Peirson Business Finance

Chapter 15
Leasing and Other

Equipment Finance
Copyright 2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
15-1
Learning Objectives
Explain the main features of finance leases
and operating leases.
Understand the reasons for leveraged leases
and cross-border leases.
Outline the accounting and tax treatment of
leases in Australia.
Calculate rentals for a finance lease.
Evaluate a finance lease from the lessees
point of view.

15-2
Learning Objectives (cont.)

Evaluate an operating lease from the lessees
viewpoint.
Critically evaluate the suggested advantages
of leasing.
Explain the factors that can influence leasing
policy.
Outline the main features of chattel mortgages
and hire-purchase agreements.

15-3
Introduction
Leasing is distinguished from most other forms of
finance by the fact that the financier (the lessor) is
the legal owner of the leased asset.
The asset user (the lessee) obtains the right to use
the asset in return for periodic payments (lease
rentals) to the lessor.
Equipment finance: a general term that
encompasses leasing hire-purchase and chattel
mortgages.
Recent figures from the Australian Equipment
Lessors Association (2004) estimate that around
20% of all new capital equipment acquired by
Australian businesses is leased.

15-4
Finance Leases
A long-term agreement that generally covers

most of the economic life of the asset.
Non-cancellable, or cancellable only if the
lessee pays a substantial penalty to the lessor.
The obligation is essentially the same as a
borrowers obligation to repay a loan.
From the lessor's point of view it is, in effect, a
secured loan.
The risks and benefits of ownership of the asset
are effectively transferred from the lessor to the
lessee.

15-5
Operating Leases
Essentially a rental agreement.
More attractive to lessors if there is an active secondhand market for the leased asset.
In Australia, operating leases have been limited mainly
to motor vehicles and multi-purpose industrial
equipment such as forklifts.
Normally only for a short period, which is considerably
less than the useful life of the leased asset. The assets
are likely to be leased to a series of users.
Risks of ownership borne by the lessor.
Maintenance lease: operating lease where the lessor
is responsible for all maintenance and service of the
leased asset.

15-6
Sale and Lease-Back

The owner of an asset sells the asset to a financial
Agreements
institution for an amount usually equal to its current
market value and immediately leases it back from
the institution.
An alternative to raising cash by borrowing, using
the asset as security.
Lessor is typically an insurance company, super
fund, bank, or specialist lease company.
Typical assets include commercial real estate,
railway rolling stock, and vehicle fleets.
15-7
Leveraged Leasing
Form of finance lease.
A lease in which most of the funds needed to
purchase the leased asset are borrowed by
the lessor.
Involves at least three parties instead of the
normal two. The additional party is a lender,
normally referred to as a debt participant.
Typically involves a non-recourse loan, whereby
the lessor is not responsible for its repayment.

15-8
Cross-Border Leasing
A lease in which the lessee and lessor are located
in different countries.
Usually leveraged, and motivated by differences
between the tax regulations of different countries.
Generally structured so that the lessor and lessee
can both claim depreciation deductions on the
same asset.
Complex tax issues in Australia:
Difficult for Australian lessor to participate in a CBL
involving an offshore asset.
Australian lessee can be involved in CBL provided there
is a purchase option.

15-9
Accounting for Leases

In Australia, AASB 117 Leases provides that the
accounting treatment of a lease depends on
whether it is classified as an operating or a finance
lease.
Operating leases are treated in the traditional way
(lease rentals expensed and no recognition of any
assets or liabilities).
AASB 117 provides that a lease would normally be
classified as a finance lease if:
Substantially all of the risks and rewards associated with
ownership of the leased asset are effectively transferred to
the lessee.

15-
Accounting for Leases (cont.)

Where lease is a finance lease, lease asset and
liability equal to fair value of leased property or PV
of lease payments must be recognised on balance
sheet.
The previous criteria are, however, only guidelines.
The classification of a lease should depend on the
economic substance of the transaction.
However, lessors have made efforts to structure
finance leases such that they are recognised as
operating leases to avoid the need to recognise
finance leases as assets or liabilities.
15-
Taxation Treatment of Leases

If a leased asset is used to generate taxable
income, the lease rentals paid by the lessee are an
allowable tax deduction, provided that the lease is
classified as a genuine lease rather than an
instalment purchase arrangement.
While lease rentals are deductible, the lessee
cannot deduct, for tax purposes, depreciation on
the leased asset.

