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Chapter Twenty One

Leasing Corporate Finance
Ross ∙ Westerfield ∙ Jaffe 21
Sixth Edition

Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
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Chapter Outline
21.1 Types of Leases
21.2 Accounting and Leasing
21.3 Taxes and Leases
21.4 The Cash Flows of Leasing
21.5 A Detour on Discounting and Debt Capacity with
Corporate Taxes
21.6 NPV Analysis of the Lease-versus-Buy Decision
21.7 Debt Displacement and Lease Valuation
21.8 Does Leasing Ever Pay: The Base Case
21.9 Reasons for Leasing
21.10 Some Unanswered Questions

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21.1 Types of Leases

• The Basics
– A lease is a contractual agreement between a lessee and
lessor.
– The agreement establishes that the lessee has the right to
use an asset and in return must make periodic payments
to the lessor.
– The lessor is either the asset’s manufacturer or an
independent leasing company.

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Operating Leases

• Usually not fully amortized. This means that the

payments required under the terms of the lease are
not enough to recover the full cost of the asset for
the lessor.
• Usually require the lessor to maintain and insure the
asset.
• Lessee enjoys a cancellation option. This option
gives the lessee the right to cancel the lease contract
before the expiration date.

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Financial Leases

The exact opposite of an operating lease.

1. Do not provide for maintenance or service by the lessor.
2. Financial leases are fully amortized.
3. The lessee usually has a right to renew the lease at
expiry.
4. Generally, financial leases cannot be cancelled, i.e., the
lessee must make all payments or face the risk of
bankruptcy.

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Sale and Lease-Back

• A particular type of financial lease.

• Occurs when a company sells an asset it already
owns to another firm and immediately leases it from
them.
• Two sets of cash flows occur:
– The lessee receives cash today from the sale.
– The lessee agrees to make periodic lease payments,
thereby retaining the use of the asset.

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Leveraged Leases

• A leveraged lease is another type of financial lease.

• 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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21.2 Accounting and Leasing

• In the old days, leases led to off-balance-sheet

financing.
• In 1979, the Canadian Institute of Chartered
Accountants implemented new rules for lease
accounting according to which financial leases must
be “capitalized.”
• Capital leases appear on the balance sheet—the
present value of the lease payments appears on both
sides.

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Accounting and Leasing

Balance Sheet
Truck is purchased with debt
Truck $100,000 Debt $100,000
Land $100,000 Equity $100,000
Total Assets $200,000 Total Debt & Equity $200,000

Operating Lease
Truck Debt
Land $100,000 Equity $100,000
Total Assets $100,000 Total Debt & Equity $100,000

Capital Lease
Assets leased $100,000 Obligations under capital lease $100,000
Land $100,000 Equity $100,000
Total Assets $200,000 Total Debt & Equity $200,000

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Capital Lease
• A lease must be capitalized if any one of the following is
met:
– The present value of the lease payments is at least
90-percent of the fair market value of the asset at the start
of the lease.
– The lease transfers ownership of the property to the lessee
by the end of the term of the lease.
– The lease term is 75-percent or more of the estimated
economic life of the asset.
– The lessee can buy the asset at a bargain price at expiry.

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21.3 Taxes and Leases

• The 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 of ownership to a party who can.
• If the CCRA (Canada Customs and Revenue Agency)
detects one or more of the following, the lease will be
disallowed.
1. The lessee automatically acquires title to the property after
payment of a specified amount in the form of rentals.
2. The lessee is required to buy the property from the lessor.
3. The lessee has the right during the lease to acquire the
property at a price less than fair market value.

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21.4 The Cash Flows of Leasing

Consider a firm, ClumZee Movers, that wishes to

acquire a delivery truck.
The truck is expected to reduce costs by $4,500 per
year.
The truck costs $25,000 and has a useful life of five
years.
If the firm buys the truck, they will depreciate it
straight-line to zero.
They can lease it for five years from Tiger Leasing with
an annual lease payment of $6,250.

