Chapter 20

Leasing

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 Leasing

• Often referred to as “off-balance-sheet” financing if

a lease is not “capitalized.”
• Leasing is a substitute for debt financing and, thus,
uses up a firm’s debt capacity.
• Capital leases are different from operating leases:
– Capital leases do not provide for maintenance
service.
– Capital leases are not cancelable.
– Capital leases are fully amortized.
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 Lease vs. Borrow-and-Buy

Data:
• New computer costs $1,200,000.
• 3-year MACRS class life; 4-year economic life.
• Tax rate = 40%.
• rd = 10%.
• Maintenance of $25,000/year, payable at beginning
of each year.
• Residual value in Year 4 of $125,000.
• 4-year lease includes maintenance.
• Lease payment is $340,000/year, payable at
beginning of each year.
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 Depreciation Schedule

Depreciable basis = $1,200,000

Year MACRS Depreciation End-of-Year

Rate Expense Book Value
1 0.33 $ 396,000 $804,000
2 0.45 540,000 264,000
3 0.15 180,000 84,000
4 0.07 84,000 0
1.00 $1,200,000
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 In a lease analysis, at what discount rate should cash
flows be discounted?

• Since cash flows in a lease analysis are evaluated on

an after-tax basis, we should use the after-tax cost
of borrowing.

• Previously, we were told the cost of debt, rd, was

10%. Therefore, we should discount cash flows at
6%.

rd(1  T) = 10%(1 – T) = 10%(1 – 0.4) = 6%.

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 Cost of Owning Analysis

0 1 2 3 4
Cost of asset -1,200.0
Deprec. tax savings 158.4 216.0 72.0 33.6
Maintenance (AT) -15.0 -15.0 -15.0 -15.0
Residual value (AT) 75.0
Cash flow -1,215.0 143.4 201.0 57.0 108.6

PV of the cost of owning (@ 6%) = -$766.948

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 Notes on Cost of Owning Analysis

• Depreciation is a tax deductible expense, so it

produces a tax savings of T(Depreciation). Year 1
= 0.4($396) = $158.4.
• Each maintenance payment of $25 is deductible
so the after-tax cost of the maintenance payment
is (1 – T)($25) = $15.
• The ending book value is $0 so the full $125
salvage (residual) value is taxed,
(1 – T)($125) = $75.0.

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 Cost of Leasing Analysis

0 1 2 3 4

A-T Lease pmt -204 -204 -204 -204

• Each lease payment of $340 is deductible, so the

after-tax cost of the lease is
(1 – T)($340) = $204.
• PV cost of leasing (@6%) = -$749.294.

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 Net Advantage of Leasing

• NAL = PV cost of owning – PV cost of leasing

• NAL = $766.948 – $749.294

= $17.654 (Dollars in thousands)

• Since the cost of owning outweighs the cost of

leasing, the firm should lease.

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 What if there is a lot of uncertainty about the
computer’s residual value?

• Residual value could range from $0 to $250,000 and

has an expected value of $125,000.
• To account for the risk introduced by an uncertain
residual value, a higher discount rate should be
used to discount the residual value.
• Therefore, the cost of owning would be higher and
leasing becomes even more attractive.

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 What if a cancellation clause were included in the lease?
How would this affect the riskiness of the lease?

• A cancellation clause lowers the risk of the lease to

the lessee.
• However, it increases the risk to the lessor.

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