15-
Setting Lease Rentals

Four steps:
Calculate the present value of the cash flows from
ownership of the asset.
Calculate the required present value of the lease
payments.
Calculate the minimum after-tax lease payment.
Calculate the minimum before-tax payment, given
the tax rate tc.

15-
Evaluation of Finance Leases

Should we compare:
Leasing with borrowing, or leasing with buying?
Myers, Dill and Bautista (1976) (MDB) suggested

analysing a finance lease in the context of its effect
on the lessees capital structure.
MDB emphasised that entering into a finance lease
uses some of the lessees debt capacity.
Therefore, it follows that a finance lease should be analysed
by comparing it with debt.
MDB method:
Leasing will be economically advantageous to a lessee if
the finance provided by leasing is greater than the liability
incurred by leasing.

15-
Leasing Decisions and

Investment Decisions
In practice, the investment decision would normally
be considered first and, if the project were profitable,
the alternative of leasing the required assets would
be evaluated.
However, a project revealing a negative NPV should
not necessarily be discarded, as the NPV of a lease
can be large enough to rescue an otherwise
marginally unprofitable project.

15-
The Value of Leasing in

Competitive Capital Markets
Suppose that all financiers and asset users

operate in a perfect capital market where the
following conditions apply:
Leasing involves no transactions costs.
Information is costless and freely available.
All parties are subject to the same tax laws and

tax rates.
Under these conditions, the cost of leasing an

asset should be the same as the cost of buying
it. The lease or buy decision should be a matter
of indifference.
15-
The Value of Leasing in

Competitive Capital Markets
(cont.)
The popularity of leasing has varied over time.
It is particularly popular for some types of
assets.
This suggests that there are cases where
asset users have a systematic preference for
leasing or buying.
For this to be so, there must be tax differences
or imperfections that can make leasing
advantageous in some cases.
15-
Establishing an Advantage for

Leasing
To make leasing attractive to the user of an asset
without simultaneously making leasing unattractive
to the lessor requires some departure from the
perfect-market conditions.
The symmetry between the positions of the two
parties needs to be broken:
Quantity discounts available to specialty lessors.
Differences in tax positions of the parties.

15-
Taxes and the Size of Leasing

Gains
The NPV of a lease to the lessee (NPV ) can be
LES
expressed as:
NPVLES C PV L PV Dep
where:
C cost of the leased asset
PV ( L) present value of the lease rentals
PV ( Dep ) present value of depreciation tax savings
Similarly, the NPV to the lessor (NPVLOR ) will be:
NPV LOR C PV L * PV Dep *

15-

Gains (cont.)
A lease can affect the present value of the
governments tax receipts in two ways:
The government gains, in that it can tax the lease

rentals received by the lessor.
The government loses, in that the lessor is able to
claim deductions for depreciation on the leased
asset.
The net result is that the government can lose

through deferral of tax receipts this net loss
by the government is why the lease is
advantageous to the parties to the lease.
15-

Gains (cont.)
Other things being equal, the governments net
loss will be larger in present value terms if:
Lessors tax rate is much greater than the
lessees.
Depreciation tax savings are received early.
The term of the lease is long and the lease rentals
are paid late.
Interest rate is high.

15-
Leasing and the Imputation

Tax System
Under the imputation tax system, any advantage

associated with deferring a companys tax
payments is likely to be small.
This is because company tax is, from the point of view
of resident shareholders, only a withholding tax
(effective rate of company income tax is low).
Hence, any tax advantage from leasing must also
be small.

15-
Evaluation
of
Operating
Leases
Short-term lease that allows lessee to obtain the

services provided by an asset, without directly
bearing the risks of asset ownership.
Operating leases are more complex than finance

leases.
Equivalent annual cost model can be used to
evaluate operating leases where projects have
different economic lives.
The principle involved explains that an operating
lease is attractive to the lessee if the annual rental is
less than the equivalent annual cost of buying and
operating the asset.
Care must be taken in applying this principle to
ensure that the lease and buy alternatives are treated
consistently.

