LEASING

Corporate Finance
2019-2020
 DEFINITION
• A lease is a contractual agreement between two parties.
The lessee and the lessor.

LESSEE: The users of the asset in a leasing agreement.

The lessee make payment to the lessor.

LESSOR: The owner of an asset in a leasing agreement.

The lessor receives payments from the lessee.
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 LEASE VRS BUYING
• Whether it leases or buys an asset the company ends up
using the asset.
• The key difference is that in one case (when buying) the
company arranges the financing, purchases the asset and
holds title to the asset.
• In the other case (lease) the leasing company (could be
manufacturer) arranges the financing, purchases the
asset, and holds title to it.
 Buying versus Leasing (Figure 1)
Buy Lease
Enterprises buys asset and uses Enterprises leases asset from lessor; the
asset; financing raised by debt lessor owns the asset

Manufacturer Manufacturer
of asset of asset

Enterprises arranges Lessor arranges

financing and buys financing and buys
asset from asset
manufacturer Enterprises leases asset
from lessor

Enterprises 1. Uses Lessor Lessee (Enterprises)

asset 1. Owns asset 1. Uses asset
2. Owns asset 2. Does not use asset 2. Does not own asset
 TYPES OF LEASES

Operating / Service leases

• This is usually a shorter –term lease under which the lessor is
responsible for insurance, taxes and upkeep.
• This type may be cancelable by the lessee on short notice.
• Due to above characteristics, payments received by lessor are
usually not enough to allow the lessor to fully recover the cost
of the asset.
• The asset is usually re-leased to another person.
 Financial lease / Capital lease

• This is typically a longer term, fully amortized lease under which

the lessee is responsible for maintenance, taxes and insurance.
• It is usually not cancelable by the lessee without penalty.
• Financial leases are essentially considered as substitutes for buying
the asset and financing same by borrowing the money required.
• With financial leases, the payments made (plus the anticipated
residual or salvage, value) are usually sufficient to fully cover the
lessor’s cost of purchasing the asset and pay the lessor a return on
the investment.
• Hence a financial lease is said to be fully amortized or a full-pay
lease making it very similar to debt financing
Some financial leases particular interest are……
Tax-oriented leases: This is a financial lease in which the lessor is the owner for tax-
purposes. It is also called true or a tax lease.
Leveraged lease (read more ): This is a financial lease in which the lessor borrows a
substantial fraction of the cost of the leased asset on a non recourse basis. Meaning
if the lessee stops making the lease payments, the lessor does not have to keep
making loan payments. Instead the lender must proceed against the lessee to
recover its investment.
Sale and lease back Agreements: This occurs when the lessee sells an asset to the
lessor and then leases it back. Here two things happen: The lessee receives cash
from the sale of the asset
The lessee continues to use the asset. Often the lessee may have option to repurchase
the asset after the end of the leasing term.
 LEASING AND ACCOUNTING
Operating leases are not disclosed on the balance sheet. However certain financial leases must be
capitalized and hence reported on the balance sheet. However in more recent times, operating
leases are disclosed in some jurisdictions.

For accounting purposes a lease is declared to be a capital lease and must therefore be disclosed
on the balance sheet if at least one of the following criteria is met:
• The lease transfers ownership of the property to the lessee by the end of the term of the lease.
• The lessee can purchase the asset at a price below fair market value (bargain purchase price
option) when the lease expires.
• The lease term is 75% or more of the estimated economic life of the asset
• The present value of the lease payments is at least 90% of the fair market value of the asset at
the start of the lease.

Capital leases are reported such that the PV of the lease payments are calculated and reported
along with debt and other liabilities on the right hand side of the lessee’s balance sheet. The
same amount must be shown as the capitalized value of leased assets on the left-hand side of
the balance sheet
 Leasing and the Balance Sheet
A. Balance Sheet with Purchase (co. finances $100,000 truck with debt)
Truck $100,000 Debt $100,000
Other assets 100,000 Equity 100,000
Total assets $200,000 Debt plus equity $200,000

B. Balance Sheet with Operating Lease (co. finances truck with an operating lease)
Truck $ 0 Debt $ 0
Other assets 100,000 Equity 100,000
Total assets $100,000 Debt plus equity $100,000

C. Balance Sheet with Operating Lease (co. finances truck with an operating lease)
Truck $ 0 Debt $ 0
Other assets 100,000 Equity 100,000
Total assets $100,000 Debt plus equity $100,000

