Leasing and Other Asset-Based Financing

21

Corporate Financial Management 3e Emery Finnerty Stowe

Modified for course use by Arnold R. Cowan

Lease Financing
A lease is a rental agreement that extends for one year or longer. The owner of the asset (the lessor) grants exclusive use of the asset to the lessee for a fixed period of time.

In return, the lessee makes fixed periodic payments to the lessor.

At termination, the lessee may have the option to either renew the lease or purchase the asset.
1

Types of Leases
Full-service lease

Lessor responsible for maintenance, insurance, and property taxes. Lessee responsible for maintenance, insurance, and property taxes.

Net lease

Types of Leases
Operating lease
short-term may be cancelable

Financial lease
long-term similar to a loan agreement

Types of Lease Financing

Direct leases Sale-and-lease-back agreements Leveraged leases

Direct Lease

Lessee

Lease

Manufacturer / Lessor
or

Lessee

Lease

Lessor

Sale of Asset

Manufacturer / Lessor
5

Sale-and-Lease-Back

Sale of Asset

Lessee
Lease

Lessor

Leveraged Lease
Manufacturer
Sale of Asset

Lessee

Lease

Single Purpose Leasing Company

Lien Loan

Lender
Equity Investor
7

Equity

Synthetic Leases
Firms have used synthetic leases to get the use of assets but keep debt off their balance sheets. An unrelated financial institution invests some equity and sets up a special-purposeentity that buys the assets and leases it to the firm under an operating lease. Since the Enron bankruptcy, firms have been reluctant to use synthetic leases.
8

Enrons Murky Deals

Enron used outside partnerships to move assets off its balance sheet and monetize assets. But the company was deeply involved with funding those partnerships.

Outside investors inject at least 3% of the funding so that Enron doesnt have to claim it as a subsidiary.

Enron provided some or all of the 3%.

2
Partnership or Special Purpose Entity

Equity Investor

Enron

Enron sells assets, gets debt off the balance sheet and recognizes a gain on the sale.

Banks provided the other 97% of the financing.

Enron guarantees the loan. Sometimes with nowworthless Enron shares.

Lending Group

Enrons Partnerships
Reasons for setting up SPEs:
By

setting up partnerships, partly owned by the company, Enron could draw in capital from outside investors. If structured properly (the tax code requires that at least 3% of the partnership equity be obtained from outside investors), the partnerships could also be kept separate from Enron.
10

Enrons Partnerships
As a result, any debt incurred by the partnership could be kept off the company's balance sheet. As an added bonus, Enron often recognized a gain on the sale of the assets.

11

Why did Enron want debt off their balance sheet?

The simple answer is that Enron feared that too much debt would damage its credit rating.

12

Why did Enron want debt off their balance sheet?

A more complex answer lies with agency costs. Enron executives headed and partly owned some of the partnerships, which provided a huge source of outside income for those involved.

Enrons former CFO, Andrew Fastow, made more than $30 million from two partnerships that he ran.

If you were a shareholder in a SPE buying an asset from your employer, where would your loyalties lie?
13

How Widespread Was This at Enron?

There were hundreds, and perhaps even thousands, of these partnerships. The exact number isn't known. In all, Enron had about 3,500 subsidiaries and affiliates, many of them limited partnerships and limited-liability companies, which are a sort of hybrid between corporations and partnerships.
14

How Did They Get Away With It?

The company and its board of directors claimed that allowing executives to be involved with the outside partnerships gave it the advantage of speed. Enron claimed that it set up safeguards to protect itself, but in retrospect they were clearly inadequate.

15

Advantages of Leases
Efficient use of tax deductions and tax credits of ownership Reduced risk Reduced cost of borrowing Bankruptcy considerations Tapping new sources of funds Circumventing restrictions

debt covenants off-balance sheet financing

16

Disadvantages of Leasing

Lessee forfeits tax deductions associated with asset ownership. Lessee usually forgoes residual asset value.

17

Valuing Financial Leases

Basic approach is similar to debt refunding. Lease displaces debt. Missed lease payments can result in the lessor

claiming the asset. filing lawsuits. forcing firm into bankruptcy.

