Download Chapter 1: An Introduction to Corporate Finance

Laurence Booth
Sean Cleary
16 Leasing
LEARNING OBJECTIVES
16.1 Identify the characteristics of leases and differentiate between
operating and financial (or capital) leases.
16.2 Describe the accounting treatment of both operating and financial
leases.
16.3 Evaluate the lease decision using the discounted cash flow valuation
methods.
16.4 Explain the various motives for leasing.
16.1 LEASING ARRANGEMENTS
• In asset-based lending the decision to purchase an asset and the
arrangement of its financing are combined into one decision.
• Leases are an example of secured financing, where the leased asset
serves as collateral in the event of a default by the lessee.
• The Canadian Finance and Leasing Association (CFLA) is the
professional body that acts as the umbrella group for asset-based
lenders; it has about 160 members.
– 60% are independent asset-based finance companies (e.g., CIT)
which are mainly involved in machinery and equipment financing
– 29% are captive finance companies which are subsidiaries of
major manufacturing companies which give financing to their
customers to buy their products (e.g., GM, Ford, Toyota)
– 11% are chartered banks (on which the Bank Act imposes
restrictions)
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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16.1 LEASING ARRANGEMENTS
• A lessor is the owner of the asset and the party in a lease
agreement who conveys the right to use the asset in return
for payment
• A lessee is the party in a lease agreement who pays the lessor
to obtain the right to use the asset
• In operating leases some of the benefits of ownership do not
transfer to the lessee but remain with the lessor
• In financial leases (or capital leases or full-payout leases)
essentially all of the benefits of ownership transfer to the
lessee
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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16.1 LEASING ARRANGEMENTS
• In a sale and leaseback (SLB) agreement the owner of an
asset sells it to another party and then leases the asset back
from them
• Leveraged leases, which are popular in the United States, are
a three-way agreement between a lessee, a lessor and a thirdparty lender where the lessor buys the asset with only a small
down payment and the lender supplies the remaining
financing. Differences between Canadian and American tax
regulations on the restrictions on CCA deductions make
leveraged leases less advantageous in Canada.
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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16.2 ACCOUNTING FOR LEASES
• Financing leases are included on the balance sheet of the lessee,
while operating leases are not and so provide off-balance-sheet
financing for the lessee
• A lease is classified as a financial if at least one of the four following
criteria is met:
– The lease transfers ownership of the property to the lessee by
the end of the lease term.
– The lessee has a bargain purchase option—that is, it can
purchase the asset at a price below fair market value when the
lease expires.
– The lease term is 75 percent or more of the estimated economic
life of the asset.
– The present value of lease payments is 90 percent or more of
the asset’s fair market value at the inception of the lease.
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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16.2 ACCOUNTING FOR LEASES
• The impact of operating and financial leases on the financial
statements of the lessor and lessee is summarized in the table
below
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
7
16.2 ACCOUNTING FOR LEASES
Financial Statement Effects of Lease Classification
• Income Statement Effects
– Net income will generally be higher for operating leases in the early
years and lower in later years, because the interest expense charged
for financial leases declines as the lease obligation is amortized.
•
Cash Flow Statement Effects
– The overall effect on total cash flow is the same for operating and
financial leases; the difference depends on the classification not the
amount of the cash flows.
– Cash flow from operations will be lower for operating leases since the
full lease payment is subtracted from cash from operations. For
financial leases, only the interest portion of the lease payments is
subtracted from cash from operations.
– Cash flow from financing will be higher for operating leases because
there is no principal repayment component for operating leases.
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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16.2 ACCOUNTING FOR LEASES
Financial Statement Effects of Lease Classification
• Balance Sheet Effects
– Financial leases cause a firm’s assets and liabilities to be larger
than operating leases because operating leases provide offbalance-sheet financing.
• Financial Ratio Effects
– If ratio analysis fails to take off-balance-sheet operating lease
obligations into consideration, a company’s ratios will look
better than they would if the lease were financial.
– If a lease is classified as financial rather than operating, a firm
will have:
•
•
•
•
Lower current ratios
Higher debt and leverage ratios
Lower asset turnover ratios
Lower profitability ratios
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
9
16.3 EVALUATING THE LEASE DECISION
• If a company needs an asset and has the opportunity to lease it, it
must compare the cash flows from leasing with the cash flows from
buying in order to determine which is better. There are four main
differences in the cash flows for a company that leases an asset
instead of buying it:
1.
2.
3.
4.
It does not have to pay for the asset up front.
If the lease is an operating lease, or it title is not transferred through a
financial lease, the company does not get to sell the asset when it is
finished with it.
It makes regular lease payments. If the lease is an operating lease, the
full amount of these lease payments is tax deductible; if it is a financial
lease, then only the interest portion of the payments is deductible.
It does not get to depreciate the asset for tax purposes if it is an
operating lease. If it is a financial lease, it does get to charge
depreciation.
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
10
16.3 EVALUATING THE LEASE DECISION
Leasing versus Buying
• Example 16-4:
– A firm wishes to obtain a limousine for its executives. The
limousine would cost $1 million to buy (it is very luxurious
and also bulletproof). The limousine would be depreciated
at a rate of $100,000 per year for tax purposes. Assume
the limousine could be sold in five years for $500,000. The
firm could also sign a five-year operating lease for the
limousine, with lease payments of $140,000 per year. Each
payment would be due at the beginning of the year. The
firm’s effective tax rate is 40 percent. Determine whether
or not the firm should lease the limousine, assuming its
before-tax cost of borrowing is 7 percent.
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
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16.3 EVALUATING THE LEASE DECISION
Leasing versus Buying
• The company’s before-tax cost of borrowing is 7%. We should use the
after-tax cost of borrowing to discount: 7% (1 – 0.4) = 4.2%
• The purchase price savings is the cost of the limousine, or $1,000,000.
• Depreciation tax savings = 0.4 × $100,000 = $40,000 per year. The
• present value of the depreciation tax savings is:
$40,000 
1 
1

