Additional - Leases

8/12/2019 Additional - Leases

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McGraw-Hill/Irwin Copyright 2002byTheMcGraw-Hill Companies,Inc. All rightsreserved.

21-1

Chapter Outline

21.1 Types of Leases21.2 Accounting and Leasing

21.3 Taxes, the IRS, and Leases

21.4 The Cash Flows of Leasing

21.5 A Detour on Discounting and Debt Capacity with

Corporate Taxes21.6 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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21-2

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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21-4

Financial Leases

The exact 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 cancelled.



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21-5

Sale and Lease-Back

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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21-6

Leveraged Leases

A leveraged lease is another type of financial lease.

A three-sided arrangement between the lessee, the

lessor, and lenders.

The lessor owns the asset and for a fee allows the lessee

to use the asset.The lessor borrows to partially finance the asset.

The lenders typically use a nonrecourse loan. This means

that the lessor is not obligated to the lender in case of a

default by the lessee.



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21-7

21.2 Accounting and Leasing

In the old days, leases led to off-balance-sheet

financing.

Today, leases are either classified as capital leases

or operating leases.

Operating leases do not appear on the balance sheet.

Capital leases appear on the balance sheetthe

present value of the lease payments appears on both

sides.



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21-9

Capital Lease

A lease must be capitalized if any one of the following is

met:

The present value of the lease payments is at least 90

percent of the fair market value of the asset at the start of

the lease.

The lease transfers ownership of the property to the

lessee by the end of the term of the lease.

The lease term is 75 percent or more of the estimated

economic life of the asset.

The lessee can buy the asset at a bargain price at expiry.



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21-10


The principal benefit of long-term leasing is tax reduction.

Leasing allows the transfer of tax benefits from those who

need equipment but cannot take full advantage of the tax

benefits of ownership to a party who can.

Naturally, the IRS seeks to limit this, especially if the lease

appears to be set up solely to avoid taxes.



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21-11


The lessee can deduct lease payments if the lease

is qualifiedby the IRS.

1. The term must be less than 30 years.

2. There can be no bargain purchase option.

3. The lease should not have a schedule of payments that isvery high at the start of the lease and low thereafter.

4. The lease payments must provide the lessor with a fair

market rate of return.

5. The lease should not limit the lessees right to issue debt

or pay dividends.6. Renewal options must be reasonable and reflect fair

market value of the asset.



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21-12


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 useful life of 5 years.

If the firm buys the truck, they will depreciate it

straight-line to zero.

They can lease it for 5 years from Tiger Leasing with an

annual lease payment of $6,250.



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21-13


Cash Flows: BuyYear 0 Years 1-5

Cost of truck $25,000

After-tax savings 4,500(1-.34) = $2,970

Depreciation Tax Shield 5,000(.34) = $1,700

$25,000 $4,670

Cash Flows: LeaseYear 0 Years 1-5

Lease Payments 6,250(1-.34) = $4,125

After-tax savings 4,500(1-.34) = $2,970

$1,155

Cash Flows: Leasing minus Buying

Year 0 Years 1-5$25,000 $1,155$4,670 =$5,825

$4,125$1,700 =$5,825



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21-14


Cash Flows: Leasing Instead of BuyingYear 0 Years 1-5

$25,000 $1,155 $4,670 = $5,825

Cash Flows: Buying Instead of LeasingYear 0 Years 1-5

$25,000 $4,670 $1,155 = $5,825

However we wish to conceptualize this, we need to

have an interest rate at which to discount the future

cash flows.

That rate is the after-tax rate on the firms secured

debt.



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21-1521.5 A Detour on Discounting and DebtCapacity with Corporate Taxes

Present Value of Riskless Cash Flows

In a world with corporate taxes, firms should discount

riskless cash flows at the after-tax riskless rate of interest.

Optimal Debt Level and Riskless Cash Flows

In a world with corporate taxes, one determines theincrease in the firms optimal debt level by discounting a

future guaranteed after-tax inflow at the after-tax riskless

interest rate.



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21-1621.6 NPV Analysis of the Lease-vs.-BuyDecision

A lease payment is like the debt service on a

secured bond issued by the lessee.

In the real world, many companies discount both the

depreciation tax shields and the lease payments at

the after-tax interest rate on secured debt issued bythe lessee.