Risk of a firms lease payments are similar to those of its interest and principal payments.
18

Equivalent Ways to Analyze

Net Advantage to Leasing (NAL) approach:

Lease if NAL > 0. Lease if IRR of leasing < after-tax cost of debt financing.

The Internal Rate of Return (IRR) approach:

19

Leases Analysis Example

The Emerson Co. needs the use of a special purpose stamping machine for the next 10 years. The machine costs $6 million, has a life of 10 years, and a salvage value of $300,000. Emerson can lease this machine from the General Supply Co. for 10 years, with annual year-end lease payments of $1.05 million. Emersons tax rate is 40%.

20

Leases Analysis Example

If Emerson were to buy the machine, it would finance 80% of the purchase price with a 11.5% secured installment loan, with the remainder being borrowed as unsecured installment debt at 14% interest. The after-tax required return on the asset is 15%. Evaluate this leasing opportunity.
21

Leasing Displaces Borrowing

Suppose initially that the Emerson Co. has net assets worth $50 million, and a debt ratio of 50%. Compute the debt ratio if Emerson uses:

Conventional financing for the stamping machine. Leases the stamping machine. How would the target debt ratio be restored?
22

Leasing Displaces Borrowing

Initial Capitalization $ 25 M
$0M $25 M $25 M $50 M 50%
23

Conventional Debt Financial Lease Obligation Total Debt

Equity Total Debt Ratio

Leasing Displaces Borrowing

Conventional Financing $ 28 M
$0M $25 M $28 M $56 M 50%
24

Conventional Debt Financial Lease Obligation Total Debt

Equity Total Debt Ratio

Leasing Displaces Borrowing

Lease Financing $ 25 M
$6M $ 31 M $25 M $56 M 5 5.36%
25

Conventional Debt Financial Lease Obligation Total Debt

Equity Total Debt Ratio

Leasing Displaces Borrowing

Debt Ratio Restored $ 22 M
$6M $28 M $28 M $56 M 50%
26

Conventional Debt Financial Lease Obligation Total Debt

Equity Total Debt Ratio

Analyzing Leases
The Net Advantage to Leasing (NAL) equals the purchase price (P) minus the present value of the incremental after-tax cash flows (CFAT) associated with the lease. NAL = P PV(CFATs)

27

Analyzing Leases - the Discount Rate

The discount rate should be the lessees after-tax cost of similarly secured debt. Since the lease obligation is not overcollateralized, the secured debt rate should reflect this. Fully secured means the asset is worth more than 25% of the loan.

$80M loan on $100M asset: $20/$80 = 25%

Use weighted average of secured and unsecured debt rates if necessary.

28

Analyzing Leases - the Cash Flows

Cost of asset (saving) Lease payments (cost) Incremental differences in operating and other expenses (cost or savings) Depreciation tax shelter (foregone benefit) Expected net residual value (foregone benefit) Investment tax credits (foregone benefit)
29

Net Advantage to Leasing

Dt = year t depreciation deduction

DEt = year t cash expense savings from leasing

ITC = investment tax credit, if available CFt = lease payment in year t N = life of lease (in years) P = purchase price of asset r = assets after-tax required return r = cost of debt (secured & unsecured) Salvage = net salvage value T = lessees marginal income tax rate
N

(1 T )(CFt DEt ) TDt Salvage NAL P ITC ' t (1 (1 T )r ) (1 r ) N t 1

Net Advantage to Leasing

(1 T )(CFt DEt ) TDt Salvage NAL P ITC ' t N (1 (1 T )r ) (1 r ) t 1
N

We save paying the purchase price P. We lose the ITC and salvage value. We pay the lease payment CF; this may be partly offset by savings on operating and other cash expenses (E) and by tax deductibility. We lose the depreciation tax shield TD. Discount main cash flows at the after-tax cost of debt.

