TOPIC 5:LEASE FINANCING

Lease Defined
A lease is a contract under which the
owner of an asset (the lessor) gives
another party (the lessee) the exclusive
right to use the asset , usually for a
specific period of time ,in return for the
payment of rent.
 TYPES OF LEASES
1. Operating lease - a short term lease that is often cancellable at
the option of the lessee with proper notice. The term of this
type of lease is shorter than the asset economic life. Because
of the short duration and lessee`s option to cancel the lease,
the risk of obsolescence remains with the lessor.
2. Financial lease – it is a long term non cancellable lease
contract. The lessee is obliged to make lease payments until
the lease contract expiration, which generally corresponds to
the useful life of the asset.
3. Full service lease/Maintenance lease-The lessor pays for
maintenance, repairs ,fees and insurance (maintenance or
rental lease)
 Continuation: types of lease
4.Net lease-the lessee pays for maintenance ,
repairs, taxes and insurance.
5.Up-fronted lease-more rentals are charged in
the initial years and less in the later years of the
contract.
6.Back added lease-less rentals are charged in
the initial years and more in the later years of
the contract.
Difference between financial and operating
leases
• To distinguish between the financial and
operating lease:-
• Class discussion:
 Forms of lease financing
1) Sale and lease back
• It involves a situation whereby a firm sells an asset it already
owns with the agreement to immediately lease it back for an
extended period of time from the buyer.
• T.M stores for instance, may wish to raise cash by selling the
building for cash to the leasing company and simultaneously
sign a long term lease contract for the building .Legal
ownership of the building is passed to the leasing company
but the right to use it stays with T.M.
• The lessor benefits in terms of lease rentals and residual
value ,whilst the lessee benefits in terms of immediate cash
and reduction in the tax payments.
 2.Direct leasing
• Lessee identifies the equipment, arranges for
the lease company to buy it from the
manufacturer and signs a lease contract with
the leasing company.
• The major lessors are manufacturers , finance
companies, banks, independent leasing
companies and partnerships.
• Under direct leasing,a company acquires the
use of an asset it did not own previously.
 Leveraged leasing
• There are three parties involved in leveraged leasing.
1. The lessee
2. The lessor
3. The lender.
• From the stand point of the lessee, there is no difference between
leveraged lease and any other type of lease.
• The lessee contracts to make periodic payments over the basic lease
period and in return , is entitled to use an asset over that period of time.
• The lessor however provides part of the purchase price(usually 20%-
40%) of the leased asset and borrows the rest from a third party using
the lease contracts as security for the loan.
• The lessor then receives lease rentals and pays payments on the debt
(interest and principal) to the third party.
 Rational For Leasing
a. Convenience
• Short term leases are convenient , eg if one needs a car for a week or a
company needs to use an asset 1 or 2 years, a lease can meet that need.
However, short term leases tend to be very expensive for equipment that can
easily be damaged.
b. Maintenance and Advise
• In a full service lease, the lessor provides expertise maintenance .
• Lease agencies also provides expertise advise to lessees on the best equipment
to lease
c. Standardising leads to low administration and transaction costs
• Leasing companies usually provide a simple standard lease contract .
• Unlike borrowing funds from banks, where a lot of administrative, legal and
transaction costs are involved in terms of investigations and collateral.
• Leasing provides financing on a flexible ,piecemeal basis, with low transaction
costs, than in a private placement or public bond or stock issue.
 ..rational cont’d
d. Tax shields
• The lessor deducts the asset`s depreciation from taxable income. If such depreciation tax
shields are put into a better use than an asset`s user can, the benefit can be passed on to
the lessee in the form of low lease payments. (how does a lessee enjoy tax shield benefits)
e. Avoiding the Alternative Minimum Tax (AMT)
• AMT is an alternative, separate tax calculation based on the tax payer`s regular taxable
income increased by certain tax benefits, collectively referred to as “tax preference items”.
• The tax payer pays the large of the regularly determined tax or the AMT.
• Since finance managers want to earn lots of money for their shareholders but report low
profits to the tax authorities, firms may use straight line depreciation in its annual report
but use accelerated depreciation for its tax books
• AMT, therefore, trap companies that shield too much income; hence AMT must be paid
whenever it is higher than their tax computed in the regular way
• Using AMT, part of the benefit of accelerated depreciation and other tax reducing items
are added back hence increasing total tax to be paid.
• However, lease payments are not on the list of items added back in calculating AMT
(accounting standards).
• Thus, if you lease rather than buy tax depreciation is less and AMT is less .
 ..rational cont’d
f. Leasing preserves capital
• That is, however, a dubious reason for leasing.
• It is argued that leasing companies provide “100% financing” ;they
advance the full cost of the lease asset hence the company
preserves cash for other things.
• However the firm can also “preserve capital” by borrowing money.
• If, for example, a company leases a 1billion dollar vehicle rather
than buying it, it does conserve 1billion cash. It could also buy the
vehicle for cash and borrow 1billion , using the vehicle as security.
Its bank balance ends up the same whichever way , it has the
vehicle and it incurs a 1 billion dollar debt in either case
 Tax treatment of lease payments
• For tax purposes, the lessee can deduct the
full amount of the lease payment in a properly
structured lease. The tax shield benefits
effectively reduce the annual cash outflow for
the lease.
 Evaluating lease financing in relation to
debt financing.
• To evaluate whether or not a proposal for
lease financing makes economic sense ,one
should compare the proposal with financing
the asset with debt .The best financing
method depends on the pattern of cash flows
for each financing method and on the
opportunity cost of funds.
 Example
Past Exam Question
NUST Co has decided to acquire a piece of equipment valued at $148 000 to be used in the
fabrication of student id cards. The company is faced with two financing options; 1)lease
financing 2)debt financing