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21-17

NPV Analysis of the Lease-vs.-Buy Decision

20.219$)05.1(

825,5$000,25$

5

1

== =t

tNPV

20.219$)05.1(

825,5$000,25$

5

1

=+= =t

tNPV

NPV Buying Instead of Leasing

Year 0 Years 1-5

-$25,000 $4,670 + $1,155 = $5,825

There is a simple method for evaluating leases: discountall cash flows at the after-tax interest rate on secured debt

issued by the lessee. Suppose that rate is 5 percent.

NPV Leasing Instead of Buying

Year 0 Years 1-5

$25,000 $1,155 $4,670 = -$5,825



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21-19


The debt displaced by leasing results in forgoneinterest tax shields on the debt that ClumZee movers

didnt go into when they leased instead of bought

the truck.

Suppose ClumZee agrees to a lease payment of

$6,250 before tax. This payment would support a

loan of $25,219.20 (see the next slide)

In exchange for this, they get the use of a truck

worth $25,000.

Clearly the NPV is a negative $219.20, whichagrees with our earlier calculations.



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21-20


Suppose ClumZee agrees to a lease payment of $6,250 beforetax. This payment would support a loan of $25,219.20

0 1 2 3 4 5

Outstanding Balanceof theL oan $25,219.20 $20,655.16 $15,862.92 $10,831.07 $5,547.62 $0.00

Interest $1,910.55 $1,564.78 $1,201.74 $820.54 $420.27

Tax Deduction on interest $649.59 $532.03 $408.59 $278.98 $142.89

After-tax Interest Expense $1,260.96 $1,032.76 $793.15 $541.55 $277.38

Extra Cash that purchasing

firm genereates over leasing firm 5,825.00$ 5,825.00$ 5,825.00$ 5,825.00$ 5,825.00$

05.020.219,25$96.260,1$ =

After-Tax Lease Payments 6,250(1-.34) = $4,125

Forgone Depreciation Tax Shield 5,000(.34) = $1,700

-$5,825Calculate the increase in debt capacity by discounting thedifference between the cash flows of the purchase and the cashflows of the lease by the after-tax interest rate.

[ ]96.260,1$.825,5$20.219,25$16.655,20$ =



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21-21

21.8 Does Leasing Ever Pay: The Base Case

In the above example, ClumZee Movers chose to buy,

because the NPV of leasing was a negative $219.20

Note that this is the opposite of the NPV that Tiger Leasing

would have:

20.219$)05.1(

825,5$000,25$

5

1

=+= =t

tNPV

Cash Flows: Tiger Leasing

Year 0 Years 1-5



Lease Payments 6,250(1-.34) = $4,125

$25,000 $5,825



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21-22

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



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21-23

A Tax Arbitrage

Suppose ClumZee movers is actually in the 25% tax bracket and TigerLeasing is in the 34% tax bracket. If Tiger reduces the lease payment to$6,200, can both firms have a positive NPV?

Cash Flows: Tiger LeasingYear 0 Years 1-5



Lease Payments 6,200(1 .34) = $4,092

$25,000 $5,792

NPV = 76.33

Cash Flows ClumZee Movers: Leasing Instead of BuyingYear 0 Years 1-5

Cost of truck we didnt buy $25,000

Lost Depreciation Tax Shield 5,000(.25) = $1,250

After-Tax Lease Payments 6,200(1 .25) = $4,650$25,000 $5,900

Remember todiscountat .07575757*.75, theafter-tax rate. Then NPV =NPV = -$69.55531



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21-24

Reservations and Negotiations

What is the smallest lease payment that Tiger Leasing will

accept? Set their NPV to zero and solve for $Lmin:

Cash Flows: Tiger Leasing

Year 0 Years 1-5

Cost of truck -$25,000


Lease Payments $Lmin (1 .34) = $Lmin .66

-$25,000 $1,700 + $Lmin .66

=

++==

5

1

min

)05.1(

700,1$66.000,25$0

tt

LNPV

==

+=5

1

5

1

min)05.1(

700,1$)05.1(

1$66.000,25$t

tt

tL

=

=

=5

1

5

1min

)05.1(1$66.