Net Advantage to Leasing

For the Emerson Co.,
P = $6 million CFt = $1.05 million per year for 10 years Dt = ($6,000,000 - $300,000) / 10 = $570,000 per year for 10 years

DEt

= 0, ITC = 0 r = 15% r = 80%(11.5%) + 20%(14%) = 12.0%

32

Net Advantage to Leasing

(1 T )(CFt DEt ) TDt Salvage NAL P ITC ' t N (1 (1 T )r ) (1 r ) t 1
N

(1 .40)($1.05m) 0.4 $570,000 $300,000 NAL $6m t 10 (1 (1 0.40) 0.12) (1.15) t 1

10

NAL $45,068

33

The IRR Approach

For Emersons leasing opportunity, the IRR is 7.58%. The after-tax cost of debt financing is 12%(1 0.40) = 7.20%. Since the IRR (the cost of lease financing) is greater than the after-tax cost of debt financing, Emerson should not lease the machine.
34

Break-Even Lease Payments

The break-even lease payments can be computed by setting the NAL to zero. In the case of Emersons lease, the annual break-even payments are $1,039,206.

Since the lease contract calls for payments of $1,050,000; the leasing alternative is not preferred.

35

NPV of Lease to the Lessor

In a perfect market with no tax, leasing is a zero-sum game.

The NPV of the lease to the lessor will be - (NAL to the lessee).

If lessee and lessor have the same marginal income tax rates, leasing is still a zero sum game in an otherwise perfect market.
36

NPV of Lease to the Lessor

(1 T ' )(CFt DEt ) T ' Dt Salvage P ITC ' ' t N (1 (1 T ) r ) (1 r ) t 1
N

NALLessor

where T = lessors marginal income tax rate.

37

NPV of Lease to the Lessor

NALLessor (1 T ' )(CFt DEt ) T ' Dt Salvage P ITC ' ' t N (1 (1 T ) r ) (1 r ) t 1
N

(1 .40)($1.05m) 0.4 $570,000 $300,000 NALLessor $6m t 10 ( 1 ( 1 0 . 40 ) 0 . 12 ) ( 1 . 15 ) t 1

10

NALLessor $45,068
38

Effect of Tax Asymmetries

Suppose lessees (Emersons) tax rate is zero. Also assume that the before-tax required return on the asset for the lessee is 17.50%. The NAL to Emerson is then $7,460. The NPV to the lessor is still $45,068. Thus, both parties gain from the leasing arrangement.
39

Tax Treatment of Financial Leases

IRS has guidelines for distinguishing between true leases and
installment sales agreements. secured loans.

If lessor meets these guidelines:

lessor can claim tax deductions and credits of asset ownership. lessee can deduct full amount of lease payment for tax purposes.

40

IRS Guidelines for Financial Leases

Term of lease < 80% of assets useful life. Lessor must maintain an equity investment of at least 10% of assets original cost. Exercise price of the purchase option must equal the assets fair market value at the time the option is exercised. Lessee does not pay any portion of the assets purchase price. Lessor must hold title to the property.
41

Accounting Treatment of Financial Leases

SFAS 13 requires lessees to capitalize all leases that meet any one of the following:
Lease transfers ownership of asset to lessee before the lease expires. Lessee has option to purchase asset at a bargain price. Term of lease is greater than or equal to 75% of assets useful economic life. PV of lease payments is 90% of asset value.

42

Project Financing
Desirable when
Project can stand alone as an economic unit. Project will generate enough revenue (net of operating costs) to service project debt.

Examples:
Mines & mineral processing facilities Pipelines Oil refineries Paper mills

43

Project Financing Arrangements

Completion undertaking Purchase, throughput, or tolling agreements Cash deficiency agreements

44

Advantages and Disadvantages of Project Financing

Advantages
Risk sharing Expanded debt capacity Lower cost of debt

Disadvantages
Significant transaction costs and legal fees Complex contractual agreements Lenders require a higher yield premium

45

Limited Partnership Financing

Another form of tax-oriented financing. Allows the firm to sell the tax deductions and credits associated with asset ownership to the limited partners. Income (or loss) for tax purposes flows through to the partners. Limited partners are passive investors. General partner operates the limited partnership and has unlimited liability.
46