Financial leasing

Topics in Chapter
 Types of leases ; Tax treatment of leases
 Effects on financial statements
 Lessee’s (use) analysis
 Lessor’s analysis(own)
 Other issues in lease analysis

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Who are the two parties to
a lease transaction?

 The lessee, who uses the asset and makes the lease, or rental, payments.
 The lessor, who owns the asset and receives the rental payments.
 Note that the lease decision is a financing decision for the lessee and an
investment decision for the lessor.

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Leasing:
• A lease is a binding legal contract that typically lasts for a
fixed period of time, often a year or more.
• Leases often come with more specific terms and
conditions than rental agreements, including provisions
for rent increases, security deposits, and other fees.
• Leases provide more stability and predictability for both
landlords and tenants, as the terms of the lease are
agreed upon in advance and cannot be changed without
mutual agreement.
• Leasing can be advantageous for lessor who want to
ensure a steady income stream and minimize vacancy
rates, as well as for tenants who want to establish a long-
3 term residence and avoid the hassle of moving frequently.
Advantages of leasing:
• More stability and predictability for both landlords and
tenants
• Provides a long-term residence for tenants
• Establishes a steady income stream for landlords
• May offer lower monthly payments than short-term rentals
 Disadvantages of leasing:
• May require a higher upfront cost, such as a security
deposit or first and last month's rent
• May be more difficult to terminate early without breaking
the contract and incurring penalties
• May offer less flexibility for tenants who need to move
frequently
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Renting:
• Renting typically involves a more informal, short-term
agreement between a landlord and tenant, often on a
month-to-month basis.
• Rental agreements may be less specific than leases,
allowing for more flexibility in terms of rent increases,
move-out dates, and other factors.
• Renting can be advantageous for tenants who want more
flexibility and don't want to commit to a long-term lease,
as well as for landlords who want to maintain a higher
degree of control over their property.

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Advantages of renting:
• More flexibility for tenants who need to move frequently
• Lower upfront costs, such as security deposits or first
month's rent
• May allow for easier termination of the agreement
without incurring penalties
 Disadvantages of renting:
• May be subject to rent increases or other changes with
little notice
• May offer less stability and predictability for both
landlords and tenants
• May not provide a long-term residence for tenants

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What are the primary lease types?

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 What are the five primary lease types?

1. Operating lease
1. Short-term and normally cancelable
2. Maintenance usually included
2. Financial lease
1. Long-term and normally noncancelable
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2. Maintenance usually not included
Revise
 Operating leases help to shift the risk of obsolescence from
the user to the lessor.
 A sale and leaseback arrangement is a type of financial, or
capital, lease.
 Under a sale and leaseback arrangement, the seller of the
leased property is the lessee and the buyer is the lessor.
 The full amount of a lease payment is tax deductible provided
the contract qualifies as a true lease under IRS guidelines.
 Leasing is typically a financing decision and not a capital
budgeting decision. Thus, the availability of lease financing
cannot affect the size of the capital budget.

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What are the five primary lease types?

1. Sale and leaseback: which allows the owner to lease the assets
to him self after selling it

2. Combination lease: a features of both finance or capital lease

& operating lease. Usually found in the operation
3. "Artificial" or synthetic lease: i.e : Enron a firm use it to get
use of the assets but keep debt out of their balance.

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 How are leases treated for tax purposes?

 Leases are classified by the internal revenue services (IRS )as

either guideline or non-guideline.
 For a guideline lease, the entire lease payment is deductible to
the lessee. allowing the lessee to deduct the full amount of the lease payment
from taxable income.
 Leasse term <80% of MACRS life , no right to purchase at predetermined price
and so on.
 For a non-guideline lease, only the assigned interest payment is
deductible.
 Why should the IRS be concerned about lease provisions? If the IRS
does re-characterize your lease as a sale, your rental payments will
not be deductible. Restrict companies from setting up lease with fully
deductible rapid payments

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How does leasing affect a firm’s balance
sheet?
 For accounting purposes, leases are classified as either
capital or operating.
 Capital leases must be shown directly on the lessee’s balance
sheet. As PV of future lease payments
 Operating leases, sometimes referred to as off-balance
sheet financing, must be disclosed in the footnotes.
 X want trucks but don’t want to put it on BS ask
subsidiary to buy trucks and lease them to X, record lease
payment
 Why are these rules in place? Enron’s sum of PV for leasing
and hiding debt

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 What impact does leasing have on a firm’s
capital structure?
 Leasing is a substitute for debt.
 As such, leasing uses up a firm’s debt capacity.
 Assume a firm has a 50/50 target capital structure. Half
of its assets are leased. How should the remaining assets
be financed?
◼ Leasing is like debt financing.
◼ The cash flows have relatively low risk; most are fixed by contract.
◼ Therefore, the firm’s 10% cost of debt is a good candidate.
◼ The tax shield of interest payments must be recognized, so
the discount rate is: 10%(1 - T) = 10%(1 - 0.4) = 6.0%.
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 If Lewis Securities plans to acquire some new
equipment having a 6-year useful life.
 A- If equipment is leased: Firm could obtain a 4-year lease
which includes maintenance .
 Lease meets IRS guidelines to expense lease payments.
 Rental payment would be $260,000 at the beginning of each year;
cost of capita 6%

◼ Equipment cost: $1,000,000; Loan rate on equipment = 10% ;

Marginal tax rate = 40%; 3-year MACRS ( Depreciation )life.
B. If company borrows ( Loan ) & buys, 4 year maintenance contract
costs $20,000 at beginning of each year.
◼ Residual value at t = 4: $200,000 ( the estimated value of a fixed

asset at the end of its lease term or useful life)

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A-Time Line: After-Tax Cost of Leasing (Rental )

