Finance 319 Chapter 26

Front 1

Lease

Back 1

A contractual agreement between two parties: the lessee and the lessor

Front 2

Lessee

Back 2

The party that has the right to use an asset and makes periodic payments to the asset’s owner

Front 3

Lessor

Back 3

Owner of the asset

Front 4

Leasing versus Buying

Back 4

The decision involves a comparison of the alternative financing methods employed to secure the use of the asset. In both cases, the company ends up using the asset.

Front 5

Operating Leases

Back 5

Also called a service lease.
Characteristics:
1. Payments are not high enough for the lessor to recover the full cost of the asset.
2. Life of the lease is often less than the economic life of the asset.
3. The lessor often provides the routine maintenance for the asset.
4. It is often cancelable.

Front 6

Financial Leases

Back 6

Also called capital leases.
Characteristics:
1. Payments are typically sufficient to cover the lessor’s cost of purchasing the asset and to provide the lessor a fair return (therefore, also called a fully amortized lease)
2. The lessee is responsible for insurance, maintenance and taxes
3. There is generally no cancellation clause without severe penalty

Front 7

The three financial lease types are:

Back 7

Tax-oriented leases
Leveraged leases
Sale and leaseback agreements

Front 8

Tax-oriented leases

Back 8

The lessor is the owner for tax purposes

Front 9

Leveraged leases

Back 9

Lessor borrows a substantial portion of the purchase price on a non-recourse basis

Front 10

Sale and leaseback agreements

Back 10

Lessee sells the asset to the lessor and leases it back

Front 11

A lease is declared a capital (financial) lease if one or more of the following criteria is met:

Back 11

1. Property ownership is transferred to the lessee by the end of the lease term
2. Lessee can purchase the asset for below market value at the lease’s expiration
3. Lease term is 75 percent of the asset’s economic life
4. Present value of payments is at least 90 percent of the market value of the asset at inception

Front 12

Three important cash flow differences between leasing and buying:

Back 12

1. The lessee’s lease payments are fully tax deductible.
The after-tax lease payment is equal to the pre-tax payment times (1 – tax rate).
2. The lessee does not own and may not depreciate the asset.
The lost depreciation tax shield is depreciation expense times tax rate.
3. The lessee does not have the upfront cost of purchasing the asset.

Front 13

Leasing is advantageous if:

Back 13

The implied after-tax interest rate on the lease is less than the company’s after-tax cost of borrowing.

Front 14

NPV Analysis for Leasing:

Back 14

The net advantage to leasing can be determined by discounting the cash flows back at the lessee’s after-tax cost of borrowing.

Front 15

Good Reasons for Leasing

Back 15

1. Taxes may be reduced by leasing. A potential tax shield that cannot be used effectively by one firm can be transferred to another firm through a leasing arrangement. The firm in the higher tax bracket would act as the lessor and then utilize the majority of the tax shields. (The loser is the IRS.)
2. Leasing may reduce uncertainty regarding the asset’s residual value. This uncertainty may reduce firm value.
3. Transaction costs may be lower for leasing than buying.
4. Leasing may require fewer restrictive covenants than borrowing.
5. Leasing may encumber fewer assets than secured borrowing.

Front 16

Dubious Reasons for Leasing

Back 16

1. The balance sheet may appear stronger when operating leases are used (since they are considered off-balance sheet financing).
2. A firm may secure a lease arrangement when additional debt would violate existing loan agreements.