Professional Documents
Culture Documents
What is a Lease?
Why Lease?
Operating versus Financial Leases
Valuing Leases
When Do Leases Pay?
The Basics
A lease is a contractual agreement between a
lessee and lessor.
The agreement establishes that the lessee
has the right to use an asset and in return
must make periodic payments to the lessor.
The lessor is either the assets manufacturer
or an independent leasing company.
2
Lease
Manufacturer
of asset
Manufacturer
of asset
Firm U
1.
2.
Lessor
Uses asset
Owns asset
Equity
shareholders
Creditors
1.
Owns asset
Equity
shareholders
Lessee (Firm U)
1.
Uses asset
Creditors
3
Bad Reasons
Leasing and accounting income
100% financing
4
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 enjoys a cancellation option. This option
gives the lessee the right to cancel the lease
contract before the expiration date.
5
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.
8
Leveraged Leases
Lessor buys asset, Firm U leases it.
Manufacturer
of asset
Lessor
1.
Owns asset
Equity
shareholders
Debt
Equity
Total Debt & Equity
$100,000
$100,000
$200,000
Operating Lease
Truck
Land
Total Assets
$100,000
$100,000
Debt
Equity
Total Debt & Equity
$100,000
$100,000
Capital Lease
Assets leased
Land
Total Assets
$100,000
$100,000
$200,000
$100,000
$100,000
$200,000
11
Operating Lease
Example : Acme Limo has a client who will sign a lease for 7 years,
with lease payments due at the start of each year. The following
table shows the NPV of the limo if Acme purchases the new limo
for $75,000 and leases it for 7 years.
0
Initial cost
Maintenance, insurance, selling,
and administrative costs
Tax shield on costs
Depreciation tax shield
Total
NPV @ 7% = - $98.15
Break even rent(level)
Tax
Break even rent after-tax
NPV @ 7% = - $98.15
Year
3
-75
-12
-12
-12
-12
-12
-12
-12
4.2
0
-82.8
4.2
5.25
-2.55
4.2
8.4
0.6
4.2
5.04
-2.76
4.2
3.02
-4.78
4.2
3.02
-4.78
4.2
1.51
-6.29
26.18
-9.16
17.02
26.18
-9.16
17.02
26.18
-9.16
17.02
26.18
-9.16
17.02
26.18
-9.16
17.02
26.18
-9.16
17.02
26.18
-9.16
17.02
14
Financial Leases
Example : Greymare Bus Lines is considering a lease. Your
operating manager wants to buy a new bus for $100,000. The bus
has an 8 year life. The Bus Saleswoman says she will lease
Greymare the bus for 8 years at $16,900 per year, but Greymare
assumes all operating and maintenance costs.
Should Greymare Buy or Lease the bus?
(7.00)
(16.90)
5.92
(17.98)
(11.20)
(16.90)
5.92
(22.18)
Year
3
(4.03)
(16.90)
5.92
(15.01)
(4.03)
(16.90)
5.92
(15.01)
(2.02)
(16.90)
5.92
(13.00)
(16.90)
5.92
(10.98)
100.00
(16.90)
5.92
89.02
(6.72)
(16.90)
5.92
(17.70)
15
Financial Leases
Example - cont
Greymare Bus Lines can borrow at 10%, thus the value of the lease should be discounted
at 6.5% or .10 x (1-.35). The result will tell us if Greymare should lease or buy the bus.
0
Cost of new bus
Lost Depr tax shield
Lease payment
Tax shield of lease
Cash flow of lease
(7.00)
(16.90)
5.92
(17.98)
(11.20)
(16.90)
5.92
(22.18)
Year
3
(4.03)
(16.90)
5.92
(15.01)
(4.03)
(16.90)
5.92
(15.01)
(2.02)
(16.90)
5.92
(13.00)
(16.90)
5.92
(10.98)
100.00
(16.90)
5.92
89.02
(6.72)
(16.90)
5.92
(17.70)
16
Financial Leases
Example A loan with same cash flows as lease
0
Amount borrowed
at year end
Interest paid @ 10%
Tax shield @ 35%
Interest paid after tax
Principal repaid
Net cash flow of
equivalent loan
Year
3
89.72
77.56
-8.97
3.14
-5.83
-12.15
60.42
-7.76
2.71
-5.04
-17.14
46.64
-6.04
2.11
-3.93
-13.78
34.66
-4.66
1.63
-3.03
-11.99
21.89
-3.47
1.21
-2.25
-12.76
10.31
-2.19
0.77
-1.42
-11.58
0.00
-1.03
0.36
-0.67
-10.31
89.72
-17.99
-22.19
-17.71
-15.02
-15.02
-13.00
-10.98
17
Financial Leases
Example - cont
The Greymare Bus Lines lease cash flows can also be treated as a
favorable financing alternative and valued using APV.
