of the lease payments appear as a Liability
The same value appears as an Asset
FAS 13 requires a lease be classified as a capital lease if any one of the
follow hold:
The present value of the lease payments equals or exceeds 90% of the fair
market value of the asset at the start of the lease
The lease transfers ownership to the lessee by the end of the lease
The lease term is 75% or more the economic life of the asset
The lessee can purchase the asset at below fair market price when the lease
expires (Bargain Purchase Price Option)
Operating Leases
All other leases are classified as Operating Leases
Operating leases are off-Balance Sheet Financing
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Questionable Strategies
Since the lease liability is hidden with an operating lease,
the balance sheet of a firm with an operating lease looks
stronger
A clever financial manager could try to negotiate a lease
contract the does not meet the requirements for it to be
booked
However, operating leases do appear in a firms annual
report in the notes. Therefore, assuming (semi-strong form)
market efficiency, how leases are classified should not
affect firm value
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APPENDIX II: Taxes, Leases, & IRS
The key driver of leasing is the relative tax advantage of letting the lessor recognize the
tax benefits of ownership
The IRS role is tax collection. Consequently, it seeks to ensure some semblance of a
legitimate business purpose for a lease
In order for the the lessee to deduct lease payments for income tax purposes, the lease
must qualify under IRS rules
Prior to major lease transaction, all interested parties typically obtain an opinion from the IRS
Rules:
Lease must be less than 30 years and not exceed 80% of the assets useful life including all
renewal and extension periods
Lease should not have an option to acquire below the assets fair market value (otherwise, lessee
has something like an equity claim on the residual value)
Lease may not have early balloon payments as they are evidence the lease is an attempt to
avoid taxes, not a legitimate business transaction
Essentially a way to accelerate depreciation
Lease payments themselves must provide the lessor with a fair market return. The profit from the
lease for the lessor should not stem solely from the deals tax benefits
Lease should not limit the right of lessee to pay dividends or issue debt
Renewal options must be reasonable and reflect the fair market value of the asset
Lessee may not pay for any portion of the asset or guarantee any loans for its purchase
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APPENDIX III: Debt Service Parity
Why use the After-Tax Cost of Secured Debt?
To see why, lets consider a parallel situation: suppose the firm has a series of secured
loan obligations equal to the NAL cash flows (excluding the Year 0 initial equipment
cost)
Consider Debt Service Parity: how much money could the firm borrow and have these NAL cash
flows fully repay the principal and interest?
If the firm can get more cash from this Equivalent Loan than it takes to buy the equipment, the
NAL is negative and its cheaper to buy
Lets revisit Example 1:
The net cash flows (excluding Year 0) are $23,135 after-tax, per year for five years
We can prove this is correct if $23,135 for five years is sufficient to amortize the Equivalent Loan
$100,162.46exactly
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Indeed, the following table shows the equivalent loan is fully
amortized by the NAL flows (excluding Year 0)
The correct discount rate in the NAL calculation is therefore
the after-tax cost of secured debt!
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APPENDIX IV: Debt Displacement
& Leasing
Our approach to valuing leases is to 1) compare the lease to
a comparable loan and 2) choose whichever source of
finance is cheaper!
This gives an apples-to-apples comparison of the two
But only debt finance is considered
Would a firm with a target debt ratio regularly choose to
finance equipment purchases with only debt? No!
Over the longer run, firms typically seek to maintain a target
leverage ratio
But a lease is a form of secured borrowing
IMPLICATION: If a firm regularly uses lease finance, it must also
periodically issue equity and repay debt. This is called DEBT
DISPLACEMENT
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EXAMPLE: Suppose a firm has an initial balance
sheet as follows, showing its target D/E ratio of 6:4
or 150%
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Consider the balance sheet after the firm Buys a machine
for $100,000 (and leverage rebalances)
Instead, suppose the firm Leases (and the firm is exactly
indifferent between leasing and buying)
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Because a lease is equivalent to a loan, the firm offsets,
the $100,000 increase in debt by
Issuing $40,000 of new equity and
Paying off $40,000 of old outstanding debt
This recapitalization leaves the capital structure at its
optimal ratio:
D/E=(100,000+560,000)/440,000=660,000/440,000=150%

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Professor Jawad M.

Addoum FIN303: Spring 2013

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