Unit 3

Leasing

Part 1 of Unit 2-1

Gurdeepak

Leasing
Lease -- A contract under which one party, the lessor (owner) of an asset, agrees to grant the use of that asset to another, the lessee, in exchange for periodic rental payments.

Examples of familiar leases Apartments Offices Houses Automobiles

Part 1 of Unit 2-2

Gurdeepak

Issues in Leasing
Advantage Use of an asset without Advantage: purchasing the asset Obligation: Make periodic lease payments Obligation Contract specifies who maintains the asset
Full-service lease -- lessor pays maintenance FullNet lease -- lessee pays maintenance costs

Cancelable or noncancelable lease?

Operating lease (short-term, cancellable) vs. financial lease (longer-term, noncancelable)

Options at expiration to lessee

Part 1 of Unit 2-3
Gurdeepak

Types of Leasing
Sale and Leaseback -- The sale of an asset with the agreement to immediately lease it back for an extended period of time.
The lessor realizes any residual value. There may be a tax advantage as land is not depreciable, but the entire lease payment is a deductible expense. Lessors insurance companies, institutional Lessors: investors, finance companies, and independent companies.
Part 1 of Unit 2-4
Gurdeepak

Types of Leasing
Direct Leasing -- Under direct leasing a firm acquires the use of an asset it did not previously own.
The firm often leases an asset directly from a manufacturer (e.g., IBM leases computers and Xerox leases copiers). Lessors manufacturers, finance companies, Lessors: banks, independent leasing companies, specialpurpose leasing companies, and partnerships.
Part 1 of Unit 2-5
Gurdeepak

Types of Leasing
Leverage Leasing -- A lease arrangement in which the lessor provides an equity portion (usually 20 to 40 percent) of the leased assets cost and third-party lenders provide the balance of the financing. Popular for big assets such as aircraft, oil rigs, and railway equipment. The role of the lessor changes as the lessor is borrowing funds itself to finance the lease for the lessee (hence, leveraged lease). Any residual value belongs to the lessor as well as any net cash inflows during the lease.
Part 1 of Unit 2-6
Gurdeepak

Economic Rationale for Leasing

Leasing allows higher-income taxable companies to own equipment (lessor) and take accelerated depreciation, while a marginally profitable company (lessee) would prefer the advantages afforded by leases. Thus, leases provide a means of shifting tax benefits to companies that can fully utilize those benefits. Other nonnon-tax issues: issues economies of scale in the purchase of assets; different estimates of asset life, salvage value, or the opportunity cost of funds; and the lessors expertise in equipment selection and maintenance.
Part 1 of Unit 2-7
Gurdeepak

Should I Lease or Should I Buy?

Analyze cash flows and determine which alternative has the lowest (present value) cost to the firm. Example: Example :
SB Basket Wonders (BW) is deciding between leasing a new machine or purchasing the machine outright. The equipment, which manufactures Baisakhi baskets, costs 74,000 and can be leased over seven years with payments being made at the beginning of each year.
Part 1 of Unit 2-8
Gurdeepak

Should I Lease or Should I Buy?

The lessor calculates the lease payments based on an expected return of 11% over the seven years. (Ignore possible residual value of equipment to lessor.) The lease is a net lease. lease The firm is in the 40% marginal tax bracket. If bought, the equipment is expected to have a final salvage value of 7,500.
Part 1 of Unit 2-9
Gurdeepak

Should I Lease or Should I Buy?

The purchase of the equipment will result in a depreciation schedule of 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76% for the first six years (5-year property class) based on a 74,000 depreciable base. Loan payments are based on a 12% loan with payments occurring at the beginning of each period.

Part 1 of Unit 2-10

Gurdeepak

Determining the PV of Cash Outflows for the Lease

0 11% 1 2 3 4 5 6

L L L L L L L This is an annuity due that equals 74,000 today. 74,000.00 = L (PVIFA 11% 11) 11%, 7) (1.11 66,666.67 = L (4.712) 14,148.27 = L

The lessor will charge SBBW 14,148.27 14,148.27, beginning today, for seven years until expiration of the lease contract.
Part 1 of Unit 2-11
Gurdeepak

Determining the PV of Cash Outflows for the Lease

0
L

1
L B

2
L B

3
L B

4
L B

5
L B

6
L B

B = Tax-shield benefit (Inflow) = 5,659.31 L = Lease payment (Outflow) = 14,148.27

