A.

What is a LEASE?
Leasing and financial distress
Rental agreement o LESSOR may fare better during Bankruptcy
With series of payments i. if asset is deemed essential by the court
That extends for a year or more then the court will AFFRIM the lease. The
lessee must still continue to pay the lessor
st
B. Parties Involved: and continue to use the asset (1 scenario)
a) Lessor (Owner of Asset) ii. If court REJECTS lease, then the lessor may
nd
b) Lessee (Borrower of Asset) recover asset (2 scenario)
iii. If the LESSEE renegotiates with the lessor,
C. Types of Lease: lessor might be forced to accept lower
rd
lease payments (3 scenario)
1. Operational Leases: Tax Shield can be used:
Short term and Cancelable o Lessor owns asset, and so deducts its
at the option of the lessee depreciation
2. Financial Leases: o If lessor can make better use of tax shield than
Long-Term and Non-Cancelable lessee, then lessor should own equipment and
Long-Term: extends at the economical life of the pass on some tax benefits to lessee
asset o So direct tax gain to lessor, indirect gain to lessee
Non-cancelable UNLESS Lessor is reimburse for any
loss F. Dubious Reasons for Leasing

D. Leases Differ in Service: Leasing avoids capital expenditure controls
1. Full Service/Rental/Lease: o Leasing may enable an operating manager to avoid
LESSOR promises to maintain and insure the the approval procedures needed to buy an asset
equipment and to pay property tax due on it Leasing preserves capital
2. Net Lease: If Greymare Bus Lines leases a $100,000 bus
LESSEE promises to maintain and insure the rather than buying it, it does conserve $100,000
equipment and to pay property tax due on it cash. It could also (1) buy the bus for cash and
3. Direct Lease: (2) borrow $100,000, using the bus as security.
LESSEE identifies the equipment, arranges for the Its bank balance ends up the same whether it
leasing company to buy it from the manufacturer, and leases or buys and borrows. It has the bus in
signs a contract with the leasing company. either case, and it incurs a $100,000 liability in
4. Sale and lease-back Arrangements: either case.
The firm sells an asset it already owns and leases it
back from the buyer Leases may be off balance sheet financing
5. Leveraged Lease: o In some countries financial leases are off- balance-
The lessor puts up some of the money required to sheet financing; that is, a firm can acquire an asset,
purchase the asset and borrows the rest from a finance it through a financial lease, and show neither
lender. the asset nor the lease contract on its balance sheet.
The lender is given a senior secured interest on the Leasing effects book income
asset and an assignment of the lease and lease o Leasing can make the firms balance sheet and
payments. The lessee makes payments to the lessor, income statement look better by increasing book
who makes payments to the lender. income or decreasing book asset value, or both.
o A lease that qualifies as off-balance-sheet financing
E. Sensible Reasons for Leasing: affects book income in only one way: The lease
payments are an expense.
Short-term leases are convenient
G. Financial accounting Standard Board(FASB) and Leases
Lower Monthly payment
The FASB defines capital leases as leases that meet any one of
Protection against obsolescence the following requirements:

Cancellation options are valuable The lease agreement transfers ownership to the lessee
o Some leases that appear expensive really are before the lease expires.
fairly priced once the option to cancel is The lessee can purchase the asset for a bargain price
recognized. when the lease expires.
Maintenance is provided The lease lasts for at least 75% of the assets estimated
o Under a full-service lease, the user receives economic life.
maintenance and other services. The present value of the lease payments is at least 90% of
Standardization leads to low costs the assets value.
o Standardization makes it possible to lend small
sums of money without incurring large
investigative, administrative, or legal costs.
H. International Financial Reporting Standards (IFRS) and Lease L. Evaluation of LESSEE

A lease is classified as a finance lease if it transfers substantially all Add cost of asset
the risks and rewards incident to ownership. All other leases are Subtract lease payments
classified as operating leases. Classification is made at the Add tax shield from lease payments
inception of the lease. Subtract depreciation tax shield
Subtract residual value of asset
Add/ subtract tax gain/loss on sale of asset

I. Situations that would normally lead to a lease being classified as a M. Evaluation of LESSOR
finance lease include the following:
Subtract Cost of asset
i. the lease transfers ownership of the asset to the lessee by Add lease payments
the end of the lease term Subtract tax shield from lease payments
ii. the lessee has the option to purchase the asset at a price Add depreciation tax shield
which is expected to be sufficiently lower than fair value at Add residual value of asset
the date the option becomes exercisable that, at the
Subtract/ Add tax loss/gain on sale of asset
inception of the lease, it is reasonably certain that the
option will be exercised

