CHAPTER 21

LEASING

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 KEY CONCEPTS AND SKILLS

• Define the types of leases and how the IRS

qualifies leases

• Explain the reasons for leasing and the

reasons for not leasing

• Show how to calculate the net advantage

of leasing and related issues

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 CHAPTER OUTLINE

• Leases and Lease Types

• Accounting and Leasing

• Taxes, the IRS, and Leases

• The Cash Flows from Leasing

• Lease or Buy?

• A Leasing Paradox

• Reasons for Leasing

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 LEASE TERMINOLOGY

• Lease – contractual agreement for use of an asset

in return for a series of payments

• Lessee – user of an asset; makes payments

• Lessor – owner of the asset; receives payments

• Direct lease – lessor is the manufacturer

• Captive finance company – subsidiaries that lease

products for the manufacturer
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 TYPES OF LEASES

• Operating lease (or service lease)

 Shorter-term lease
 Lessor is responsible for insurance, taxes, and maintenance.
 Often cancelable on short notice

• Financial lease (or capital lease)

 Longer-term lease
 Lessee is responsible for insurance, taxes, and
maintenance.
 Generally not cancelable without penalty
 Specific capital leases
• Tax-oriented
• Leveraged
• Sale and leaseback
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 TYPES OF CAPITAL LEASES

• Tax-Oriented Lease:
 A lease in which the lessor is the owner of the leased asset
for tax purposes
 Also called a true lease or a tax lease

• Leveraged lease:
 A financial lease in which the lessor borrows a substantial
fraction of the cost of the leased asset on a nonrecourse
basis

• Sale and leaseback:

 A financial lease in which the lessee sells an asset to the
lessor and then leases it back
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 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.
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 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.

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 TAXES, THE IRS, AND LEASES

• 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 – lessor should earn a fair return
 Renewal options must be reasonable and consider fair
market value at the time of the renewal.
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 INCREMENTAL CASH FLOWS
FROM LEASING
• Cash flows from the lessee’s point of view
 Tax deductible lease payment (outflow)
• Lease payment × (1 – T)

 Lost depreciation tax shield from lack of

ownership (outflow)
• Depreciation × T

 Initial cost of machine (inflow)

• Inflow because we save the cost of purchasing the asset
now.

 May have incremental maintenance, taxes, or

insurance
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 EXAMPLE: LEASE CASH FLOWS

• ABC, Inc. needs some new equipment. The

equipment would cost $100,000 if purchased and
would be depreciated straight-line over 5 years. No
salvage is expected. Alternatively, the company
can lease the equipment for $25,000 per year. The
marginal tax rate is 21%.

 What are the incremental cash flows?

• After-tax lease payment = 25,000(1 - 0.21) = 19,750
(outflow years 1 to 5)
• Lost depreciation tax shield = (100,000 / 5) × 0.21 = 4,200
(outflow years 1 to 5)
• Cost of machine = 100,000 (inflow year 0)
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 LEASE OR BUY?

• Net advantage to leasing (NAL):

 The NPV that is calculated when deciding whether to
lease an asset or to buy it
 The company needs to determine whether it is better
off borrowing the money and buying the asset, or
leasing.
 Compute the NPV of the incremental cash flows.
 Appropriate discount rate is the after-tax cost of debt
since a lease is essentially the same risk as a
company’s debt.
 A positive NAL supports leasing over buying.
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 EXAMPLE: NET ADVANTAGE TO
LEASING
• Consider the previous example on Slide 11.
Assume the firm’s cost of debt is 7.1%.
 Aftertax cost of debt = 7.1(1 - 0.21) = 5.609%

 CF0 = $100,000

 CF1 to CF5 = (-$19,750 + -$4,200) = -$23,950

 NPV = NAL = -$1,968

• Should the firm buy or lease?

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 WORK THE WEB EXAMPLE

• Many people must choose between buying and

leasing a car.

• Go to Bankrate's Auto Lease vs. Buy calculator.

 Do the calculations for a $30,000 car, 5-year loan at 7%

with monthly payments, and a $3,000 down payment. The
available lease is for 3 years and requires a $550 per month
payment with a $1,000 security deposit and $1,000 other
upfront costs.

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 GOOD REASONS FOR LEASING

• Taxes may be reduced

• May reduce some uncertainty

• May have lower transaction costs

• May require fewer restrictive covenants

• May encumber fewer assets than secured

borrowing

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 DUBIOUS REASONS FOR LEASING

• Balance sheet, especially leverage ratios, may look

better if the lease does not have to be accounted
for on the balance sheet.

• 100% financing – except that leases normally do

require either a down-payment or security deposit

• Low cost – some may try to compare the “implied”

rate of interest to other market rates, but this is not
directly comparable

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 QUICK QUIZ

• What is the difference between a lessee and a lessor?

• What is the difference between an operating lease and a

capital lease?

• What are the requirements for a lease to be tax deductible?

• What are typical incremental cash flows, and how do you

determine the net advantage to leasing?

• What are some good reasons for leasing?

• What are some dubious reasons for leasing?

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 ETHICS ISSUES

• Suppose a manager chooses to lease an

asset (operating lease) rather than buy,
simply to keep the asset off-balance sheet
and thereby avoid reporting the liability?

 Although this may be legal, is there any ethical

implication?

 Are investors able to effectively monitor and

analyze such activity?

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 COMPREHENSIVE PROBLEM

• What is the net advantage to leasing for

the following project, and what decision
should be made?
 Equipment would cost $250,000 if purchased.
 It would be depreciated straight-line to zero
salvage over 5 years.
 Alternatively, it may be leased for $65,000/yr.
 The firm’s after-tax cost of debt is 6%, and its tax
rate is 21%.
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 END OF CHAPTER
CHAPTER 27

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