SIMAD UNIVERSITY

Learning objective

What is a Lease?

Why Lease?

Operating versus Financial Leases

Steps of leasing

Example leasing

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Lecturer .Yusuf H.Mohamed

Subj: Corporate finance Chapter 7

SIMAD UNIVERSITY
Define lease

A lease is an agreement between a lessor and a lessee that conveys to the lessee the right to use
specific property, real or personal, owned by the lessor, for a stated period of time.
A financing arrangement that provides a firm with an advantage of using an asset, without
owning it, may be termed as leasing.

Lessee user of an asset; makes payments

Lessor owner of the asset; receives payments

Types of lease

Operating lease

Shorter-term lease

Lessor is responsible for insurance, taxes and maintenance

Often cancelable

Financial lease (capital lease)

Longer-term lease

Lessee is responsible for insurance, taxes and maintenance

Generally not cancelable

Specific capital leases

1. Direct lease is a lease under which a lessor owns or acquires the assets that are leased to
a given lessee.
2. A sale-leaseback arrangement is a lease under which the lessee sells an asset for cash to a
prospective lessor and then leases back the same asset.
3. A leveraged lease is a lease under which the lessor acts as an equity participant,
supplying about 20 percent of the cost of the asset with a lender supplying the balance. A
three-sided arrangement between the lessee, the lessor, and lenders. The lessor owns the
asset and for a fee allows the lessee to use the asset. The lessor borrows to partially
finance the asset. The lenders typically use a nonrecourse loan. This means that the lessor
is not obligated to the lender in case of a default by the lessee.

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Lecturer .Yusuf H.Mohamed

Subj: Corporate finance Chapter 7

SIMAD UNIVERSITY
A capital lease must meet one of four criteria:
Ownership transfers to the lessee at the end of the lease term, or . . .
A bargain purchase option (BPO) exists, or . . .
The non-cancelable lease term is equal to 75% or more of the expected
economic life of the asset, or . . .
The PV of the minimum lease payments (MLP) is 90% or more of the fair
value of the asset.

Why lease
Short-term leases are convenient
Cancellation options are valuable
Maintenance is provided
Standardization leads to low costs
Tax shields can be used
Avoiding the alternative minimum tax
Steps involved in Leasing
1. Deciding the required asset, make, price, supplier
2. Entering into agreement with lessor containing
A. Nature of the lease : financial lease, operating lease etc.
B. Description: of the equipment, its actual condition, size, estimated useful life,
components etc.
C. Delivery and Re-delivery : when and how the equipment would be delivered to
the lessee and redelivered by him.
D. Lease Rentals; procedure for payments of lease rentals with the rates. Besides,
the late payment charges.
E. Repairs & Maintenance: responsibility of repairs, insurance etc.
F. Title : identification and ownership of equipment.
G. Events of default and Remedies : consequences of default and recourse
available to the lessor.
3. After signing above agreement, lessor request supplier to supply asset to lessee.

Example 1 Lease classification

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Lecturer .Yusuf H.Mohamed

Subj: Corporate finance Chapter 7

SIMAD UNIVERSITY
Crossbow Limited, a manufacturer of machinery, leased out two machines during
the year ended 31 December 2012 as follows:

Machine A

Machine B

Annual rental

8,000

10,000

Cost of manufacturing machinery

25,000

30,000

Expected useful life

8 years

8 years

Lease Term

2 years

8 years

Normal sales value

40,000

45,000

Requirement

Based upon the information provided, assess whether the two machines have been leased out by
Crossbow Limited on either a finance lease or operating lease.
Solution
The lease for Machine A is an operating lease, as the lease term is 2 years and the expected
useful life of the asset is 8 years.
The lease of Machine B appears to be leased out under a finance lease as the lease term matches
the expected life of the machine and the minimum lease payments are 80,000 (10,000 X 8
payments) are greater than the normal sales value of the asset of 45,000.

Example 2 Operating Lease

Acme Limo has a client who will sign a lease for for 7 years, with lease payments
due at the start of each year. The following table shows the NPV of the limo if Acme
purchases the new limo for $75,000 and leases it our for 7 years After tax 35% 7
Real cost of capital using MACRS

4
Lecturer .Yusuf H.Mohamed

Subj: Corporate finance Chapter 7

SIMAD UNIVERSITY
0
Initial cost
Maintenance, insurance, selling,
and administrative costs
Tax shield on costs
Depreciation tax shield
Total
NPV @ 7% = - $98.15

Year
3

-75
-12

-12

-12

-12

-12

-12

-12

4.2
0
-82.8

4.2
5.25
-2.55

4.2
8.4
0.6

4.2
5.04
-2.76

4.2
3.02
-4.78

4.2
3.02
-4.78

4.2
1.51
-6.29

Example 3 Financial Leases

Greymare Bus Lines is considering a lease. Your operating manager wants to buy a
new bus for $100,000. The bus has an 8 year life. The Bus Saleswoman says she
will lease Greymare the bus for 8 years at $16,900 per year, but Greymare assumes
all operating and maintenance costs.
Should Greymare Buy or Lease the bus

