A B C D E F G H

1 Chapter 18. Lease Analysis (ch18boc-model.xls)

2
3 This model analyzes a lease transaction from the viewpoints of both the lessee and the lessor. It addresses the following
4 issues:
5
6 1. Leasing is an alternative to borrowing and buying. How should a company make the lease vs. purchase decision?
7 2. How can we tell if the lease transaction a good deal for the lessor?
8 3. What fundamental economic factors, or drivers, make leasing arrangements attractive?
9 4. If leasing leads to cost savings, how should those savings be allocated between the lessor and the lessee? Should the
10 lessor negotiate with the lessee over the size of the lease payment, and thus the allocation of the benefits of leasing? If
11 negotiations are appropriate, how should they be conducted?
12 5. How does competition affect the allocation of savings through adjustments to the size of the lease payment?
13
Leasing is important--about one-third of all equipment is finance through leasing. Moreover, most retail stores are leased, as is over 50
14 percent of all corporate office space in large cities. Therefore, finance students should know how to answer these questions, and how to
deal with lease analysis in general.
15
16 LEASING PROBLEM
Note, in the analysis that follows, that most of the cash flows are set by contract (the lease payment, the loan costs, and the maintenance
charge) or by Congress (the depreciation schedule and the tax rate). Thus, these cash flows are quite predictable and have a low risk--they
are not at all like the cash flows in a capital budgeting project, where there is normally a lot of risk. Also, the cash flows on the time line
17 are net of taxes, i.e., after-tax. Since we are dealing with low-risk, after-tax cash flows, we need to discount at a low-risk, after-tax discount
rate. That means use the after-tax cost of debt.

18
Anderson Corporation plans to acquire $10 million of new trucks. It can borrow the funds and then buy the trucks or else it can arrange
to lease them. The basic facts are given below. Note that Anderson plans to use the trucks for only 5 years. Therefore, if it buys, it will sell
19 them after 5 years, and if it leases, it will not want to renew the lease. Anderson is discussing the lease with a large leasing company that
specializes in truck leasing.

If Anderson owns the trucks, it will have to maintain them. If it leases, the leasing company will provide maintance, and this cost is built
20 into the rental charge. Data on both Anderson and the leasing company are given below. All dollars are in thousands. Note that initially
we assume that all the data are the same for the lessee and the lessor We change inputs later.
21 Note that the lease payment must be the same for the lessee and the lessor, so we set the lessor's payment equal to
22 that of the lessee. Change only the lessee's payment; the lessor's payment will change automatically. Similarly, the
23 after-tax cost of debt is determined by a formula. Don't change it.
24
25 INPUT DATA: Original Data: Modified Data: KEY OUTPUT:
26 For Lessee For Lessor For Lessee For Lessor NAL to Anderson
27 NPV to leasing company
28 New Equipment cost $10,000 $10,000 $9,500 Synergy: NAL + NPV
29 New Equipment life 5 5 6
30 Equip. Salvage Value $1,000 $1,000 $2,000 Leasing "Synergy" is defined as the
31 Annual Maintenance $500 $500 $400 sum of the NAL and the NPV. It tells
32 Tax Rate 40% 40% 30% us how much economic value the
33 Loan interest rate 10% 10% 9% leasing arrangement is creating. If
34 Annual lease payment $2,577.59 $2,577.59 synergy = 0, then no value is created.
35 After-tax cost of debt 6.0% 6.0%
36
37 MACRS 5-year Depreciation Schedule
38 Year 1 2 3 4 5 6
39 Depr. Rate 20% 32% 19% 12% 11% 6%
40 Lessee's Depr. Exp. $2,000 $3,200 $1,900 $1,200 $1,100 $600
41 EOY Book Value $8,000 $4,800 $2,900 $1,700 $600 $0
42
43 Lessor's Depr. Exp. $2,000 $3,200 $1,900 $1,200 $1,100 $600 The MACRS deprn
44 EOY Book Value $8,000 $4,800 $2,900 $1,700 $600 $0 schedule determines
45 this, not the actual life.

Copyright (c) 2002 by Harcourt, Inc.