)05.1(

700,1$000,25$

tt

tt

L

29.173,6$min =L



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21-25

Reservations and Negotiations

What is the highest lease payment that ClumZee Movers can

pay? Set the NPV to zero and solve for $Lmax. Remember todiscount at 0.0568181 = .0757575*.75, the after-tax rate.

Cash Flows ClumZee Movers: Leasing Instead of Buying

Year 0 Years 1-5



After-Tax Lease Payments $Lmax( 1 .25) = .75 Lmax$25,000 1,250 .75 Lmax

=

+==

5

1

max

)056818.1(

250,1$75.000,25$0

tt

LNPV

6178.17$max =L

A lease is barely possible because Lmin < LmaxBoth

gain NPV at, for instance, 6175 per annum.



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21-26

21.10 Some Unanswered Questions

Are the Uses of Leases and of Debt

Complementary?

Why are Leases offered by Both Manufacturers and

Third Party Lessors?

Why are Some Assets Leased More than Others?



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21-27

21.11 Summary and Conclusions

There are three ways to value a lease.1. Use the real-world convention of discounting the

incremental after-tax cash flows at the lessors after-taxrate on secured debt.

2. Calculate the increase in debt capacity by discounting

the difference between the cash flows of the purchaseand the cash flows of the lease by the after-tax interestrate. The increase in debt capacity from a purchase iscompared to the extra outflow at year 0 from a

purchase.

3. Use APV (presented in the appendix to this chapter).

They all yield the same answer. The easiest way is the least intuitive.



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21-28

Appendix 21A: APV Approach to Leasing

APV = All-Equity Value + Financing NPV

Calculations shown on the following slides will show

that for the latest Clumzee Movers example (tax rate

is 25%)

APV = $591.38 $1,135.30

APV = $543.91

Which is the same value as the easier NPV analysis.



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21-29


APV =All-Equity Value+ Financing NPV

To find the all-equity value, discount the cash flows at the

pre-tax interest rate. The after tax rate was 5% which implies

a pretax rate of

6.66% = 5%/(1-.25).

38.591$)06667.1(

900,5$000,25$ueequity val-All

5

1

== =t

t

Cash Flows ClumZee Movers: Leasing Instead of Buying

Year 0 Years 1-5



After-Tax Lease Payments 6,200(1 .25) = $4,650

$25,000 $5,900



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21-30


APV = All-Equity Value +Financing NPV

The NPV of the financing is the forgone interest tax shields

on the debt that ClumZee movers didnt go into when they

leased instead of bought the truck.

ClumZee agreed to a lease payment of $5,900.

This payment would support a loan of $25,543.91

=

==5

1 )05.1(

900,5$91.543,25$capacitydebtIncreased

tt



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5432 )06667.1(

65.93$

)06667.1(

84.182$

)06667.1(

79.267$

)06667.1(

69.348$

)06667.1(

73.425$30.135,1$ ++++=

91.543$30.135,1$38.591$ ==APV

The lost interest tax shield associated with this additional debt

capacity of $25,543.91 has a present value of $1,135.30

0 1 2 3 4 5

OutstandingBalanceoftheLoan $25,543.91 $20,921.11 $16,067.16 $10,970.52 $5,619.05 $0.00

Interest $1,702.93 $1,394.74 $1,071.14 $731.37 $374.60

TaxDeductiononinterest $425.73 $348.69 $267.79 $182.84 $93.65

After-taxInterestExpense $1,277.20 $1,046.06 $803.36 $548.53 $280.95



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5432 )06667.1(

65.93$

)06667.1(

84.182$

)06667.1(

79.267$

)06667.1(

69.348$

)06667.1(

73.425$30.135,1$ ++++=

91.543$30.135,1$38.591$ ==APV

The lost interest tax shield associated with this additional debt

capacity of$25,219.20has a present value of $

0 1 2 3 4 5

Outstanding Balanceof the L oan $25,219.20 $20,655.16 $15,862.92 $10,831.07 $5,547.62 $0.00

Interest $1,910.55 $1,564.78 $1,201.74 $820.54 $420.27

Tax Deduction on interest $649.59 $532.03 $408.59 $278.98 $142.89

After-tax Interest Expense $1,260.96 $1,032.76 $793.15 $541.55 $277.38

Extra Cash that purchasing

firm genereates over leasing firm 5,825.00$ 5,825.00$ 5,825.00$ 5,825.00$ 5,825.00$

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