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21.4 The Cash Flows of Leasing

• Cash Flows: Buy
Year 0 Years 1-5
Cost of truck –$25,000
After-tax savings 4,500×(1-.34) = $2,970
Depreciation Tax Shield 5,000×(.34) = $1,700
–$25,000 $4,670

• Cash Flows: Lease

Year 0 Years 1-5
Lease Payments –6,250×(1-.34) = –$4,125
After-tax savings 4,500×(1-.34) = $2,970
–$1,155

• Cash Flows: Leasing Instead of Buying

Year 0 Years 1-5
$25,000 –$1,155 – $4,670 = –$5,825

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21.4 The Cash Flows of Leasing

• Cash Flows: Leasing Instead of Buying

Year 0 Years 1-5
$25,000 –$1,155 – $4,670 = –$5,825
• Cash Flows: Buying Instead of Leasing
Year 0 Years 1-5
–$25,000 $4,670 –$1,155 = $5,825

• However we wish to conceptualize this, we need to

have an interest rate at which to discount the future
cash flows.
• That rate is the after-tax rate on the firm’s secured
debt.

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21.5 A Detour on Discounting and Debt
Capacity with Corporate Taxes
• Present Value of Riskless Cash Flows
– In a world with corporate taxes, firms should discount
riskless cash flows at the after-tax riskless rate of interest.
• Optimal Debt Level and Riskless Cash Flows
– In a world with corporate taxes, one determines the
increase in the firm’s optimal debt level by discounting a
future guaranteed after-tax inflow at the after-tax riskless
interest rate.

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21.6 NPV Analysis of the Lease-vs.-Buy
Decision
• A lease payment is like the debt service 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 interest rate on secured debt issued by the lessee.
• The various tax shields could be riskier than lease payments
for two reasons:
1. The value of the CCA tax benefits depends on the firm’s
ability to generate enough taxable income.
2. The corporate tax rate may change.

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NPV Analysis of the Lease-vs.-Buy Decision
• There is a simple method for evaluating leases: discount
all cash flows at the after-tax interest rate on secured debt
issued by the lessee. Suppose that rate is 5-percent.
NPV Leasing Instead of Buying
Year 0 Years 1-5
$25,000 –$1,155 – $4,670 = -$5,825

NPV Buying Instead of Leasing

Year 0 Years 1-5
-$25,000 $4,670 – $1,155 = $5,825

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21.7 Debt Displacement and Lease Valuation

• Considering the issues of debt displacement allows

for a more intuitive understanding of the lease
versus buy decision.
• Leases displace debt—this is a hidden cost of
leasing. If a firm leases, it will not use as much
regular debt as it would otherwise.
– The interest tax shield will be lost.

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21.7 Debt Displacement and Lease Valuation
• The debt displaced by leasing results in forgone
interest tax shields on the debt that ClumZee movers
didn’t go into when they leased instead of bought
the truck.
• Suppose ClumZee agrees to a lease payment of
$6,250 before tax. This payment would support a
loan of $25,219.20 (see the next slide)
• In exchange for this, they get the use of a truck
worth $25,000.
• Clearly the NPV is a negative $219.20, which
agrees with our earlier calculations.

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21.7 Debt Displacement and Lease Valuation

Suppose ClumZee agrees to a lease payment of $6,250 before
tax. This payment would support a loan of $25,219.20

After-Tax Lease Payments –6,250×(1-.34) = –$4,125

Forgone Depreciation Tax Shield – 5,000×(.34) = –$1,700
-$5,825
Calculate the increase in debt capacity by discounting the
difference between the cash flows of the purchase and the cash
flows of the lease by the after-tax interest rate.
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21.8 Does Leasing Ever Pay: The Base Case

• In the above example, ClumZee Movers chose to buy,

because the NPV of leasing was a negative $219.20
• Note that this is the opposite of the NPV that Tiger Leasing
would have:
• Cash Flows: Tiger Leasing
Year 0 Years 1-5
Cost of truck –$25,000
Depreciation Tax Shield 5,000×(.34) = $1,700
Lease Payments 6,250×(1-.34) = $4,125
–$25,000 $5,825