 A B C D E F G H
46 EVALUATION OF THE LEASE FROM THE LESSEE'S STANDPOINT
47 Year = 0 1 2 3 4 5
48 Cost of Owning
49 Equipment cost ($10,000)
50 Loan amount $10,000
51 Interest on loan ($1,000) ($1,000) ($1,000) ($1,000) ($1,000)
52 Tax savings on int. $400 $400 $400 $400 $400
53 Repayment of loan ($10,000)
54 Maintenance Cost ($500) ($500) ($500) ($500) ($500)
55 Tax savings on main. $200 $200 $200 $200 $200
56 Tax savings on depr. $800 $1,280 $760 $480 $440
57 Residual value $1,000
58 Tax on res. value ($160)
59 Net cash flow ($300) ($100) $380 ($140) ($420) ($9,320)
60 PV owning @ 6% ($7,470.81)
61
62 Cost of Leasing
63 Lease payment ($2,578) ($2,578) ($2,578) ($2,578) ($2,578)
64 Tax savings on lease $1,031 $1,031 $1,031 $1,031 $1,031
65 Net cash flow ($1,547) ($1,547) ($1,547) ($1,547) ($1,547) $0
66 PV leasing @ 6% ($6,905.53)
67
68 Net Advantage to Leasing = NAL = PV Owning cost - PV Leasing cost = $565.29
69
Note that we use absolute values, so a positive NAL indicates that the PV costs associated with leasing are lower than the PV costs of
owning. In that case, Anderson should lease rather than buy, and vice versa if the NAL were negative. With the data used thus far, the
70 lease is neutral, so Anderson would see no reason to incur the administrative costs of leasing.

71
72 LESSOR'S ANALYSIS TO DETERMINE THE NPV OF AN INVESTMENT IN THE LEASE
The leasing company undertakes a similar analysis. The lessor would have to make an investment at Year 0, and it would analyze the lease
73 like a capital budgeting project, accepting the lease only if the NPV is positive, in which case the IRR will exceed the after-tax cost of
capital.
74
75 Year = 0 1 2 3 4 5
76 Costs to the Lessor
77 Net purchase price ($10,000)
78 Maintenance cost ($500) ($500) ($500) ($500) ($500)
79 Tax savings from main. $200 $200 $200 $200 $200
80 Tax savings from depr. $800 $1,280 $760 $480 $440
81 Lease payment $2,578 $2,578 $2,578 $2,578 $2,578
82 Tax on lease payment ($1,031) ($1,031) ($1,031) ($1,031) ($1,031)
83 Residual value $1,000
84 Tax on residual value ($160)
85 Net cash flow ($8,753) $2,047 $2,527 $2,007 $1,727 $1,280
86
87 NPV @ 5.4% ($565.29)
88 Unless NPV > 0 and IRR > after-tax cost of debt, the lessor would not want to
89 IRR 3.4% incur the costs associated with the lease transaction.

We should also note that for simplicity we assumed uniform annual payments. However, leases are occasionally set up with payments that
vary over time. For example, a timber company might lease equipment on a lease that calls for larger payments during the summer, when
90 production and cash flows are high, and lower payments during the winter. Or, payments might be structured so that they rise over time
as the business grows sales and cash flows. Of course, the PV of these varying payment streams would be the same as under the fixed
stream system.

Copyright (c) 2002 by Harcourt, Inc.

 A B C D E F G H
91 FACTORS THAT FAVOR THE USE OF LEASING
In the Anderson example with the initial inputs, the lease is not beneficial to either the lessee or the lessor. But why did things work out
that way? Leasing must occasionally provide benefits or else lease deals would never be consumated. What circumstances and conditions
favor leasing, and when is leasing likely to be advantageous? We can use the model to gain insights into these questions. We begin by
92 making the following data tables and then plotting the output as shown in the Negotiation Graph.