15-
Evaluation of Operating
Leases (Cont.)
Operating lease is more costly than buying an
asset that is needed for extended period.
However, operating leases can be less costly than
buying an asset in the following circumstances:
Operating lease can be cheaper if lessors can take
advantage of cost savings that are not available to the
lessee.
Operating leases provide options that are valuable to the
lessee and, in some cases, the option to cancel a lease
can be the most effective way of obtaining a benefit, such
as the risk that an asset is no longer needed due to
decline in demand.

15-
Possible Advantages of
Leasing
Company taxation:
Advantages may arise from the deferral of taxes.

Firms with lower marginal tax rates use leasing more
than firms with high marginal tax rates, found by
Graham, Lemmon and Schallheim (1998) for US.
Cross-border leases take advantage of the differences
between the tax environments in different countries.
Possible advantages where lessors are able to choose
between different accounting methods to calculate their
taxable income.

15-
Leasing (cont.)
Conservation of capital:
By leasing, a company can conserve its capital for

investment elsewhere.
However, there are problems with this argument.
Off-balance sheet finance:

Because in the past lessees have not been required to
report their lease obligation on the balance sheet, they
can use leasing to increase their access to debt.
However, AASB 117 now requires the capitalisation of
finance lease obligations, which means that any potential
off-balance sheet advantage for leasing should no longer
be available.

15-
Leasing (cont.)
Cost of capital:
If the lessors cost of capital is lower (higher) than that
of the potential lessee, the existence of competitive
capital markets will result in leasing (buying) being
preferred to buying (leasing).
The circumstances when the cost of capital of the
lessor and lessee will differ depending on the risks
associated with using the asset.
Miller and Upton (1976) cost of capital for leasing
and buying should be the same, otherwise one would
dominate the other in marketplace.

15-
Leasing (cont.)
Transaction cost:
If a lessee defaults, the lessor, as owner of the asset, can
immediately repossess it.
However, a secured lender is likely to face considerable
delay and greater costs because it may be necessary for the
defaulting borrower to be liquidated.

15-
Leasing (cont.)
Agency costs:
Leasing and debt are not perfect substitutes as they

can differ in terms of incentive effects and control of
agency costs.
Remuneration packages can create incentive to lease
rather than purchase impact on ROI, to which pay
packages may be linked Smith and Wakeman (1985).
If manager has large equity stake in company, he/she
may prefer to lease assets to reduce personal exposure
to specific asset risk Mehran, Taggart and Yermack
(1999).

15-
Leasing Policy
Why does a business lease some assets while
purchasing other similar assets?
Sensitivity to use and maintenance decisions:
A lessee does not have a right to the salvage value of an
asset at the end of the lease.
Therefore, there is less incentive to care for and maintain
assets that are leased rather than owned.
Therefore, lessors set lease rentals on the basis of
expected levels of abuse.
Consequently, assets that are sensitive to use and
maintenance decisions will tend to be purchased.

15-
Leasing Policy (cont.)

Specialised assets:
There is an incentive to buy, rather than lease, specialised
(or company-specific) assets.
The residual value of such assets tends to be disputed
between lessor and lessee, i.e. lessor places lower
residual value on asset than lessee.
This leads to unacceptably high lease payments, making
outright purchase relatively more attractive to potential
lessee.
Flexibility and transaction costs:

An operating lease is likely to involve lower costs than
purchasing an asset and then selling it.
Leasing may also involve lower search costs and costs of
assessing quality.

15-
Leasing Policy (cont.)

Comparative advantage in asset disposal:
Three potential sources of comparative advantage
in asset disposal by a lessor:
Lower search, information and transaction costs
associated with the lessor providing a specialised
market for used assets.
Reduced repair and maintenance costs for current
machines from reusing components of previously
leased machines.
Reduced production costs resulting from reusing
components of previously leased machines in the
production of new machines.

15-
Chattel Mortgages and Hire

Purchase
Chattel mortgages and hire purchase

agreements are similar to finance leases.
Chattel mortgage (CM)

User purchases goods and financier registers charge
over goods as security.
Loan secured over movable property rather than real
estate.
Hire purchase (HP)

Financier purchases asset and hires it to user for
agreed period.