See https://www.investopedia.com/terms/o/operatinglease.asp and IAS 17, Leases

 LEASES AND TAXES
• If a lease is deemed to be a true lease, payments can be deducted
for income tax purposes. The tax shields associated with lease
payments are critical to the economic viability of lease.
• True lease : lessor receives the depreciation deductions
• Lessee can deduct the full amount of lease payments as an
operating expense
• Lease payments are treated as revenue for the lessor
 LEASES AND TAXES
A lease is treated as a non-tax lease when:
• The lessee obtains equity in the leased asset
• The lessee receives ownership of the asset on completion of
full lease payments
• Lease payments greatly exceed the current fair rental value
• The total amount the lessee pays for a short period covers a
substantial part of the asset value
• Some portion of the lease payment is specifically designated as
interest or its equivalent
• The property may be acquired at bargain price if sold
(this position is gradually changing as in recent years there is an increasing number
of short term leases that are being treated like long term leases. Refer to the IAS)
 THE CASH FLOWS FROM LEASING
To enable a firm take a leasing decision, the relevant cash flows must be
identified bearing in mind that taxes are very important considerations in a
lease analysis.
Consider this:
Tasha corp. manufactures pipe. IBMC makes a pipe-boring machine price
worth $10,000. Tasha needs a new machine and the IBMC model will save
Tasha Corp. $6,000 in reduced electricity bills for the next 5years.Tasha Corp.
has a tax rate of 34%. Assume a five-year straight line depreciation. J leasing
Corp. has offered to lease the same machine to Tasha for lease payments of
$2500 paid at the end of each year for the next five years. Tasha Corp. is
responsible for maintenance insurance and operating expenses. Tasha Corp.
has a five-year back log of pipe orders. Compare incremental cash flows from
leasing the IBMC machine to the cash flows associate with buying it.
 Lease Vs. Buy Cash Flows
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
After Tax -$1,650 -$1,650 -$1,650 -$1,650 -$1,650
lease
payment
Lost -$680 -$680 -$680 -$680 -$680
Depreciation
tax shield
Cost of +$10,000
Machine
Total cash $10,000 -$2,330 -$2,330 -$2,330 -$2,330 -$2,330
Flow
 Lease Vs Buying
Whether Tasha buys or leases the $6,000 savings will be realized from using the machine hence we
disregard it the analysis

(i). If the machine is leased, Tasha must make a lease payment of $2500 each year. However lease
payments are fully tax deductible so after tax lease payments will be
$ 2500 x (1-0.34) = $1650 cost of leasing
(ii). If leased Tasha cannot depreciate it for tax purposes because Tasha does not own it
Depreciation would be $ 10,000 /5 = $ 2000 per year

Tax shield per year would be $2000x0.34= $ 680

Since Tasha looses the $ 680 if it leases, it is now a cost to Tasha from leasing.
(iii). If the machine is leased Tasha does not have to spend $10000 to buy it. This is a benefit from leasing.
Positive 10,000 because Tasha saves from not buying the machine it leases.
Note
Other cash inflows and outflows (that have not been listed here may be applicable)
 LEASE OR BUY?
Based on the above if Tasha Corp. leases instead of buying, it saves
$10,000 because is avoids having to pay for the machine, but it must give
up $2,330 per years for the next five years in exchange. There are two
ways to look at this

IRR (implicit rate)

• Now suppose Tasha borrows $10,000 today and promises to make after
tax payment of $2330 per year for the next 5 years , the unknown rate for
a 5 years annuity with payments of $2330 per year and a PV of $10000
will be 5.317% (verify using trial and error method)
• This is effectively what Tasha will be doing if it leases the machine.
However to determine if this is a good deal, we must consider the rate
Tasha would pay on a five-year loan with the bank.
 Lease vs. Buying
• Suppose the bank rate were 7.5757 percent. The after tax
interest rate would be 7.57575x (1-0.34)=5%. This is less than
5.317% implicit after tax rate on the lease.
• In this case Tasha Corp would better off borrowing the money
because the rate would be better.
 The steps in our analysis are as follows:

(a) Calculate the incremental after tax cash flows from leasing instead
of buying.
(b) Use the cash flows to calculate the implicit after tax interest rate on
the lease
(c) Compare this rate to the company’s after tax borrowing cost and
choose the cheaper source of financing.
Note that since the alternative to leasing is long-term borrowing, the
after tax interest rate or borrowing is the relevant bench mark.
What are the three pitfalls to this method? Page 791 RWJ 5ed.
 NPV Analysis

• Since we know the relevant rate for evaluating a lease versus buy
decision is the firm’s after tax cost of borrowing as NPV analysis
would involve discounting the cash flows back to the present at
Tasha’s after tax borrowing rate of 5% as follows:
• NPV = $10,000-2,330 x (1- 1 /1.055)/0.05 = -$ 87.68

• The NPV from leasing instead of buying & -$87.68 verifying our
earlier conclusion that leasing is a bad idea.
 NPV Analysis
Note the signs of cash flows
First is positive, the rest are negative. The NPV computed here is called ‘net
advantage to leasing (NAL). This NAL approach has been found to be the most
popular means of lease analysis in the real world.
E.g. In our Tasha Corp example, suppose Tasha is able to negotiate a lease
payment of $ 2000 per year. What would be the NPV of the lease in this case?
Solution:
• After tax lease payment would be $2000 x (1-0.34) = $1320 which is $1650-
1320= $330 less than before.
• After tax cash flow would be -$2000 instead of -$2330. At 5%, the NPV would be
• NPV= $ 10000-2000x (1 - 1 / 1.055)/ 0.05 = $1341.05.
• The lease would be very attractive here.
 REASONS FOR LEASING

• Good reasons
– Tax advantages
– A reduction in uncertainty
– Lower transaction costs
– Fewer restrictions and security requirements
• Bad Reasons
– Leasing and accounting income
– 100 % financing
– Low cost.
 To Do
• The leasing paradox
• Leases and bankruptcy
• For further reading, see Corporate Finance
by Demarzo and Berk, chapter 25