Nama: Randrianantenaina Solohery Mampionona Aime

NIM: 041924353041
Chapter 21. LEASING
21.1Types of Leases
The basics:
 A lease is a contractual agreement between a lessee and lessor.
 The agreement establishes that the lessee has the right to use an asset and in return
must make periodic payments to the lessor.
 The lessor is either the asset’s manufacturer or an independent leasing company.
OPERATING LEASES
• Usually not fully amortized. This means that the payments required under the terms of
the lease are not enough to recover the full cost of the asset for the lessor.
• Usually require the lessor to maintain and insure the asset.
• Lessee enjoys a cancellation option. This option gives the lessee the right to cancel
the lease contract before the expiration date.
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, i.e., the lessee must make all
payments or face the risk of bankruptcy.
Two special types of financial leases are the sale and leaseback arrangement and the
leveraged lease arrangement.
21.2Accounting and Leasing
• In the old days, leases led to off-balance-sheet financing.
• In 1979, the Canadian Institute of Chartered Accountants implemented new rules for
lease accounting according to which financial leases must be “capitalized.”
• Capital leases appear on the balance sheet—the present value of the lease payments
appears on both sides.
A lease must be capitalized if any one of the following is met:
1. 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.
2. The lease transfers ownership of the property to the lessee by the end of the term of
the lease.
Nama: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041
3. The lease term is 75-percent or more of the estimated economic life of the asset.
4. The lessee can buy the asset at a bargain price at expiry.
21.3Taxes, the IRS, and Leases
• The principal benefit of long-term leasing is tax reduction.
• Leasing allows the transfer of tax benefits from those who need equipment but cannot
take full advantage of the tax benefits of ownership to a party who can.
• If the CCRA (Canada Customs and Revenue Agency) detects one or more of the
following, the lease will be disallowed.
1. The lessee automatically acquires title to the property after payment of a specified
amount in the form of rentals.
2. The lessee is required to buy the property from the lessor.
3. The lessee has the right during the lease to acquire the property at a price less than fair
market value.
21.4The Cash Flows of Leasing
Consider a firm, ClumZee Movers, that wishes to acquire a delivery truck. The truck is
expected to reduce costs by $4,500 per year. The truck costs $25,000 and has a useful life of
five years. If the firm buys the truck, they will depreciate it straight-line to zero. They can
lease it for five years from Tiger Leasing with an annual lease payment of $6,250.
• Cash Flows: Buy
Year 0 Year 1-5
Cost of truck –$25,000
After-tax savings 4,500×(1-.34) = $2,970
Depreciation Tax 5,000×(.34) = $1,700
Shield
-$25,000 $4,670

• Cash Flows: Lease

Year 0 Years 1-5
Lease Payments –6,250×(1-.34) = –$4,125
After-tax savings 4,500×(1-.34) = $2,970
–$1,155

• Cash Flows: Leasing Instead of Buying

Year 0 Years 1-5
$25,000 –$1,155 – $4,670 = –$5,825

• Cash Flows: Buying Instead of Leasing

Nama: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041
Year 0 Years 1-5
- $25,000 $4,670 –$1,155 = –$5,825
• 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.
21.5A Detour for 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.
21.6NPV Analysis of the Lease-versus 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.
• The various tax shields could be riskier than lease payments for two reasons:
1. The value of the CCA tax benefits depends on the firm’s ability to generate enough
taxable income.
2. The corporate tax rate may change.
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.
5
$ 5,825
NPV =$ 25,000−∑
t =1
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21.7Debt Displacement and Lease Valuation
• Considering the issues of debt displacement allows for a more intuitive understanding
of the lease versus buy decision.
• Leases displace debt—this is a hidden cost of leasing. If a firm leases, it will not use
as much regular debt as it would otherwise.
– The interest tax shield will be lost.
• 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.
Nama: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041
• 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.
21.9Reasons 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
– Leasing and accounting income
– 100% financing
21.10Some Unanswered Questions
• Are the Uses of Leases and of Debt Complementary?
– Ang and Peterson find that firms with high debt tend to lease frequently, as
well
• Why are Leases offered by Both Manufacturers and Third Party Lessors?
– For manufacturer lessors, the basis for determining capital cost allowance is
the manufacturer’s cost.
– For third party lessors, the basis is the sale price that the lessor paid to the
manufacturer.
• Why are Some Assets Leased More than Others?
– The more sensitive is the value of an asset to use and maintenance decisions,
the more likely it is that the asset will be purchased instead of leased.