Net cash outflows at t = 0: Net cash outflows at t = 1 to 6: Net cash outflows at t = 7:

Part 1 of Unit 2-12
Gurdeepak

14,148.27 8,488.96 -5,659.31

Determining the PV of Cash Outflows for the Lease

Comments : Since the lease payments are prepaid, the company is not able to deduct the expenses until the end of each year. The lessee, SBBW, can deduct the entire 14,148.27 as an expense each year. Thus, the net cash outflows are given as the difference between lease payments (outflow) and tax-shield benefits (inflow). The difference in risk between the lease and the purchase (using debt) is negligible and the appropriate before-tax cost is the same as debt, 12%.
Part 1 of Unit 2-13
Gurdeepak

Determining the PV of Cash Outflows for the Lease

Calculating the Present Value of Cash Outflows for the Lease
The after-tax cost of financing the lease should be equivalent to the after-tax cost of debt financing. After-tax cost = 12% ( 1 - .4 ) = 7.2%. The discounted present value of cash outflows: 14,148.27 x (PVIF 7.2%, 1) = 13,198.01 8,488.96 x (PVIFA 7.2%, 6) = 40,214.34 -5,659.31 x (PVIF 7.2%, 7) = -3,478.56 Present Value 49,933.79
Part 1 of Unit 2-14
Gurdeepak

Determining the PV of Cash Outflows for the Term Loan

0 12% 1 2 3 4 5 6

TL TL TL TL TL TL TL This is an annuity due that equals 74,000 today. 74,000.00 = TL (PVIFA 12% 12) 12%, 7) (1.12 66,071.43 = TL (4.564) 14,477.42 = TL

SBBW will make loan payments of 14,477.42, beginning today, for seven 14,477.42 years until full payment of the loan.
Part 1 of Unit 2-15
Gurdeepak

Determining the PV of Cash Outflows for the Term Loan

End of Year 0 1 2 3 4 5 6 Loan Payment 14,477.42 14,477.42 14,477.42 14,477.42 14,477.42 14,477.42 14,477.43 Loan Balance* Balance 59,522.58 52,187.87 43,972.99 34,772.33 24,467.59 12,926.28 0 Annual Interest --7,142.71 6,262.54 5,276.76 4,172.68 2,936.11 1,551.15

Loan balance is the principal amount owed at the end of each year.
Part 1 of Unit 2-16
Gurdeepak

Determining the PV of Cash Outflows for the Term Loan

End of Year 0 1 2 3 4 5 6 7 Annual Interest --7,142.71 6,262.54 5,276.76 4,172.68 2,936.11 1,551.15 0 Annual Depreciation* Depreciation 0 14,800.00 23,680.00 14,208.00 8,524.80 8,524.80 4,262.40 0 Tax-Shield TaxBenefits** Benefits --8,777.08 11,977.02 7,793.90 5,078.99 4,584.36 2,325.42 -3,000.00***

* Based on schedule given on Question Slide. ** .4 x (annual interest + annual depreciation). *** Tax due to recover salvage value, 7,500 x .4.
Part 1 of Unit 2-17
Gurdeepak

Determining the PV of Cash Outflows for the Term Loan

End of Loan Year Payment 0 1 2 3 4 5 6 7 Tax Tax-Shield Benefit Cash Outflow* Outflow Present Value** Value 14,477.42 5,317.48 2,175.80 5,425.26 7,116.66 6,988.06 8,007.18 - 2,765.98

14,477.42 14,477.42 14,477.42 14,477.42 14,477.42 14,477.42 14,477.43 - 7,500.00***

--14,477.42 8,777.08 5,700.34 11,977.02 2,500.40 7,793.90 6,683.52 5,078.99 9,398.43 4,584.36 9,893.06 2,325.42 12,152.01 -3,000.00 - 4,500.00

* Loan payment - tax-shield benefit. ** Present value of the cash outflow discounted at 7.2%. *** Salvage value that is recovered when owned.
Part 1 of Unit 2-18
Gurdeepak

Determining the PV of Cash Outflows for the Term Loan

The present value of costs for the term loan is 46,741.88. The present value of the lease 46,741.88 program is 49,933.79 49,933.79. The least costly alternative is the term loan. loan SBBasket Wonders should proceed with the term loan rather than the lease. Other considerations: considerations The tax rate of the potential lessee, timing and magnitude of the cash flows, discount rate employed, and uncertainty of the salvage value and their impacts on the analysis.
Part 1 of Unit 2-19
Gurdeepak