93
94 Data Tables for Use in Making the Negotiation Graph:
95
96 Payment Lessee's NAL Payment Lessor's NPV
97 C34 $565.29 C34 ($565.29) Synergy
98 $2,200 $1,577 $2,200 -$1,577 $0.00
99 $2,750 $103 $2,750 -$103 $0.00
100 $2,788.59 $0 $2,788.59 $0 $0.00
101 $2,900 -$298 $2,900 $298 $0.00
102
103 We created two scenarios using Excel's Scenario Analysis tool. See Part 3, Scenario Analysis, of the model for Chapter 10,
104 ch10BOC-model, for instructions on how to use the Scenario Analysis tool. When the scenarios are changed, the data tables above
105 change, and this causes the graph to change. With base case inputs, Synergy should be $0.00 for all lease payments. With "Typical"
106 inputs, Synergy would be positive for all lease payments.
107
108 You can change the inputs by clickingTools > Scenarios, then highlighting Base to get the initial inputs, then clicking Show, and then
109 clicking Close. Then click the Negotiation Graph tab. That puts all the model inputs at the initially assumed levels. You can also follow
110 the same procedures to input the "Typical" inputs. The Negotiation Graph shows that there is no basis for an agreement under the initial
111 inputs--under these assumptions and inputs, we have a zero sum game in which neither party would benefit unless the other party
112 suffered a loss, hence thelease would not occur. The company would just buy the trucks and save the administrative costs and hassle of
113 setting up the lease. ALL THIS DEMONSTRATES THAT IF THE INPUTS ARE THE SAME FOR THE LESSEE AND THE LESSOR,
114 THERE IS NO POINT IN LEASING.
115
116 Now think about the factors that make leasing advantageous, and thus why leasing is an important financing instrument. Ask
117 yourself the following questions:
118
119 1. Might a large national company like Ryder be able to negotiate better prices from Ford or GM than a small company that
120 that buys far fewer trucks, like Anderson? If so, then the lessor might have a lower purchase cost than the lessee.
121 2. Might a specialized leasing company like Ryder be able to maintain trucks at a lower cost than a company like Anderson,
122 which has no particular expertise in truck maintenance? Or perhaps it could obtain lower cost insurance. This would give
123 the lessor a lower maintenance cost.
124 3. Might a company like Ryder be in a better position to refurbish used trucks and then find a buyer, or someone who wants
125 to rent older trucks, than a non-specialist like Anderson? This could raise the lessor's estimated salvage value.
126 Also, if the lessor could maintain the trucks better, this might prolong their lives and further raise the residual value.
127 4. Might a large leasing company have a lower cost of capital than a smaller company? Note that GE Capital is
128 world's largest leasing company, and many other large lessors are affiliated with financial institutions like Citibank.
129 5. Might some leasing companies be both larger and more profitable, and thus pay a higher tax rate, than many
130 potential lessees, and might tax rate differentials affect the synergy from leasing? In connection with this point, note that
131 most of the depreciation comes early in an asset's life, that depreciation produces tax savings, but that the tax saving is
132 larger the higher the tax rate. Thus, an unprofitable lessee, with a zero tax rate, would get no benefit from the large front
133 end depreciation, but depreciation would be quite valuable to a profitable lessor in the 40% tax bracket.
134 6. As noted above, a lease can be structured with a varying payment stream to accommodate the lessee's needs.
135 When you think about it this way, it is easy to see why the inputs used to calculate the lessee's NAL might differ from those
136 used to calculate the lessor's NPV, hence why synergies might arise. This is indeed often the case.
137

Copyright (c) 2002 by Harcourt, Inc.

 A B C D E F G H
138 Using Goal Seek to Help Establish the Actual Lease Payment
139 With the more typical data, leasing is seen to benefit both the lessee and the lessor. Synergy is created, so the issue then is,
140 "How do we divide up the synergy?" The lower the lease payment, the more of it goes to the lessee, and vice versa if the lease
141 payment is increased.

With the modified inputs in the model, we can use Goal Seek to determine (1) the maximum amount the lessee could pay, (2) the
142
minimum amount the lessor could accept, and (3) the crossover point of the NAL and NPV lines in the Negotiation Graph.

To do the Goal Seek, first use the Scenario tool to set the model to the "Typical" case, with modified data reflected in the Input Data
section. Then put the pointer on Cell G68 and click Tools>Goal Seek. Leave G68 as the "Set Cell;" go to "Set To" and enter 0, then tab
down to the "By changing" cell and enter C34, the input cell for the lease payment. Then click OK. Note the lease payment that causes
143 NAL=0 and record it in D148. When you finish, repeat the process to find the lease payment that causes NPV in cell B87 to equal zero.
Then restore the original lease payment in the input data section.

Then, set up in Cell I145 the equation G68 - B87. Leave the pointer on this cell and click Goal Seek. This is the cell to set to 0, so tab
144 down and enter 0. Then tab down and enter C34, then click OK. Record the lease payment, and then click Cancel to restore.

