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Corporate Finance (1) (Read-Only) PDF
Corporate Finance (1) (Read-Only) PDF
Chapter Outline
21.1 Types of Leases
21.2 Accounting and Leasing
21.3 Taxes, the IRS, and Leases
21.4 The Cash Flows of Leasing
21.5 A Detour on Discounting and Debt Capacity with
Corporate Taxes
21.6 NPV Analysis of the Lease-versus-Buy Decision
21.7 Debt Displacement and Lease Valuation
21.8 Does Leasing Ever Pay: The Base Case
21.9 Reasons for Leasing
21.10 Some Unanswered Questions
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• 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.
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Operating Leases
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Financial Leases
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Leveraged Leases
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21-8
Operating Lease
Truck Debt
Land $100,000 Equity $100,000
Total Assets $100,000 Total Debt & Equity $100,000
Capital Lease
Assets leased $100,000 Obligations under capital lease $100,000
Land $100,000 Equity $100,000
Total Assets $200,000 Total Debt & Equity $200,000
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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.
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21.5 A Detour on Discounting and Debt
Capacity with Corporate Taxes
• Present Value of Riskless Cash Flows
– In a world with corporate taxes, firms should discount
riskless cash flows at the after-tax riskless rate of interest.
• Optimal Debt Level and Riskless Cash Flows
– In a world with corporate taxes, one determines the
increase in the firm’s optimal debt level by discounting a
future guaranteed after-tax inflow at the after-tax riskless
interest rate.
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21.6 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.
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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
$25,000 –$1,155 – $4,670 = -$5,825
5
$5,825
NPV = $25,000 − ∑ t
= −$219.20
t =1 (1.05)
NPV Buying Instead of Leasing
Year 0 Years 1-5
-$25,000 $4,670 + $1,155 = $5,825
5
$5,825
NPV = −$25,000 + ∑ = $219.20
t =1 (1.05) t
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21.7 Debt Displacement and Lease Valuation
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21.7 Debt Displacement and Lease Valuation
• The debt displaced by leasing results in forgone
interest tax shields on the debt that ClumZee movers
didn’t go into when they leased instead of bought
the truck.
• Suppose ClumZee agrees to a lease payment of
$6,250 before tax. This payment would support a
loan of $25,219.20 (see the next slide)
• In exchange for this, they get the use of a truck
worth $25,000.
• Clearly the NPV is a negative $219.20, which
agrees with our earlier calculations.
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21.8 Does Leasing Ever Pay: The Base Case
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A Tax Arbitrage
• Suppose ClumZee movers is actually in the 25% tax bracket and Tiger
Leasing is in the 34% tax bracket. If Tiger reduces the lease payment to
$6,200, can both firms have a positive NPV?
• Cash Flows: Tiger Leasing
Year 0 Years 1-5
Cost of truck –$25,000
Depreciation Tax Shield 5,000×(.34) = $1,700
Lease Payments 6,200×(1 –.34) = $4,092
–$25,000 $5,792
NPV = 76.33
• Cash Flows ClumZee Movers: Leasing Instead of Buying
Year 0 Years 1-5
Cost of truck we didn’t buy $25,000
Lost Depreciation Tax Shield 5,000×(.25) =
–$1,250
After-Tax Lease Payments 6,200×(1 –.25) =
–$4,650
$25,000 –$5,900
Remember to discount at .07575757*.75, the after-tax rate. Then NPV = NPV = -$69.55531
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5
.66 × Lmin + $1,700
NPV = 0 = −$25,000 + ∑
(1.05) t 5
$1,700
t =1
$25,000 − ∑ t
t =1 (1.05)
Lmin = 5
$1
.66 × ∑
5 5
$1 $1,700
$25,000 = .66 × Lmin ∑ +∑ t
(1.05) t =1 (1.05) t
t t =1 (1.05)
t =1
Lmin = $6,173.29
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5
.75 × Lmax + $1,250
NPV = 0 = $25,000 − ∑
t =1 (1.056818) t
Lmax = $6178.17
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5
$5,900
Increased debt capacity = $25,543.91 = ∑ t
t =1 (1 .05)
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The lost interest tax shield associated with this additional debt
capacity of $25,543.91 has a present value of $1,135.30
0 1 2 3 4 5
OutstandingBalanceoftheLoan $25,543.91 $20,921.11 $16,067.16 $10,970.52 $5,619.05 $0.00
Interest $1,702.93 $1,394.74 $1,071.14 $731.37 $374.60
TaxDeductiononinterest $425.73 $348.69 $267.79 $182.84 $93.65
After-taxInterestExpense $1,277.20 $1,046.06 $803.36 $548.53 $280.95
$425.73 $348.69 $267.79 $182.84 $93.65
− $1,135.30 = + + + +
(1.06667) (1.06667) 2 (1.06667)3 (1.06667) 4 (1.06667)5
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The lost interest tax shield associated with this additional debt
capacity of $25,219.20 has a present value of $
0 1 2 3 4 5
Outstanding Balance of the Loan $25,219.20 $20,655.16 $15,862.92 $10,831.07 $5,547.62 $0.00
Interest $1,910.55 $1,564.78 $1,201.74 $820.54 $420.27
Tax Deduction on interest $649.59 $532.03 $408.59 $278.98 $142.89
After-tax Interest Expense $1,260.96 $1,032.76 $793.15 $541.55 $277.38
Extra Cash that purchasing
firm genereates over leasing firm $ 5,825.00 $ 5,825.00 $ 5,825.00 $ 5,825.00 $ 5,825.00
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