1.If financed with lease, the manufacturer will provide such financing over seven years , with a
before tax return to the lessor of 11,61%.
The salvage value of the equipment at the end of the seven years is expected to be $30 000.
Lease payments are made in advance, ie, at the beginning of each of the seven years.

2. If financed with debt, NUST Co will be able to get a 12% term loan, with a payment schedule
being of the same configuration as the lease payment schedule. Depreciation on the asset is on
the straight line basis and the tax rate is 40% with $30 000 residual value.
 ..example cont’d
Required:
1. Calculate the lease payments
2. Calculate the Present Value for the lease alternative.
3. Calculate the annual amortizing payments on the debt
alternative.
4. Draw the amortisation schedule for the borrowing
alternative.
5. Calculate the present value for the borrowing
alternative
6. Which financing option is the best for NUST Co?
 ..example cont’d
Solution:
1. Calculating lease payments
Current value of machine =PV of lease obligation
annual lease payments made in advance for seven years =annuity due
148 000=X[1-(1+i)^-n] (1+i) + 30 000
i (1+i)^n
Where X=Annual lease payments
i=before the tax return to lessor
n=lease periods
co=cost of the equipment ($148 000)

148 000 = X[1-(1.1161)^-7] (1.1161) + 30 000

0.1161 (1.161)^7

X= $26 000
 ..example cont’d
2.Calculate PV of lease alternative
End of year 0 1 2 3 4 5 6 7 8

Lease payments (26 000) (26 000) (26 000) (26 000) (26 000) (26 000) (26 000)
Tax Shield
benefit* 10 400 10 400 10 400 10 400 10 400 10 400 10 400

Net cashflows (26 000) (15 600) (15 600) (15 600) (15 600) (15 600) (15 600) 10 400
 ..example cont’d
PV of cash =
Where i is the discounting factor = after the cost of
borrowing
After tax cost of borrowing* = 12% (1-0.4)
= 7,2%

PV of lease alternative
=(26 000) + (15 600) [1-1,072^-6] + 10 400
1,072^0 0,072 1,072^7
=($93 508, 64)
 ..example contn’d
3. Calculating annual interest payments
• To enable comparisons with the lease option, assume that interest payments on the borrowing are
also payable in advance.
• Calculate the annual amortising payments needed such that PV of loan payments = Amount needed to
buy machine
Co
ie, $148 000 = PV of loan payments
• Use formula for annuity due since payments are made in advance.