145 Cell set to 0 to find crossover point:

146 Maximum Payment for NAL = 0: $2,778.74 Lease Payment for reference:
147 Minimum Payment for NPV = 0: $2,349.48 Observe and write down before
148 Payment where NAL = NPV: $2,577.59 clicking "Cancel" to restore.
149
To get an agreement, the payment must be set within the range $2,349.48 to $2,778.74. If it is set at $2,577.59, then the synergy will be
150
divided equally between the lessee and the lessor.
151
152 Where the payment is set will depend on the relative bargaining power of the lessee and the lessor. The leasing company
153 will obviously be seeking out other potential customers and other uses for its funds, and it will not get funds unless it can
154 enploy them in profitable leases. If its money costs go down, it could afford to lower the lease payment offered.
155
156 The lessee should also get bids from other leasing companies, just as one would shop for a bank loan or an automobile.
157 If the leasing company has a competitive advantage over other leasing companies--as Ryder Trucks might have in the
158 truck leasing business due to its scale and resulting economies in buying, maintaining, and selling used trucks, then it
159 might be able to keep most of the synergistic gains. However, for many leases, there are many equally efficient
160 lessors, so the lessee would probably be able to negotiate a lease that would capture most of the synergies.
161
We can do one other bit of analysis with the model--we can relate the lease payment to the IRR on the lease, under the modified data set.
The higher the IRR, the greater the likelihood that other leasing companies will bid for the lease. In general, the higher a lessor's rate of
return, the greater entry into the industry will be, and that entry will lead to more competition and lower lease payments. Only if a given
162 leasing company has some competitive advantage, such as a superior ability to maintain equipment or dispose of used equipment, can it
continue to earn rates of return in excess of its cost of capital in the long run.

163
164 Key Outputs as a Function of the Lease Payment, "Typical" Inputs
165
166 Lessor's Lessor's Lessee's
167 Payment A-T IRR NPV NAL Lessor's Pre-
168 C34 3.4% ($565.29) $565 Tax IRR Synergy
169 $2,349 0.6% -$1,176 $1,176 1.0% $0
170 $2,577.59 $2,300 0.0% -$1,309 $1,309 0.0% $0
171 $2,400 1.2% -$1,041 $1,041 2.0% $0
172 $2,500 2.4% -$773 $773 4.1% $0
173 $2,578 3.4% -$565 $565 5.6% $0
174 $2,600 3.7% -$505 $505 6.1% $0
175 $2,700 4.9% -$237 $237 8.2% $0
176 $2,779 5.9% -$26 $26 9.8% $0
177

Copyright (c) 2002 by Harcourt, Inc.

 A B C D E F G H
The above data table gives the range of feasible lease payments under the modified inputs situation. At the minimum payment, all the
synergies go to to the lessee, and the lessor just earns its cost of capital, 9% before tax and 5.4% after tax. At the maximum payment, the
lessor gets all the synergies, and the lessor earns more than twice its cost of capital on the low-risk investment in the lease. Unless the lessor
178 has some competitive advantage, other leasing companies will enter the market, bid for the lease, and in the process drive lease payments
down to the point where leasing companies are earning just over their costs of capital.

179 Note that synergies decline as the lease payment increases. This occurs because the lessor is in a higher tax bracket, so more of the lease
payment goes to tax payments by the lessor than to tax savings by the lessee.

Copyright (c) 2002 by Harcourt, Inc.

 I
1 6/25/2001
2
3
4
5
6
7
8
9
10
11
12
13
res are leased, as is over 50
hese questions,
14 and how to

15
16
costs, and the maintenance
able and have a low risk--they
cash flows on the time line
t a low-risk, 17
after-tax discount

18
e trucks or else it can arrange
Therefore, if it buys, it will sell
large leasing19company that

aintance, and this cost is built

20 that initially
housands. Note

21
22
23
24
25
26 $565.3
27 ($565.3)
28 ($0.0)
29
ynergy" is defined
30 as the
NAL and the 31NPV. It tells
ch economic32 value the
angement is 33creating. If
, then no value
34 is created.
35
36
37
38
39
40
41
42
The MACRS43 deprn
schedule44determines
this, not45
the actual life.

Copyright (c) 2002 by Harcourt, Inc.

 I
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
wer than the PV costs of
the data used thus far, the
70

71
72
and it would analyze the lease
eed the after-tax
73 cost of

74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89

ally set up with payments that

nts during the summer, when
90 rise over time
ed so that they
same as under the fixed

Copyright (c) 2002 by Harcourt, Inc.

