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Chapter 18. Lease Analysis (Ch18boc-Model
Chapter 18. Lease Analysis (Ch18boc-Model
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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.
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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.
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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.
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
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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.
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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.
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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:
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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
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.
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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
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.
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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
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e trucks or else it can arrange
Therefore, if it buys, it will sell
large leasing19company that
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26 $565.3
27 ($565.3)
28 ($0.0)
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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.
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The MACRS43 deprn
schedule44determines
this, not45
the actual life.
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and it would analyze the lease
eed the after-tax
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the data tables
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yments. With 105"Typical"
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clicking Show,
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levels. You can also follow
n agreement110under the initial
unless the other
111 party
strative costs
112 and hassle of
ESSEE AND 113THE LESSOR,
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instrument.
116 Ask
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all company119that
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This would give
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meone who wants
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m the large front
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racket, so more
179 of the lease
10000
1000
500
0.4
0.1
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Typical for leasing
9500
2000
400
0.3
0.09
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Negotiation Graph
$2,000
$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
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.