15-

Purchase (cont.)
In the case of a CM or HP agreement, user will be
required to make a series of payments or
instalments to the financier for an agreed period.
An HP agreement will either commit the user to
buy the asset or give the user an option to buy it.
In the case of HP, the user, rather than the
financier, will be entitled to claim deductions for
depreciation.
During 200506, CM and HP agreements made up
65% of the Australian equipment finance market.
15-

Purchase (cont.)
Equipment finance and the GST:
CM and HP agreements and leasing are treated differently
under GST.
CM are treated as a loan (financial supply):
GST applies only to cost of asset; no GST on loan or loan
repayments.
Lease rentals are subject to GST.

HP agreements can be split into financial supply and asset
purchase components:
No GST on financial supply component; GST applies only to
cost of asset.
If GST input credits can be claimed, the GST differences

between CM and HP agreements and leasing are not
relevant.

15-
Summary
Reasons for leasing differ between types of lease.
Operating lease separates risk of ownership from
use of leased asset.
Finance lease risk of ownership on lessee and
lease is an alternative method of finance, reducing
transaction costs of obtaining finance.
Leasing can be driven by tax benefits changes in
tax rules, government charges and GST treatment
can have important effects on leasing arrangements
and their popularity.
Leasing is more common for general or marketable
assets.
15-

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Chapter 15

Leasing and Other

Copyright 2009 McGraw-Hill Australia Pty Ltd

Learning Objectives (cont.)

Copyright 2009 McGraw-Hill Australia Pty Ltd

Copyright 2009 McGraw-Hill Australia Pty Ltd

A long-term agreement that generally covers

Copyright 2009 McGraw-Hill Australia Pty Ltd

Copyright 2009 McGraw-Hill Australia Pty Ltd

Sale and Lease-Back

Copyright 2009 McGraw-Hill Australia Pty Ltd

Copyright 2009 McGraw-Hill Australia Pty Ltd

Accounting for Leases

Copyright 2009 McGraw-Hill Australia Pty Ltd

Accounting for Leases (cont.)

Taxation Treatment of Leases

Copyright 2009 McGraw-Hill Australia Pty Ltd

Setting Lease Rentals

Copyright 2009 McGraw-Hill Australia Pty Ltd

Evaluation of Finance Leases

Myers, Dill and Bautista (1976) (MDB) suggested

Copyright 2009 McGraw-Hill Australia Pty Ltd

Leasing Decisions and

Copyright 2009 McGraw-Hill Australia Pty Ltd

The Value of Leasing in

Suppose that all financiers and asset users

All parties are subject to the same tax laws and

Under these conditions, the cost of leasing an

The Value of Leasing in

Establishing an Advantage for

Copyright 2009 McGraw-Hill Australia Pty Ltd

Taxes and the Size of Leasing

Similarly, the NPV to the lessor (NPVLOR ) will be:

NPV LOR C PV L * PV Dep *

Taxes and the Size of Leasing

The government gains, in that it can tax the lease

The net result is that the government can lose

Taxes and the Size of Leasing

Copyright 2009 McGraw-Hill Australia Pty Ltd

Leasing and the Imputation

Under the imputation tax system, any advantage

Copyright 2009 McGraw-Hill Australia Pty Ltd

Short-term lease that allows lessee to obtain the

Operating leases are more complex than finance

Copyright 2009 McGraw-Hill Australia Pty Ltd

Copyright 2009 McGraw-Hill Australia Pty Ltd

Advantages may arise from the deferral of taxes.

Copyright 2009 McGraw-Hill Australia Pty Ltd

By leasing, a company can conserve its capital for

Off-balance sheet finance:

Copyright 2009 McGraw-Hill Australia Pty Ltd

Copyright 2009 McGraw-Hill Australia Pty Ltd

Copyright 2009 McGraw-Hill Australia Pty Ltd

Leasing and debt are not perfect substitutes as they

Copyright 2009 McGraw-Hill Australia Pty Ltd

Copyright 2009 McGraw-Hill Australia Pty Ltd

Leasing Policy (cont.)

Flexibility and transaction costs:

Copyright 2009 McGraw-Hill Australia Pty Ltd

Leasing Policy (cont.)

Copyright 2009 McGraw-Hill Australia Pty Ltd

Chattel Mortgages and Hire

Chattel mortgages and hire purchase

Chattel mortgage (CM)