17.99
17.99 22
22.19
.19 17
17.71
.71 15
15.02
.02 13
13 10
10.98
.98
-89.02
-89.02 1.065
22
33
44
55
66
1.065
1.065
1.065
1.065
1.065
1.065 1.065
1.065 1.065 1.065 1.065
.70
.70 or
or $$700
700
Value of lease =
77
16
16.9
.9
100
100 (1.10)t t
t
t 00 (1.10)
100
10099
99.18
.18
.82
.82 or
or $$820
820
19
Example
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 five
years.
If the firm buys the truck, they will depreciate it straightline to zero.
They can lease it for five years from Tiger Leasing with an
annual lease payment of $6,250 paid at the end of the
year.
The firms borrowing rate is 7.70% and its marginal tax
rate is 34%.
20
21
Summary
Practice Question 1
Calculate NPV for lessee and lessor
Cost of machine = $85,000
CCA rate = 30%
Operating costs = $ 10,000 per year maintenance
expense
Lease payments = $53,600 per year
Lessor provides maintenance as a part of the lease
contract.
Cost of debt (rD) = 15%
After-tax cost of debt, rD(1 TC) = 9%
TC = 40% (for both the lessee and the lessor)
23
Practice Question 2
A noncancellable lease contract lasts for 4 years with
payments of $37,000 at the end of each year. The lessee
pays maintenance expense under either the lease or buy
alternatives. If purchased, the $100,000 asset has a
CCA rate of 30%. The beforetax cost of debt is 10% and
the corporate tax rate is 40%. What is the value of the
lease to the lessee?
If the lease in problem were cancelable, how much must
the cancellation option be worth to make the lease
alternative better than the purchase alternative?
24
Chapter 26 - Hedging
25
Risk Reduction
Why risk reduction does not add value
1. Hedging is a zero sum game
2. Investors do-it-yourself alternative
26
Risk Reduction
Risks to a business
1. Cash shortfalls
2. Financial distress
3. Agency costs
27
Insurance
Most businesses face the possibility of a
hazard that can bankrupt the company in
an instant.
Insurance companies have some
advantages in bearing risk.
The cost and risk of a loss due to a
hazard, however, can be shared by others
who share the same risk.
28
Insurance
Example
An offshore oil platform is valued at
$1 billion. Expert meteorologist
reports indicate that a 1 in 10,000
chance exists that the platform may
be destroyed by a storm over the
course of the next year.
Insurance
What do you expect the premium of an
insurance contract on this oil platform to
be?
Think of the following:
Administrative costs
Adverse selection
Moral hazard
30
32
Types of Futures
Commodity Futures
-Sugar
-Corn
-OJ
-Wheat
-Soy beans -Pork bellies
Financial Futures
-Tbills
-Yen
-GNMA
-Stocks
-Eurodollars
Index Futures
-S&P 500
-Value Line Index
-Vanguard Index
36
tt
F
S
(
1
y
)
Ft t S00(1 rf f y )
futures price
priceon
oncontract
contract of
of ttlength
length
FFt t futures
Today'ssspot
spot price
price
SS00 Today'
Riskfree
free rate
rate
rrf f Risk
Dividend yield
yield
yy Dividend
38
39
Today' ssspot
spot price
price
SS00 Today'
Risk free
freerate
rate
rrf Risk
f
cyConvenienc
Convenienceeyield
yield
cy
scExperss
Experssstorage
storagecost
cost
sc
ncycy
cysc
scNet
NetConvenienc
Convenienceeyield
yield
ncy
40
41
42
Swaps
Friendly Bancorp invested $50 M in debt carrying 8% fixed interest
rate and maturing in 5 years. Annual payments are $4m. However,
friendly Bancorp is predicting increases in interest rates, so it wants
a floating rate. Here is what it can do.
43
SWAPS
Birth 1981
Definition - An agreement between two
firms, in which each firm agrees to
exchange the interest rate characteristics
of two different financial instruments of
identical principal
Commodity Hedge
In June, farmer John Smith expects to harvest
10,000 bushels of corn during the month of
August. In June, the September corn futures are
selling for $2.94 per bushel (1K = 5,000
bushels). Farmer Smith wishes to lock in this
price (hedge).
Show the transactions if the Sept spot price
drops to $2.80.
Show the transactions if the Sept spot price
rises to $3.05.
Commodity Speculation
You have lived in NYC your whole life and are
independently wealthy. You think you know everything
there is to know about pork bellies (uncured bacon)
because your butler fixes it for you every morning.
Because you have decided to go on a diet, you think the
price will drop over the next few months. On the CME,
each PB K is 38,000 lbs. Today, you decide to short three
May Ks @ 44.00 cents per lbs. In Feb, the price rises to
48.5 cents and you decide to close your position. What is
your gain/loss?
If In Feb the price drops to 40.0 cents, what is your
gain/loss?
Margin
The amount (percentage) of a Futures
Contract Value that must be on deposit with a
broker.
Since a Futures Contract is not an actual
sale, you need only pay a fraction of the
asset value to open a position = margin.