iii. the lease term is for the major part of the economic life of
the asset, even if title is not transferred
iv. at the inception of the lease, the present value of the EVALUATION
minimum lease payments amounts to at least substantially
all of the fair value of the leased asset LESSEE LESSOR
v. the lease assets are of a specialized nature such that only
the lessee can use them without major modifications being COST OF ASSET + -
made
LEASE PAYMENT - +
J. Other situations that might also lead to classification as a finance
lease are: TAX SHIELD FROM + -
LEASE PAYMENT
i. if the lessee is entitled to cancel the lease, the lessor's
losses associated with the cancellation are borne by the DEPRICIATION TAX - +
lessee SHIELD
ii. gains or losses from fluctuations in the fair value of the
residual fall to the lessee (for example, by means of a RESIDUAL VALUE OF - +
rebate of lease payments) ASSET
iii. the lessee has the ability to continue to lease for a
secondary period at a rent that is substantially lower than
LOSS ON SALES OF + -
market rent
ASSET

K. Evaluation of Leases
GAIN ON SALE OF - +
ASSET
Lease rentals

Allowable deduction for lessee

taxable income for lessor

Depreciation

Allowable deduction for lessor

Not allowed for lessee

Tax payable on gain from sale of underlying asset

Payable by lessor

Avoided by lessee



 v Acme has branched out to rentals of office furniture to v If a firm can borrow at 9% , what discount rate should the
start up companies. Consider a $3000 desk. Desks last for firm use to discount lease cash flows? (The marginal tax
six years and can be depreciated on a five- year MACRS rate for the firm is 35%)
schedule. What is the break-even operating lease rate for
a new desk? Assume that lease rates for old and new Tax Shield= 0.09(1-0.35)
desks are the same and that Acmes pre-tax administrative Tax Shield =5.85%
costs are $400 per desk per year. The cost of capital is 9%
and the tax rate is 35%. Lease payments are made inn v Nodhead College needs a new computer. It can either buy
advance, that is, at the start of each year. The inflation it for $250,000 or lease it from Compulease. The lease
rate is zero. The table below provides the depreciation terms requires Nodhead to make six annual payments
schedule: (prepaid) of $62,000. Nodhead pays no tax. Compulease
pays tax at 35%. Compulease can depreciate the computer
for tax purposes over five years. The computer will have
no residual value at the end of year 5. The interest rate is
8%.
Given:
a. What is the NPV of the lease for Nodhead College?
Initial Cost: $3000
Pre Tax Admin Cost= $400
Given:
Cost of Capital/ Discount Rate: 9%
Tax Rate: 35% !
62,000
=
CASH FLOWS (1 + 0.08)!
!!!

-3260 -50 +76 -58.40 -139.04 -139.04 +60.48 NPV cash flow of Nodhead is:

250,000 value of PV = -59,500

() b. What is the NPV for Compulease?

Break Even Lease Rate =
(1 + )
- Adjusted discount rate= rD(1 - Tc)
! !
Present Value = C 1 + - The after tax interest rate is:
! !(!!!)
(1 0.35) 0.08 = 0.052 = 5.2%
- The NPV cash flow of Compulease is 40.0 or
! ! !
= ! + + + + $40,000
(1 + )! (1 + )! (1 + )!
c. What is the overall gain(loss) from leasing?
Solution:
40,000 59,500 = 19,500
50 76 58.40
= 3260 +
1 + 0.09 ! 1 + 0.09 ! 1 + 0.09 ! v Suppose that National Waferonics has before it a proposal
139.04 139.04 60.48
+ for a four-year financial lease. The table below summarizes
(1 + 0.09)! (1 + 0.09)! (1 + 0.09)! the lease cash flows of the proposal:

PV= 3,439.80

1 1
3,439.80 = C 1 + 0.09
0.09 0.09 1 + 0.09 These flows reflect the cost of machine, depreciation tax
shields, and the after-tax lease payments. Ignore salvage
3,439.80 value. Assume the firm could borrow at 10% and faces a
= C
4.889651263 35% marginal tax rate.

C = 703.49 a. What is the value of the equivalent loan?

703.49 Adjusted discount rate= rD(1 - Tc)

Break Even Lease Rate =
(1 + 0.35)
0.10 (1 0.35) = 0.065 = 6.5%
Break Even Lease Rate = 1,082.29
The value of the equivalent loan is the present
value of the cash flows for years 1, 2 and 3:
$59,307.30



 b. What is the value of the lease?

- The value of the lease is:

$62,000 $59,307.30 = $2,692.70

c. Suppose the machines NPV under normal financing is

($5,000). Should Thor Inc. invest?

- National Waferonics should not invest. The

leases value of +$2,692.70 does not offset the
machines negative NPV. On the other hand, the
company would be happy to sign the same lease
on a more attractive asset.

EQUATIONS:

()
Break Even Lease Rate =
(1 + )

1 1
Present Value = C 1 +
(1 + )

! ! !
= ! + + + +
(1 + )! (1 + )! (1 + )!

= !"#$%&'( (1 !"#$"#%&'"( )

= 1

=
(1 )

= +
+