 $177,076.81
0.042  (1.042)5 
•
$500,000
The present value of the $500,000 salvage value is: 1.0425  $407,034.68
• The after-tax lease payments are: $140,000(1 - 0.4) = $84,000 per year
• The present value of the after-tax lease payments is:
$84,000(1.042) 
1 
1

 (1.042)5   $387,479.47
0.042


Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
12
16.3 EVALUATING THE LEASE DECISION
Leasing versus Buying
• NPV (leasing versus buying) =
purchase price savings
$1,000,000.00
― PV(foregone depreciation tax savings)
177,076.81
― PV(foregone salvage value)
407,034.68
― PV(after-tax lease payments)
387,479.47
$28,409.05
• The NPV of leasing versus buying, $28,409.05, is positive,
and therefore leasing is better than buying in this case.
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
13
16.3 EVALUATING THE LEASE DECISION
Financial Leases versus Borrowing
• Example 16-7:
– A company is given the option of entering into a five-year,
$10,000 financial lease arrangement that calls for monthly
payments based on a 6 percent lease rate, or borrowing
$10,000 through a five-year loan that calls for monthly
payments based on a 6.12 percent lending rate. Which
option should the firm choose?
Note: Don’t just compare the 6% lease rate to the 6.12% lending rate.
This isn’t valid because the lease payments occur at the beginning of the
month while the loan payments occur at the end of the month. Instead,
calculate and compare the present value of the payments under each
option.
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
14
16.3 EVALUATING THE LEASE DECISION
Financial Leases versus Borrowing
Step 1: Calculate monthly payments for each option.
Lease
• The monthly lease rate is 6% / 12 = 0.5%, and over five years we
make 60 payments on the $10,000 financial lease.
PMT 
$10,000(0.005)
 $192.37


1
1

 (1.005) 60 


Loan
• The monthly loan rate is 6.12% / 12 = 0.51%, and over five years we
make 60 payments on the $10,000 loan.
PMT 
Booth • Cleary – 3rd Edition
$10,000(0.0051)
 $193.89


1
1

 (1.0051) 60 


© John Wiley & Sons Canada, Ltd.
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16.3 EVALUATING THE LEASE DECISION
Financial Leases versus Borrowing
Step 2: Calculate the present value of payments for each option using
the loan rate. (We can use either rate, but if we use the loan rate we
automatically know the PV of the loan payments is the amount
borrowed.

$192.37(1.0051) 
1
• PV(lease payments)
1

 $9,972.39

60 
0.0051
 (1.0051) 
• PV(loan payments) = Amount of loan = $10,000.00
• Conclusion: The lease arrangement costs marginally less than the
loan arrangement, therefore the firm should lease.
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
16
16.4 MOTIVATION FOR LEASING
1.
Cheaper financing
–
–
2.
Reduce the risks of asset ownership
–
3.
Equipment can be acquired and used without assuming resale and
obsolescence risks
Implicitly fixed interest rates
–
4.
The entire payment on an operating lease is tax deductible
If the lessor is better able than the lessee to take advantage of CCA
tax savings associated with asset ownership, the lessee may benefit
from lower lease costs if these savings are passed on by the lessor
If firms, such as small firms, are only able to obtain variable-rate
prime-based lending from banks, leases can offer the benefit of
fixed-rate financing over the term of the lease.
Maintenance
–
Efficiencies can be realized if the lessor specializes in maintaining the
leased equipment and offers a full-serve lease arrangement
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
17
16.4 MOTIVATION FOR LEASING
5.
Convenience
–
6.
Flexibility
–
7.
Leases can include options to cancel the lease, or other
customizations that benefit the lessee
Capital budget restrictions
–
8.
Assets that are needed only for a short period of time, which are
very specialized or relatively hard to sell in the future are more easily
leased than purchased
Although potentially dubious, leasing assets is an option if the capital
required to purchase them is not available since leasing requires a
limited initial capital outlay (just the first lease payment plus any
arrangement fees)
Financial statement effects
–
Operating leases provide off-balance-sheet financing which allows
firms to report higher net income, lower debt ratios and higher
liquidity ratios.
Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.
18
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instructors): www.wiley.com/go/boothcanada
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