Lease Financing

RWJ Chp 21
 Types of Leases
• The Basics
– A lease is a contractual agreement between a
lessee and lessor.
– The lessor owns the asset and for a fee
allows the lessee to use the asset.
 Operating Leases
• Usually not fully amortized.
• Usually require the lessor to maintain
and insure the asset.
• Lessee enjoys a cancellation option.
 Financial Leases
The exact opposite of an operating lease.
1. Do not provide for maintenance or service by the
lessor.
2. Financial leases are fully amortized.
3. The lessee usually has a right to renew the lease
at expiry.
4. Generally, financial leases cannot be cancelled.
 Sale and Lease-Back
• 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.
 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.
 Lease Accounting
• Leases are governed primarily by FASB 13
• Financial leases are essentially treated as debt
financing
– Present value of lease payments must be included on
the balance sheet as a liability
– Same amount shown on the asset as the “capitalized
value of leased assets”
• Operating leases are still “off-balance-sheet” and
do not have any impact on the balance sheet
itself
 Criteria for a Capital Lease
• If one of the following criteria is met, then the
lease is considered a capital lease and must be
shown on the balance sheet
– Lease transfers ownership by the end of the lease
term
– Lessee can purchase asset at below market price
– Lease term is for 75 percent or more of the life of the
asset
– Present value of lease payments is at least 90 percent
of the fair market value at the start of the lease
 Taxes
• Lessee can deduct lease payments for income tax
purposes
– Must be used for business purposes and not to avoid taxes
– Term of lease is less than 80 percent of the economic life of
the asset
– Should not include an option to acquire the asset at the end
of the lease at a below market price
– Lease payments should not start high and then drop
dramatically
– Must survive a profits test
– Renewal options must be reasonable and consider fair
market value at the time of the renewal
 Accounting and Leasing

Balance Sheet
Truck is purchased with debt
Truck RM100,000 Debt RM100,000
Land RM100,000 Equity RM100,000
Total Assets RM200,000 Total Debt & Equity RM200,000

Operating Lease
Truck Debt
Land RM100,000 Equity RM100,000
Total Assets RM100,000 Total Debt & Equity RM100,000

Capital Lease
Assets leased RM100,000 Obligations under cap. lease RM100,000
Land RM100,000 Equity RM100,000
Total Assets RM200,000 Total Debt & Equity RM200,000
 Capital Lease
• A lease must be capitalized if any one of the
following is met:
– The present value of the lease payments is at least 90
percent of the fair market value of the asset at the start
of the lease.
– The lease transfers ownership of the property to the
lessee by the end of the term of the lease.
– The lease term is 75 percent or more of the estimated
economic life of the asset.
– The lessee can buy the asset at a bargain price at
expiry.
 The Cash Flows of Leasing

Consider a firm, ClumZee Movers, that wishes to

acquire a delivery truck.
The truck is expected to reduce costs by RM4,500 per
year.
The truck costs RM25,000 and has a useful life of 5
years.
If the firm buys the truck, they will depreciate it
straight-line to zero.
They can lease it for 5 years from Tiger Leasing with
an annual lease payment of RM6,250.
 The Cash Flows of Leasing

• Cash Flows: Buy

Year 0 Years 1-5
Cost of truck –RM25,000
After-tax savings 4,500×(1-.34) = RM2,970
Depreciation Tax Shield 5,000×(.34) = RM1,700
–RM25,000 RM4,670
• Cash Flows: Lease
Year 0 Years 1-5
Lease Payments –6,250×(1-.34) = – RM4,125
After-tax savings 4,500×(1-.34) = RM2,970
–RM1,155

• Cash Flows: Leasing Instead of Buying

Year 0 Years 1-5
RM25,000 –RM1,155 – RM4,670 = –RM5,825
 The Cash Flows of Leasing

• Cash Flows: Leasing Instead of Buying

Year 0 Years 1-5
RM25,000 –RM1,155 – RM4,670 = –RM5,825

• Cash Flows: Buying Instead of Leasing

Year 0 Years 1-5
–RM25,000 RM4,670 –RM1,155 = RM5,825

• However we wish to conceptualize this, we need to

have an interest rate at which to discount the future
cash flows.
• That rate is the after-tax rate on the firm’s secured debt.
NPV Analysis of the Lease-vs.-Buy Decision

• A lease payment is like the debt service on

a secured bond issued by the lessee.
• In the real world, many companies
discount both the depreciation tax shields
and the lease payments at the after-tax
interest rate on secured debt issued by the
lessee.
 NPV Analysis of the Lease-vs.-Buy Decision
• There is a simple method for evaluating leases: discount all cash
flows at the after-tax interest rate on secured debt issued by the
lessee. Suppose that rate is 5 percent.
NPV Leasing Instead of Buying
Year 0 Years 1-5
RM25,000 –RM1,155 – RM4,670 = -RM5,825
5
$5,825
NPV  $25,000   t
 $219.20
t 1 (1.05)
NPV Buying Instead of Leasing
Year 0 Years 1-5
-RM25,000 RM4,670 – RM1,155 = RM5,825
5
$5,825
NPV  $25,000   t
 $219.20
t 1 (1.05)
 Reasons for Leasing
• Good Reasons
– Taxes may be reduced by leasing.
– The lease contract may reduce certain types
of uncertainty.
– Transactions costs can be higher for buying
an asset and financing it with debt or equity
than for leasing the asset.
• Bad Reasons
– Accounting