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Because learning changes everything. ®

Corporate Finance Thirteenth Edition

Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe /
Bradford D. Jordan

Chapter 21

Leasing

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Key Concepts and Skills

• Understand the different types of leases.
• Understand how to apply NPV to the lease-versus-buy
decision.
• Understand the importance of tax rates in determining the
benefit of leasing.

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Chapter Outline
21.1 Types of Leases
21.2 Accounting and Leasing
21.3 Taxes, the IRS, and Leases
21.4 The Cash Flows of Leasing
21.5 A Detour for 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 lessor owns the asset and for a fee allows the lessee
to use the asset.

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Figure 21.1 Buying versus Leasing

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Operating Leases
Usually not fully amortized
Have a life that is less than the economic life of the asset
Usually require the lessor to maintain and insure the asset
Can often be canceled by the lessee

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Financial Leases
Essentially 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 canceled.

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Tax-Oriented Leases
A particular type of financial lease
Lessor is the owner of the leased asset for tax purposes
Make the most sense when the lessee is not in a position to
efficiently use tax credits or depreciation deductions that
come with owning the asset

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Sale and Leaseback

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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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 5-year useful life.
If the firm buys the truck, it will be depreciated straight-line to
zero.
They can lease it for five years from Tiger Leasing with an
annual lease payment of $6,250.
Both firms face a 21 percent tax rate.
The company’s cost of debt is 10%

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The Cash Flows of Leasing - I

Cash Flows: Buy
Year 0 Years 1 Years 2 Years 3 Years 4 Years 5
Cost of truck −$25,000
Aftertax operation savings $3,555 $3,555 $3,555 $3,555 $3,555
Depreciation tax benefit _______ 1,050 1,050 1,050 1,050 1,050
−$25,000 $4,605 $4,605 $4,605 $4,605 $4,605

Cash Flows: Lease

Year 0 Years 1 Years 2 Years 3 Years 4 Years 5
Lease payments −$4,937.50 −$4,937.50 −$4,937.50 −$4,937.50 −$4,937.50
Aftertax 3,555.00 3,555.00 3,555.00 3,555.00 3,555.00
operation
savings
−$1,382.50 −$1,382.50 −$1,382.50 −$1,382.50 −$1,382.50
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The Cash Flows of Leasing - II

Cash Flows: Leasing Instead of Buying

Year 0 Years 1–5

$25,000 −$1,382.50 − 4,605 = −$5,987.50

We could also view the cash flows as buying minus

leasing, which would change the signs on the cash flows.
The discount rate is the aftertax rate on the firm’s secured
debt.

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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
• Accounting
• 100 percent financing

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Impact of Taxes Example - I

Now suppose a world without a flat corporate tax rate where
ClumZee movers is in the 21 percent tax bracket and Tiger
Leasing is in a 34 percent tax bracket. If Tiger reduces the lease
payment to $6,200, can both firms have 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

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Impact of Taxes Example - II

Cash Flows ClumZee Movers: Leasing Instead of Buying

Year 0 Years 1 to 5
Cost of truck we didn’t buy $25,000
Lost depreciation tax –$5,000 × .21 = −$1,050
shield
Aftertax lease payments _______ 6,200 × (1 − .21) = −4,898
$25,000 −$5,948

NPV = −$751.73

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Tiger Leasing’s Reservation Payment - I

What is the smallest lease payment that Tiger Leasing will accept?
Set their NPV to zero and solve for $Lmin:

Year 0 Years 1 to 5
Cost of truck −$25,000
Depreciation tax shield $5,000 × .34 = $1,700
Lease payments _______ $Lmin × (1 − .34) = $Lmin × (1 − .34)
−$25,000 $1,700 + $Lmin × (1 − .34)

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Tiger Leasing’s Reservation Payment - II

Step One is to find the aftertax cost of the truck.
Step Two is to find the aftertax payment required.

This is $6,173.29 on
a pretax basis.

Access the text alternative for slide images

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ClumZee’s Reservation Payment - I

What is the highest lease payment that ClumZee Movers can pay?
Set their NPV to zero and solve for $Lmax:

Year 0 Years 1 to 5
Cost of truck −$25,000
Depreciation tax shield $5,000 × .21 = $1,050
Lease payments _______ $Lmax × (1 − .21) = $Lmax × (1 − .21)
−$25,000 $1,050 + $Lmax × (1 − .21)

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ClumZee Movers’ Break-Even Payment - II

Step One is to find the aftertax cost of the truck.

Step Two is to find the aftertax payment required.

This is $5,980.22 on
a pretax basis.

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Is a Lease Possible?
The most that ClumZee Movers can afford to pay is
$5,980.22
The least that Tiger Leasing can accept is $6,173.29
So, there will not be a lease in this case.

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