 I
91
ut why did things work out
circumstances and conditions
e questions. We begin by
92

93
94
95
96
97
98
99
100
101
102
103
the data tables
104 above
yments. With 105"Typical"
106
107
108 and then
clicking Show,
109
levels. You can also follow
n agreement110under the initial
unless the other
111 party
strative costs
112 and hassle of
ESSEE AND 113THE LESSOR,
114
115
instrument.
116 Ask
117
118
all company119that
120
121
122
This would give
123
meone who wants
124
125
126
127
128
129
130
131
m the large front
132
133
134
135
136
137

Copyright (c) 2002 by Harcourt, Inc.

 I
138
139
versa if the140
lease
141

ssee could pay, (2) the

142
iation Graph.

reflected in the Input Data

t To" and enter 0, then tab
e lease payment that causes
V in cell B87 to equal zero.
143

the cell to set to 0, so tab

144
ancel to restore.
145 $1,131
146 $2,577.59
147
148
149
, then the synergy will be
150
151
152
153
154
155
156
157
158
159
160
161
under the modified data set.
the higher a lessor's rate of
se payments. Only if a given
e of used equipment,
162 can it

163
164
165
166
167
168
169
170
171
172
173
174
175
176
177

Copyright (c) 2002 by Harcourt, Inc.

 I
inimum payment, all the
the maximum payment, the
t in the lease. Unless the lessor
process drive lease payments
178

racket, so more
179 of the lease

Copyright (c) 2002 by Harcourt, Inc.

 Base

10000

1000
500
0.4
0.1

Page 11
 Typical for leasing

9500

2000
400
0.3
0.09

Page 12
 Negotiation Graph

$2,000

$1,500 Lessee's NAL

Lessor's NPV
$1,000

$500
NAL and NPV

$0
$2,200 $2,300 $2,400 $2,500 $2,600 $2,700 $2,800 $2,900

-$500

-$1,000

-$1,500

-$2,000

Lease Payment

Copyright (c) 2002 by Harcourt, Inc.

 A B C D E F G
1
2 Scenario Summary
3 Base
5 Variable Cell Current Values: Case Typical Inputs
6 Purchase Price $D$28 $10,000 $10,000 $9,500
7 Residual Value $D$30 $1,000 $1,000 $2,000
8 Maintenance Cost $D$31 $500 $500 $400
9 Tax Rate $C$32 40% 40% 30%
10 Borrowing Cost $D$33 10% 10% 9%
11 Result Cells:
12 NAL $I$26 $0.00 $0.00 ($30.27)
13 NPV $I$27 $0.00 $0.00 $1,189.10
14 Synergy $I$28 $0.00 $0.00 $1,158.83
15 Notes: Current Values column represents values of changing cells at
16 time Scenario Summary Report was created. The Base Case values were in place
17 when the scenario was created.
18
19 Note that in the base case, where the key inputs are the same for the lessee and the lessor,
20 the NAL and NPV are both zero, and there are no synergies. Thus, in this case the lease
21 would not be consumated.
22
23 In the "Typical Inputs" case the NAL is negative, so the lessee would not lease. However, the
24 lease would be highly profitable to the lessor. So, rather than not do lease, the lessor
25 would offer a lower lease payment, one that was sufficient to cause the NAL to
26 become positive. The exact lease payment is subject to negotiation, as discussed in
27 the Main Model and illustrated in the Negotiation Graph.

Copyright (c) 2002 by Harcourt, Inc.

 H
1
2
3
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
ease. However,
23 the
24
25
26
27

Copyright (c) 2002 by Harcourt, Inc.

Effect of Leasing on the Balance Sheet

Before the increase in assets

Firms B and L
Curr. Assets 50 Debt 50
Fixed Assets 50 Equity 50 Debt Ratio
Total Assets 100 Total D&E 100 50%

After the increase in assets

Firm B (Borrows and Buys)
Curr. Assets 50 Debt 150
Fixed Assets 150 Equity 50 Debt Ratio
Total Assets 200 Total Claims 200 75%

Firm L (Leases)
Curr. Assets 50 Debt 50
Fixed Assets 50 Equity 50 Debt Ratio
Total Assets 100 Total Claims 100 50%

Firm B appears to have more debt and thus to be riskier than Firm L. However, they are actually equally risky in
the senseof having about the same financial leverage. Therefore, assuming the asset has a fairly long life and the
life of the lease is75% or more of the life of the asset, it would have to be capitalized. Then, even if it leases, Firm
L's balance sheet would look like that of firm B.This treatment is important, because it helps make leasing and
borrowing-to-buy essentially equivalent in terms of risk.

Copyright (c) 2002 by Harcourt, Inc.