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Topics:
22.1 Types of Leases 22.2 Accounting and leasing 22.4 The Cash Flows of Operating Leasing 22.6 NPV Analysis of the Lease-versus-Buy Decision 22.8 Does Leasing Ever Pay: The Base Case 22.9 Reasons for Leasing
(This illustration contains a minor correction of your text. Section 22.4 should be operating lease rather than financial lease.)
Two types:
Operating lease Financial lease
Sale and lease-back Leverage lease
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Lease
Lessor buys asset, Firm U leases it.
Manufacturer of asset
Manufacturer of asset
Firm U
1. 2. Uses asset Owns asset 1.
Lessor
Owns asset 1. 2. Does not use asset
Lessee (Firm U)
Uses asset 2. Does not own asset
Equity shareholders
Creditors
Equity shareholders
Creditors
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Operating Leases
Usually not fully amortized. This means that the payments required under the terms of the lease are not enough to recover the full cost of the asset for the lessor. Usually require the lessor to maintain and insure the asset. Lessee usually enjoys a cancellation option. This option gives the lessee the right to cancel the lease contract before the expiration date.
Financial Leases
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.
Example: Sell you IT assets to HP Financial Services and lease them back.
You can easily adapt to future needs down the road.
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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.
Leveraged Leases
Lessor buys asset, Firm U leases it.
Manufacturer of asset
Lessor
1. Owns asset 1.
Lessee (Firm U)
Uses asset
Equity shareholders
Creditors
Both CRA and IRS will treat a capitalized lease as sales for tax purposes.
Lessor records leasing as installment sales; Lessee records leasing on balance sheet and take depreciation on assets. Please refer to the attached CRA or IRS regulations for further illustration.
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Operating leasing
Lessor: asset on balance-sheet
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Incremental cashflow approach to lease: An example Zee Movers needs to acquire 50 more cars. Each car will generate $12,000 per year in added sales for the next five years. The firm has a corporate tax rate of 40%. The car would qualify for a CCA (cost of capital allowance) rate of 40% (rental car). There is no residual value of the car after five years. Assume that this is an operating lease. Two options:
(1) Each car can be purchased at a wholesale price of 20,000. (2) Each car can be leased through an operating leasing with Tiger Leasing at a payment of $5,000 each year for five years (payable at the beginning of each year). Suppose that all the conditions for operating lease are met.
Buy or lease?
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2
3 4 5 Residual at yr 5 9,600 5,760 3,456 2,074 3,840 2,304 1,382
2,560
1,536 922 553 829.6
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If buy, then:
1. 2. 3. OwnershipDepreciate for tax purposes. Cash outlay of 20,000 at time 0. Tax deduction due to residual value loss.
Note: The added sales of 12,000 each car apply to both leasing and buying, so the incremental cashflow of added sales for leasing is zero. Timing of cashflow: (a bit different from the text)
Lease rental payment happens in advance Depreciation happens in arrears
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After-tax cashflows from buying the asset Asset cost Dep. tax shield Residual tax shield (2) Net cash from buying Differential cashflow (3) Lease minus buy 17,000 -4600 -5560 -4536 -3922 -1382 -20,000 1600 2560 1536 921.6 -20,000 1600 2560 1536 921.6 552.8 829.6 1,382
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Asset cost
Depreciation tax shield AT Residual cashflow (2) Net cash from buying
-20,000
1600 -20,000 1,600 2560 2,560 1536 1,536 921.6 922 552.8 3,182
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Contd: Solution
After-tax rental payment Net cash from buying Lease minus buy NPV IRR Decision? -3000 -20000 17000 -1301 9.60% -3000 1600 -4600 -3000 2560 -5560 -3000 1536 -4536 -3000 922 -3922 3182 -3182
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Net CF
-17,000
4600
5560
4536
3922
1382
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The lease contract may reduce certain types of uncertainty (the residual value risk at the end of the contract is borne by the lessor, and it may be in a better position to bear this risk) Transactions costs can be higher for buying an asset and financing it with debt or equity than for leasing the asset.
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An Illustration of Benefit of Tax Reduction: Tax Arbitrage Back to the example where theres no economic residual. Suppose Zee (the LESSEE) is still in the 40% tax bracket, but Tiger Leasing (the LESSOR) is in the 30% tax bracket instead. Can leasing happen in this case? (i.e., Can both firms have a positive NPV?)
Whats changed? For Lessee, nothing is changed: same tax rate, same interest rate, same payment Same incremental cashflow in Lease vs. buy decision. + NPV.
For Lessors Lease vs. sell decision, after-tax cashflow is now changed AT lease income Depreciation and residual tax shield AT discount rate as well!
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622
1,037
Notes: 1. Depreciation tax shield and lease payment is now calculated at tax rate of 30%. 2. Discount rate for NPV is:
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Contd
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Set 1+2 -3 = 0.
Review Questions
How would you evaluate a capital lease through incremental cashflow approach? Give the incremental cashflow from the perspective of lease vs. buy.
Assigned problems: #22. 1, 2-6, 8, 11 (Assume operating leasing for incremental cashflow analysis.)
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