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Topic: Leasing

At the end of this chapter, you will be able to:

Describe the different types of leasing


Describe the reason for leasing
Decide whether to lease or buy the asset

Introduction
Lease is a contractual agreement between two parties: the lessee and the lessor. Lessee is the party
that has the right to use an asset and makes period payments to the assets owner whereas a Lessor
is owner of the asset.
Leasing versus buying decision involves a comparison of the alternative financing methods employed
to secure the use of the asset. In both cases, the company ends up using the asset.

Types of Leases

a. Operating Leases (also called a service lease)


Characteristics:
1. Payments are not high enough for the lessor to recover the full cost of the asset.
2. Life of the lease is often less than the economic life of the asset.
3. The lessor often provides the routine maintenance for the asset.
4. It is often cancelable.

b. Financial Leases (also called capital leases)


Characteristics:
1. Payments are typically sufficient to cover the lessors cost of purchasing the asset and to
provide the lessor a fair return (therefore, also called a fully amortized lease)
2. The lessee is responsible for insurance, maintenance and taxes
3. There is generally no cancellation clause without sever penalty

There are three financial lease types are:


1. Tax-oriented leases the lessor is the owner for tax purposes

2. Leveraged leases lessor borrows a substantial portion of the purchase price on a non-
recourse basis

3. Sale and leaseback agreements lessee sells the asset to the lessor and leases it back

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The Cash Flows from Leasing

i. The Incremental Cash Flows


Three important cash flow differences between leasing and buying:
a. The lessees lease payments are fully tax deductible. The after-tax lease payment is equal to
the pre-tax payment times (1 tax rate). This is cash outflow
b. The lessee does not own and may not depreciate the asset. The lost depreciation tax shield is
depreciation expense times tax rate. This is cash outflow
c. The lessee does not have the upfront cost of purchasing the asset therefore this is consider
as cash inflow

Leasing is advantageous if the implied after-tax interest rate on the lease is less than the companys
after-tax cost of borrowing.

Example
A florist can purchase a delivery truck from her local GM dealer for $25,000. The GM dealer will also
lease the truck for $6,100 per year over five years. The truck has an expected life of seven years. The
truck is expected to be worth $2,500 in five years and the florist has the option to buy it at fair market
value at that time. If the florist wants to purchase the truck, she must borrow the money from Boone
National Bank at a current rate of 10%. Which financing option is better?

First, if we ignore taxes, the implied interest rate of these payments is (assuming lease payments are
end of year) 9.5%. This implies that the GM dealer is willing to loan money to the florist at 9.5%
instead of the conventional 10% loan being offered by the bank. The decision appears clear lease
the truck.

Unfortunately, lease versus buy decisions are not this simple. Taxes are very important. In this lease,
the entire lease payment is tax deductible since the lease term is less than 80 percent of the assets
life and the option to purchase at the end is for fair market value. If she purchases the truck, the
purchase price is deductible only through depreciation. Lease contracts also often include
maintenance, insurance, etc. Consider the following after-tax cash flows when making the decision.
The florists tax rate is 34% and for simplicity assumes straight-line depreciation.

Year 0 1 2 3 4 5
Purchase Savings 25,000
After-tax lease payment -4,026 -4,026 -4,026 -4,026 -4,026
6100(1-.34)
Lost depreciation tax shield -1,700 -1,700 -1,700 -1,700 -1,700
(25,000/5)(.34)
Purchase truck -2,500
Incremental Cash Flows 25,000 -5,726 -5,726 -5,726 -5,726 -8,226

a. After-tax discount rate = 10%(1-.34) = 6.6%

b. NPV = -547.50, she should purchase now instead of leasing. The savings of 25,000 today is not
supported by the future after-tax costs.

c. The after-tax loan rate (compute the IRR) would have to be 7.37% to be indifferent between the
two options. This corresponds to a pre-tax loan rate of 11.16%.

ii. Three Potential Pitfalls


Potential pitfalls to using the implied rate of interest on the lease instead of the NPV:
Since the cash flows are positive, then negative, you have to adjust the interpretation of the IRR
rule. The IRR represents the rate paid in this instance and you should choose the lower number.
Normally, you determine the advantage to leasing over borrowing as was done above so you
lease if the IRR is lower than the after-tax cost of borrowing. If you determine the advantage of

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borrowing over leasing (reverse all the signs), then you are back to conventional cash flows, and
you would lease if the IRR is higher than the after-tax cost of borrowing. The implied rate is based
on the net cash flows of leasing instead of borrowing you have to use incremental cash flows.

iii. NPV Analysis


The net advantage to leasing can be determined by discounting the cash flows back at the lessees
after-tax cost of borrowing. This is the same as the NPV computed in the example above.

A Misconception
The present value of the loan payments, if we borrow and buy, is the cost of the equipment
regardless of the loan repayment schedule. So, it doesnt really matter if we pay cash to purchase
the asset or we borrow and buy the asset; the initial cost is the same either way.

A Leasing Paradox

It is important to recognize that the cash flows to the lessee are exactly the opposite of the cash
flows to the lessor when they have the same tax rate and cost of debt. As a result, a lease
arrangement is often a zero-sum game. Since, in this situation, either one party wins and one party
loses, or both parties break even, why would leasing take place?

Reasons for Leasing

Good Reasons for Leasing

1. Taxes may be reduced by leasing. A potential tax shield that cannot be used effectively by one firm
can be transferred to another firm through a leasing arrangement. The firm in the higher tax bracket
would act as the lessor and then utilize the majority of the tax shields. (The loser is the IRS.)

2. Leasing may reduce uncertainty regarding the assets residual value. This uncertainty may reduce
firm value.

3. Transaction costs may be lower for leasing than buying.

4. Leasing may require fewer restrictive covenants than borrowing.

5. Leasing may encumber fewer assets than secured borrowing.

Dubious Reasons for Leasing

1. The balance sheet may appear stronger when operating leases are used (since they are considered
off-balance sheet financing).

2. A firm may secure a lease arrangement when additional debt would violate existing loan
agreements.

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3. Basing the lease decision on the interest rate implied by the lease payments and not on the
incremental after-tax cash flows.

Summary

This topic has described different lease types which are financial lease and operating leases. We also
discuss/ illustrate the evaluation of financial lease as well as the reasons why a corporation might
decide to lease an asset rather than buying it.

Questions

1. What are the differences between an operating lease and a financial lease?

2. What are the cash flow consequences of leasing instead of buying?

3. An asset costs $48,000, has a 3-year life and will be worthless after the 3 years. The firm uses
straight-line depreciation, has a cost of borrowing of 12 percent, and a tax rate of 34 percent. The
asset can be leased for $17,500 a year. What is the net present value to leasing?

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