Marini Wang Fei

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Key Concepts and Skills

Understand the different types of leases. Understand how to apply NPV to the lease vs. buy decision. Understand the importance of tax rates in determining the benefit of leasing.

.Types of Leases  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.

Owns asset 2. financed by debt and equity. Uses asset Owns asset Lessor 1. Manufacturer of asset Manufacturer of asset Firm U 1. Firm U leases it. Does not own asset Equity shareholders Creditors Equity shareholders Creditors .Buying versus Leasing Buy Firm U buys asset and uses asset. Lease Lessor buys asset. 2. Does not use asset Lessee (Firm U) 1. Uses asset 2.

Operating Leases    Usually not fully amortized Usually require the lessor to maintain and insure the asset Lessee enjoys a cancellation option .

2.Financial Leases The exact opposite of an operating lease. 4. Do not provide for maintenance or service by the lessor. 1. Financial leases are fully amortized. financial leases cannot be cancelled. The lessee usually has a right to renew the lease at expiry. 3. . Generally.

Two sets of cash flows occur:   The lessee receives cash today from the sale. The lessee agrees to make periodic lease payments.Sale and Lease-Back    A particular type of financial lease Occurs when a company sells an asset it already owns to another firm and immediately leases it from them. thereby retaining the use of the asset. .

The lessor borrows to partially finance the asset. A three-sided arrangement between the lessee. The lenders typically use a nonrecourse loan. This means that the lessor is not obligated to the lender in case of a default by the lessee. the lessor. . and lenders:    The lessor owns the asset and for a fee allows the lessee to use the asset.Leveraged Leases   A leveraged lease is another type of financial lease.

the lender has a first lien on the asset.Leveraged Leases Lessor buys asset. In the event of a default by the lessor. Lessor 1. Uses asset 2. Manufacturer of asset Lessor borrows from lender to partially finance purchase The lenders typically use a nonrecourse loan. Firm U leases it. Also. Owns asset 2. Does not own asset Equity shareholders Creditors . the lease payments are made directly to the lender after a default. Does not use asset Lessee (Firm U) 1. This means that the lessor is not obligated to the lender in case of a default by the lessee.

Operating leases do not appear on the balance sheet. Today.  Capital leases appear on the balance sheet—the present value of the lease payments appears on both sides. leases are either classified as capital leases or operating leases. leases led to offbalance-sheet financing.Leveraged Leases   In the old days.  .

Naturally. 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.Taxes. especially if the lease appears to be set up solely to avoid taxes. the IRS seeks to limit this. the IRS. . and Leases    The principal benefit of long-term leasing is tax reduction.

2. Renewal options must be reasonable and reflect fair market value of the asset. 6. The lease should not have a schedule of payments that is very high at the start of the lease and low thereafter. . the IRS. 1. 5. 3. and Leases  The lessee can deduct lease payments if the lease is qualified by the IRS. The lease should not limit the lessee’s right to issue debt or pay dividends.Taxes. The term must be less than 30 years. The lease payments must provide the lessor with a fair market rate of return. There can be no bargain purchase option. 4.

 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. .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.

Operating and Capital Leases   Firms often choose to lease long-term assets rather than buy them for a variety of reasons .the tax benefits are greater to the lessor than the lessees. a perusal of the statements will give a very misleading view of the company's financial strength . leases offer more flexibility in terms of adjusting to changes in technology and capacity needs. If a firm is allowed to lease a significant portion of its assets and keep it off its financial statements.

Since the lessee does not assume the risk of ownership. the lease expense is treated as an operating expense in the income . At the end of the lease period.Operating and Capital Leases Two ways of accounting for leases:   In an operating lease. the lessee returns the property to the lessor. the lessor (or owner) transfers only the right to use the property to the lessee.

Operating and Capital Leases Financial Accounting Standards Board has ruled that a lease should be treated as an capital lease if it meets any one of the following four conditions:  (a) if the lease life exceeds 75% of the life of the asset (b) if there is a transfer of ownership to the lessee at  the end of the lease term .

exceeds 90% of the fair market value of the asset.  (d) if the present value of the lease payments.CONT…  (c) if there is an option to purchase the asset at a "bargain price" at the end of the lease term. . discounted at an appropriate discount rate.

and interest is imputed on this amount and shown as part of the income statement. In a capital lease. the present value of the lease expenses is treated as debt.Operating versus Capital Leases   When a lease is classified as an operating lease. the lease expenses are treated as operating expense and the operating lease does not show up as part of the capital of the firm. When a lease is classified as a capital lease. the lessee assumes some of the risks of ownership and enjoys some of the benefits . and statement and the lease does not affect the balance sheet.

and the interest revenue is recognized over the term of the lease. The lease receivable is also shown as an asset on the balance sheet. . the lessor records the present value of future cash flows as revenue and recognizes expenses.Operating versus Capital Leases   The lessor uses the same criteria for determining whether the lease is a capital or operating lease and accounts for it accordingly: If it is a capital lease.

reclassifying operating leases as capital leases can increase the debt shown on the balance sheet substantially especially for firms in sectors which have significant operating leases. however.CONT…. . should not be a significant factor in whether the commitments are treated as the equivalent of debt.   In practical terms. airlines and retailing come to mind The fact that the lessee may not take ownership of the asset at the end of the lease period. which seems to be the crux on which the operating/capital lease choice is made.

Conclusion  As an approximation. but the significant difference is that the present value of capital lease payments is computed using the cost of debt at the time of the capital lease commitment. . and is not adjusted as market rates change. using the firm’s current pre-tax cost of debt as the discount rate yields a good estimate of the value of operating leases. Note that capital leases are accounted for similarly in financial statements.

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