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21.9 Reasons for Leasing

• Good Reasons
– Taxes may be reduced by leasing.
– The lease contract may reduce certain types of
uncertainty.
– Transactions costs can be higher for buying an asset and
financing it with debt or equity than for leasing the asset.
• Bad Reasons
– Leasing and accounting income
– 100% financing

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A Tax Arbitrage
• Suppose ClumZee movers is actually in the 25% tax bracket and Tiger
Leasing is in the 34% tax bracket. If Tiger reduces the lease payment to
$6,200, can both firms have a positive NPV?
• Cash Flows: Tiger Leasing
Year 0 Years 1-5
Cost of truck –$25,000
Depreciation Tax Shield 5,000×(.34) = $1,700
Lease Payments 6,200×(1 –.34) = $4,092
–$25,000 $5,792
NPV = 76.33
• 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 6,200×(1 –.25) = –$4,650
$25,000 –$5,900
NPV = -$543.91

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Reservations and Negotiations

• What is the smallest lease payment that Tiger Leasing will
accept? Set their NPV to zero and solve for $Lmin:
• Cash Flows: Tiger Leasing
Year 0 Years 1-5
Cost of truck -$25,000
Depreciation Tax Shield 5,000×(.34) = $1,700
Lease Payments $Lmin ×(1 –.34) = $Lmin × .66
-$25,000 $1,700 + $Lmin × .66

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Reservations and Negotiations

• What is the highest lease payment that ClumZee Movers can
pay? Set their NPV to zero and solve for $Lmax:
• 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 – $Lmax×( 1 –.25) = .75× Lmax
$25,000 – 1,250 – .75× Lmax

No lease is possible: Lmin > Lmax

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21.10 Some Unanswered Questions

• Are the Uses of Leases and of Debt Complementary?
• Why are Leases offered by Both Manufacturers and Third
Party Lessors?
– For manufacturer lessors, the basis for determining
capital cost allowance is the manufacturer’s cost.
– For third party lessors, the basis is the sale price that the
lessor paid to the manufacturer.
• Why are Some Assets Leased More than Others?
– The more sensitive is the value of an asset to use and
maintenance decisions, the more likely it is that the asset
will be purchased instead of leased.

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21.11 Summary and Conclusions

• There are three ways to value a lease.
1. Use the real-world convention of discounting the
incremental after-tax cash flows at the lessor’s after-tax
rate on secured debt.
2. Calculate the increase in debt capacity by discounting
the difference between the cash flows of the purchase
and the cash flows of the lease by the after-tax interest
rate. The increase in debt capacity from a purchase is
compared to the extra outflow at year 0 from a purchase.
3. Use APV (presented in the appendix to this chapter).
• They all yield the same answer.
• The easiest way is the least intuitive.

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Appendix 21A: APV Approach to Leasing

APV = All-Equity Value + Financing NPV

Calculations shown on the following slides will show

that for the latest Clumzee Movers example (tax rate
is 25%)
APV = $591.38 – $1,135.30
APV = –$543.91
Which is the same value as the easier NPV analysis.

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Appendix 21A: APV Approach to Leasing

APV = All-Equity Value + Financing NPV
• To find the all-equity value, discount the cash flows at the
pre-tax interest rate. The after-tax rate was 5% which implies
a pretax rate of
6.66% = 5%/(1-.25).
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 6,200×(1 –.25) = –$4,650
$25,000 –$5,900

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Appendix 21A: APV Approach to Leasing

APV = All-Equity Value + Financing NPV
• The NPV of the financing is the forgone interest tax shields
on the debt that ClumZee movers didn’t go into when they
leased instead of bought the truck.
• ClumZee agreed to a lease payment of $5,900.
• This payment would support a loan of $25,543.91

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Appendix 21A: APV Approach to Leasing

The lost interest tax shield associated with this additional debt
capacity of $25,543.91 has a present value of $1,135.30

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21.7 Debt Displacement and Lease Valuation

The lost interest tax shield associated with this additional debt
capacity of $25,219.20 has a present value of $

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