CME margin requirements are 15%
Thus, you can control $100,000 of assets
with only $15,000.
Chapter 32 - Mergers
50
Merger or Consolidation
A merger refers to the absorption of one firm by another.
The acquiring firm retains its name and identity, and
acquires all the assets and liabilities of the acquired firm.
After the merger, the acquired firm ceases to exist as a
separate entity.
A consolidation is the same as a merger except that an
entirely new firm is created. In a consolidation, both the
acquiring firm and the acquired firm terminate their
previous legal existence.
52
Acquisition of Stock
A firm can acquire another firm by purchasing target
firms voting stock in exchange for cash, shares of stock,
or other securities.
A tender offer is a public offer to buy shares made by
one firm directly to the shareholders of another firm.
If the shareholders choose to accept the offer, they
tender their shares by exchanging them for cash or
securities.
A tender offer is frequently contingent on the bidders
obtaining some percentage of the total voting shares.
If not enough shares are tendered, then the offer
might be withdrawn or reformulated.
53
Acquisition of Assets
One firm can acquire another by buying all of its assets.
A formal vote of the shareholders of the selling firm is
required.
Advantage of this approach: it avoids the potential
problem of having minority shareholders that may occur
in an acquisition of stock.
Disadvantage of this approach: it involves a costly legal
process of transferring title.
54
A Classification Scheme
Financial analysts typically classify acquisitions
into three types:
Horizontal acquisition: when the acquirer and
the target are in the same industry.
Vertical acquisition: when the acquirer and the
target are at different stages of the production
process; example: an airline company acquiring
a travel agency.
Conglomerate acquisition: the acquirer and the
target are not related to each other.
55
Acquiring
June 2002
6,320
Bell Canada
BCE Inc.
Jan 2002
8,000
Canada Trust
TD Bank
Jan 2002
9,203
PanCanadian Energy
Alberta Energy
56
Reduces costs
57
Firm B
58
59
60
61
$
$
$
$
2.00
40.00
20
100,000
200,000
4,000,000
World Enterprises
(after buying Muck
and Slurry)
Muck and Slurry
$
2.00 $
2.67
$
20.00 $
40.00
10
15
100,000
150,000
$
200,000 $
400,000
$
2,000,000 $
6,000,000
0.05 $
0.10 $
0.067
63
.10
.067
.05
Now
Time
64
65
67
PVA $200
PVB $50
Gain PVAB $25
68
69
72
Defensive Tactics
Target-firm managers frequently resist takeover
attempts.
It can start with press releases and mailings to
shareholders that present managements
viewpoint and escalate to legal action.
Management resistance may represent the pursuit
of self interest at the expense of shareholders.
Resistance may benefit shareholders in the end if
it results in a higher offer premium from the
bidding firm or another bidder.
73
75
Mergers 1964--83
Going private
Transactions 1977--89
- Minority buyouts
- Non-controlling bidder
Target
Bidder
9%
3%
25%
27%
24%
NA
NA
NA
78
79
Divestitures
The basic idea is to increase corporate focus.
Divestiture can take three forms:
Sale of assets: usually for cash
Spinoff: parent company distributes shares of a
subsidiary to shareholders. Shareholders wind up
owning shares in two firms. Sometimes this is done
with a public IPO.
Issuance if tracking stock: a class of common stock
whose value is connected to the performance of a
particular segment of the parent company.
80
Revenue enhancement
Cost reduction
Lower taxes
Lower cost of capital
Practice Q1
Suppose Todd Trucking Company's stock is trading for $50 a share
while Hamilton Company's stock goes for $25 a share. The EPS of
Todd is $1 while the EPS of Hamilton is $2.50. Neither company has
debt in its current capital structure. Both companies have one million
shares of stock outstanding.
a. If Todd can acquire Hamilton for stock in an exchange based on
market value, what should be the postmerger EPS?
b. Suppose Todd pays a premium of 20% in excess of Hamilton's
current market value. How many shares of Todd must be given to
Hamilton's shareholders for each of their shares?
c. Based on your results in b, what will Todd's EPS be after it acquires
Hamilton?
d. If Hamilton were to acquire Todd by offering a 20% premium in
excess of Todd's current market price, how many shares of stock
would Hamilton have to offer, and what would be the effect on
Hamilton's EPS?
83
Practice Q2
Susie's Pizza is analyzing the possible acquisition of Janet's Electric.
The projected cash flows to debt and equity expected from the
merger are as follows:
Year(s)
CF
1
150,000
2
170,000
3
200,000
4
200,000
5 on
6% growth per year
The current market price of Janet's debt is $800,000, the risk free rate
is 8%, the required return on the market is 12%, and the beta of the
firm being acquired is 1.5.
a. Determine the maximum price (NPV) Susie can afford to pay.
b. If Janet's current equity value is $1,100,000 and she demands a
30% premium, will the merger take place?
84