0
Cost of new bus
Lost Depr tax shield
Lease payment
Tax shield of lease
Cash flow of lease

Year
2

-6.8
-16.9
5.92
-17.78

-11.2
-16.9
5.92
-22.18

-6.72
-16.9
5.92
-17.7

-4.03
-16.9
5.92
-15.01

-4.03
-16.9
5.92
-15.01

-2.02
-16.9
5.92
-13

100
-16.9
5.92
89.02

-16.9
5.92
-10.98

Cash flow consequences of the lease contract to Greymare :

Greymare saves the $100,000 cost of the bus

Loss of depreciation benefit of owning the bus

$16,900 lease payment is due at the start of each year

Lease payments are tax deductible

5
Lecturer .Yusuf H.Mohamed

Subj: Corporate finance Chapter 7

SIMAD UNIVERSITY
Greymare Bus Lines can borrow at 10%, thus the value of the lease should be
discounted at 6.5% or .10 x (1-.35). The result will tell us if Greymare should lease
or buy the bus

17.99
22.19
17.71
15.02
2
3
1.065 1.065
1.065
1.065 4
15.02
13.00
10.98
5
6
1.065
1.065
1.065 7
.70 or - $700

NPV lease 89.02 -

Since lease has negative NPV , greymare is better of f buying the bus.

Example 4 Capital Leases and Installment

Matrix, Inc. acquires equipment from Apex, Inc. by paying $193,878 every six
months for the next three years. The interest rate associated with the agreement is
9%. Lets look at the arrangement as an installment note payable and as a capital
lease agreement. First, lets prepare an amortization schedule for the payments
initial value .

Effective
Date
Initial value . . . . . . . . . . . . . . . .
...
1

Payment

Interest

Decreas
e
in
Balance

Outstandin
g
Balance
$ 1,000,000

$
193,878

$
45,000

$
148,878

193,878

38,300

155,578

851,122
695,544

532,966
193,878

31,300

162,578

193,878

23,983

169,895

363,071

185,532
193,878

16,338

177,540
-

6
Lecturer .Yusuf H.Mohamed

Subj: Corporate finance Chapter 7

SIMAD UNIVERSITY
193,878

8,346

185,532

Inception of the Agreement

January

Capital Lease
Description

Debit

Equipment
Lease payable

Credit

1,000,000
1,000,000

First Semi-Annual Payment Date

Capital
Lease
Description
Interest expense
Lease payable
Cash

Debit

Credit

45,000

Example 5
Your firm will

148,878
193,878

either purchase

or lease a new $500,000 packaging machine from the manufacturer. If purchased, the machine
will be depreciated straight-line over five years. You can lease the machine using a true tax lease
for $125,000 per year for five years with the first payment today. Assume the machine has no
residual value, the secured borrowing rate is 9%, and the tax rate is 35%. Should you buy or
lease?
7
Lecturer .Yusuf H.Mohamed

Subj: Corporate finance Chapter 7

SIMAD UNIVERSITY

Step 1. Determine the cash flow consequences of buying the machine.

Capital Expenditures
Depreciation Tax
Shield
Free Cash Flow

0
500,000

35,000

35,000

35,000

35,000

35,000

500,000

35,000

35,000

35,000

35,000

35,000

Step 2. Determine the cash flow consequences of leasing the machine.

0.

Lease Payments
Income Tax Savings
Free Cash Flow

1
2
3
4
125,000 125,000 125,000 125,000 125,000
43,750
43,750
43,750
43,750
43,750
81,250
81,250
81,250
81,250
81,250

Step 3. Determine the incremental cash flows of leasing versus buying.

Free Cash Flow Lease

0.

81,250
Less: Free Cash Flow Buy
500,000
Lease Buy
418,75
0

1
81,250

2
81,250

3
81,250

4
81,250

35,000

35,000

35,000

35,000

35,000

116,250 116,250 116,250 116,250

35,000

Step 4. Determine the NPV of leasing versus buying using the incremental cash flows
The after-tax borrowing rate is 9%(1 0.35) = 5.85%.
NPV = 418,750
+
116,250 + 116,250 + 116,250 + 116,250 +35,000 = $11,796
1.0585

1.0585 2

1.0585 3

1.0585 4

1.05855

Step 5. Make a conclusion.

8
Lecturer .Yusuf H.Mohamed

Subj: Corporate finance Chapter 7

SIMAD UNIVERSITY
You are better off buying, since the NPV of leasing is less than zero

9
Lecturer .Yusuf H.Mohamed

Subj: Corporate finance Chapter 7