$148 000 = X[1-(1+i)^-n ] (1+i)

I
Where X = annual payments
I = cost of debt ie 12%

148 000=X[1-(1,12)^-7] (1,12)

0,12

X =$28 955
 ..example contn’d
4.Ammortization schedule
• This schedule will show the interest payable in
each year.
End of year Opening balance Annual payment Interest Principal paid Closing balance
0148 000 28 955 28 955 119 045
1119 045 28 955 14 285 14 670 104 375
2104 375 28 955 12 252 16 430 87 945
387 945 28 955 10 553 18 402 69 543
469 543 28 955 8 345 20 610 48 933
548 933 28 955 5 872 23 083 25 850
625 850 28 955 3 102 25 853
 Calculation of the tax shied benefit
End of year 0 1 2 3 4 5 6 7

Annual interest payments 14 285 12 525 10 553 8 345 5 872 3 102

Annual depreciation (148 000-30 000)/7 16 857 16 857 16 857 16 857 16 857 16 857 16 857

Total allowable 31 142 29 382 27 410 25 202 22 729 19 959 16 857

Tax shield benefit *0.40 12 457 11 753 10 964 10 081 9 092 7 984 6 743
 PV of alternative borrowing
End of year Payments Taxshields benefits CF after taxes PV of CF at 7,2%
0(28 955) (28 955) (28 955)
1(28 955) 12 457 (16 498) (15 390)
2(28 955) 11 753 (17 202) (14 969)
3(28 955) 10 964 (17 991) (14 604)
4(28 955) 10 081 (18 874) (14 292)
5(28 955) 9 092 (19 863) (14 030)
6(28 955) 7 984 (20 971) (13 818)
7 6 743 6 743 4 145
(111 913)
 ..example cont’d
Which financing option is best for NUST

PV (lease) = ($93 508,64)

PV (loan) = ($111 913)
• The company pays less if it decide to lease
compared to using debt finance.
• Therefore the company should lease the
asset
 Example
• IF depreciation on the asset is on straight line basis with
zero residual value what would be the best financing
option?
• Since the loan terms are still the same, interest payments
can be read from the above amortizing schedule.
• Depreciation/annum however changes to

=148 000 – 0
7
= $21 143
 ..example contn’d
• The company will still be able to sell the asset
at the end of 7yrs for $30 000, but since , due
to the depreciation method used, the asset
will be having zero NBV,
• A profit on disposal of $30 000 is realised. This
profit on disposal will be taxed at 40%
resulting in extra taxes of $12 000 being paid
at the end of year 7.
Calculation of tax shield benefits
Year Interest payable Annual dpn Profit on disposal Total Exp Tax Shield

114 285 21 143 35 428 14 171

212 525 21 143 33 668 13 467

310 553 21 143 31 696 12 678

48 345 21 143 29 488 11 795

55 872 21 143 27 015 10 806

63 102 21 143 24 245 9 698

7 21 143 (30 000) (8 857) (3 543)

PV of borrowing alternative
Year Loan Repayments Tax shield benefits CF after tax PV of CFs
0(28 955) (28 955) (2 895)
1(28 955) 14 171 (14 784) (13 791)
2(28 955) 13 467 (15 488) (13 477)
3(28 955) 12 678 (16 277) (13 212)
4(28 955) 11 795 (17 160) (12 994)
5(28 955) 10 806 (18 149) (12 820)
6(28 955) 9 698 (19 257) -12689
7(28 955) (3 543) 26 457 16 262
65 616
 ..example contn’d
PV (lease) = ($92 561,19)
PV (loan) = ($65 616)
• The analysis suggests that the company use debts as opposed
to lease financing in acquiring the use of the asset.
• This conclusion arises despite the fact that the implicit interest
rate embodied in lease payments.
• 11,61% is less than the explicit cost of debt financing of 12%.
• However, if the asset is bought, the company is able to avail
itself of tax shield through cot recovery depreciation.
• The salvage value at the end of the project is a favourable factor
, whereas this value goes to the lessor with lease financing.
 Basic questions
• Who may lease?
• Who is the lessee?
• How long the lease can be?
• Who owns the equipment at the end of the lease?
• What is the fair market value?
• When do the monthly payments start?
• Do monthly payments change during the lease?
• May the lease be paid off early?
• What is the interest rate?
• Are there any other costs with the leasing agreement?