UNIT 3

LEASING, DEBT AND EQUITY

FINANCING

Aswath Damodaran / Expanded and Edited by Del Hawley

 3.1 Leasing

Aswath Damodaran / Expanded and Edited by Del Hawley

 Introduction

 Most leases fall into the class of intermediate-

term financing
 Under a lease two parties are involved:
1. lessor – owns the asset
2. lessee – has full use of the asset and makes periodic lease payments to the
lessor

 Leasing has become a popular alternative to

buying assets

Aswath Damodaran / Expanded and Edited by Del Hawley

 Introduction

Operating leases
 contract covers a period that is shorter
than the life of the asset
 usually longer than a year

Aswath Damodaran / Expanded and Edited by Del Hawley

 Introduction

 Financial leases
 also called “full payout” leases
 a long-term contract that allows the lessor to
recover the full cost of the asset plus a return
during the period of the lease
 financial leases can take the form of:

Direct lease – lessee gets the use of an asset not
previously owned

Aswath Damodaran / Expanded and Edited by Del Hawley

 Introduction

 Tax-leveraged leases
 developed to meet the financing of million-
dollar capital equipment projects with
economic lives between 10 to 25 years
 lessor provides 20 to 40 percent of the capital
needed to purchase the equipment while the
remainder is provided by a financial institution

Aswath Damodaran / Expanded and Edited by Del Hawley

 Evaluation of Leases

 Relevant cash flow must be estimated to determine the

economic desirability of leasing versus purchasing an asset
 The lessee avoids the initial outlay of capital required in
purchasing the asset but subsequent costs are incurred
including:
1. direct cash outflows associated with the lease contract
periodic lease payments minus taxes
2. opportunity costs associated with not owning the asset

Aswath Damodaran / Expanded and Edited by Del Hawley

 Evaluation of Leases

 Leasing as a form of debt financing

 lease and debt financing affects a firm’s financial
position in the way they are committed to fixed
payments before any earning are accrued to
shareholders

Aswath Damodaran / Expanded and Edited by Del Hawley

 Evaluation of Leases

 Residual value
 when evaluating whether to lease or purchase an
asset, we have to charge a lease with the loss of
any residual value

Aswath Damodaran / Expanded and Edited by Del Hawley

 Reasons For Leasing

reasons for leasing include:

1. READY AVAILABILITY
 companies with poor credit ratings can sometimes obtain 100
percent financing through a lease compared to only partial
loan financing on the same asset
2. PAYMENT PROVISIONS
 If payments on a loan are variable while lease payments are
fixed, the borrowing option contains an additional element of
risk, giving incentive to lease

Aswath Damodaran / Expanded and Edited by Del Hawley 1

 Reasons For Leasing

 ORGANIZATIONAL CONSIDERATIONS
 some leases are written simply to circumvent
organizational restrictions on capital expenditures

 FLEXIBILITY AND OBSOLESCENCE

 leases provide the lessee with flexibility and insurance
against obsolescence

Aswath Damodaran / Expanded and Edited by Del Hawley 1

 Others Financing choices

 Debt (Leverage)
• The essence of debt is that you promise to make fixed
payments in the future (interest payments and repaying
principal). If you fail to make those payments, you lose
control of your business.
 Equity
• With equity, you do get whatever cash flows are left
over after you have made debt payments.

Aswath Damodaran / Expanded and Edited by Del Hawley 1

 Debt versus Equity

Debt Equity

Fixed Claim Residual Claim

High Priority on Cash Lowest Priority on Cash

Flows Flows
Interest is Tax Deductible No Tax Break on
Dividends
Fixed Maturity Infinite Life

Aswath Damodaran / Expanded and Edited by Del Hawley 1

 When Is It Debt?
Ask 3 Questions:

1. Is the cashflow claim created by this financing a

fixed commitment or a residual claim?
2. Is the commitment tax-deductible?
3. If you fail to uphold the commitment, do you lose
control of the business?

If all three answers are “Yes”, it’s debt.

Otherwise, it’s equity or a hybrid.

Aswath Damodaran / Expanded and Edited by Del Hawley 1

 Cost of Debt

Debt is always the least

costly form of financing.

WHY?

Aswath Damodaran / Expanded and Edited by Del Hawley 1

 Cost of Debt vs. Equity

E(R)

Debt will always be perceived

by investors to be less risky
than equity. Therefore, its
required return will always be
Equity
lower.
Rf
Debt
B
Aswath Damodaran / Expanded and Edited by Del Hawley 1
 Debt versus Equity

Factor Debt Equity

Cost Lowest Highest

High: Bankruptcy
Risk to the Firm and volatility of Low
cashflows
High: Major Low: Few
Impact on
restrictions on restrictions on
Flexibility
decision making decision making
Impact on Low, unless firm is Potentially High:
Control in bankruptcy Many owners
Aswath Damodaran / Expanded and Edited by Del Hawley 1
 The Choices

 Equity can take different forms:

• Small business owners investing their savings
• Venture capital for startups
• Common stock for corporations
 Debt can also take different forms
• For private businesses, it is usually bank loans
• For publicly traded firms, it is more likely to be
debentures (bonds) for long-term debt and commercial
paper for short-term debt

Aswath Damodaran / Expanded and Edited by Del Hawley 1

 Compare Advantages and Disadvantages
of Debt

Advantages of Debt
• Interest is tax-subsidized  Low cost
• Increases upside variability of cash
flows to equity
Disadvantages of Debt
• Possibility of bankruptcy/financial distress
• Increases downside variability of cash flows to equity
• Loss of future flexibility

Aswath Damodaran / Expanded and Edited by Del Hawley 1