0 1 2 3 4
Lease pmt -260 -260 -260 -260

Tax sav ( 40% pmt) 104 104 104 104

NCF -156 -156 -156 -156

Rate 6%
YEAR 0 1 2 3 4
NCF -156 -156 -156 -156
PV ($156.00) ($147.17) ($138.84) ($130.98) $0.00
sum ($572.99)

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PV cost of leasing @ 6% = -$572,990.
B-Time Line: After-Tax Cost of Owning (LOAN )

0 1 2 3 4
AT loan pmt ( after tax ) -60 -60 -60 -1,060
Dep Shld (Dep * Tax rate) 132 180 60 28
Maint -20 -20 -20 -20
Tax sav on main(20 *0.4) 8 8 8 8
Residual value RV 200

Tax on RV (40%* RV) -80

NCF -12 60 108 -12 -912

Rate 6%
YEAR 0 1 2 3 4
NCF -12 60 108 -12 -912
PV ($12.00) $56.60 $96.12 ($10.08) ($72.39)
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sum ($591.74)
 What is the net advantage to leasing (NAL)?
 NAL = PV cost of leasing - PV cost of owning
= - $572,990 - (-$591,741)
= $18,751.
 Should the firm lease or buy the equipment? Why?
 Note that we have assumed the company will not continue to
use the asset after the lease expires; that is, project life is the
same as the term of the lease.
 What changes to the analysis would be required if the lessee
planned to continue using the equipment after the lease
expired?

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 If the equipment is purchased at the end of the
lease for its residual value, $200,000 this
$200,000 will be depreciated with the same
schedule as if it were purchased new—3 years
MACRS. This gives an outflow of $200,000
at the end of the lease and then 4 years of
depreciation tax savings.

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 Assume the RV could be $0 or $400,000, with an expected
value of $200,000. How could this risk be reflected?
Note : RV > is more uncertain than other cash flows

 The discount rate applied to the RV inflow (a positive CF)

should be increased to account for the increased risk.
 All other cash flows should be discounted at the original
6% rate.
 If the residual value were included as an outflow (a
negative CF) in the cost of leasing cash flows, the
increased risk would be reflected by applying a lower
discount rate to the residual value cash flow.
 Again, all other cash flows have relatively low risk, and
hence would be discounted at the 6% rate.
19 (More...)
 Effect of Increased Residual Value Uncertainty

 The lessor owns the equipment when the lease expires.

Therefore, residual value risk is passed from the lessee
to the lessor.

 Increased residual value risk makes the lease more

attractive to the lessee.

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 How should the lessor analyze
the lease transaction?

 To the lessor, writing the lease is an

investment.
 Therefore, the lessor must compare the return
on the lease investment with the return
available on alternative investments of similar
risk.

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Given following data for Consolidated
Leasing, the lessor:$280,000 rental payment
instead of $260,000.
All other data are the same as for the lessee.
Time Line: Lessor’s ( OWNER) Analysis (In
Thousands)

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 Given following data for Consolidated Leasing, the
lessor:$280,000 rental payment instead of $260,000.
All other data are the same as for the lessee.
Time Line: Lessor’s ( OWNER) Analysis (In Thousands)
0 1 2 3 4
Cost (fixed) -1,000
Dep Shld(Dep * 40%) 132 180 60 28

Maint -20 -20 -20 -20

Tax sav(Dep * 40%) 8 8 8 8

Lse pmt 280 280 280 280

Tax -112 -112 -112 -112
RV 200
RV tax -80
NCF -844 288 336 216 148
Rate 6%
YEAR 0 1 2 3 4
NCF -844 288 336 216 148
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PV ($844.00) $271.70 $299.04 $181.36 $117.23
sum $25.32
Rate 6%

YEAR 0 1 2 3 4
NCF -844 288 336 216 148

PV ($844.00) $271.70 $299.04 $181.36 $117.23

sum $25.32

 The NPV of the net cash flows, when discounted at

6%, is $25,325.
 The IRR is 7.46%.
 Should the lessor write the lease? Why?

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Second :Find the lessor’s NPV if the lease
payment were $260,000.

 With lease payments of $260,000, the lessor’s cash flows would

be equal, but opposite in sign, to the lessee’s NAL.
 Thus, lessor’s NPV = -$18,751.
 If all inputs are symmetrical, leasing is a zero-sum game (one
winner & other loser).
 What are the implications?

In order for lease to be profitable for both parties they should be in

a different depreciation and tax brackets

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What impact would a cancellation clause have
on the lease’s riskiness from the lessee’s
standpoint? From the lessor’s standpoint?

 A cancellation clause/ item would lower the risk of the

lease to the lessee but raise the lessor’s risk.
 To account for this, the lessor (owner) would increase the
annual lease payment or else impose a penalty for early
cancellation.

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 Other Issues in Lease Analysis

 Do higher residual values make leasing less attractive to the

lessee?
 Should be reflected in lower lease payments in a competitive
market
 Is lease financing more available or “better” than debt
financing?
 Most lease have to be capitalized
 Lease some times delay some existing loan contract

(More...)
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Is the lease analysis presented here applicable
to real estate leases? To auto leases?

 Would spreadsheet models be useful in lease analyses?

 What impact do tax laws have on the attractiveness of
leasing? Consider the following provisions:
 Investment tax credit (when available)
 Tax rate differentials between the lessee and the lessor
 Alternative minimum tax (AMT): relatively short term lease
with high annual payments can increase reported expenses and
lower tax bills

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Numerical analyses often indicate that owning
is less costly than leasing. Why, then, is leasing
so popular?

 Provision of maintenance services.

 A furniture company might not be good at maintaining
delivery truck
 Risk reduction for the lessee.
 Project life: demand project life cycle
 Residual value: protect against technological obsolescence
 Operating risk: provide operating flexibility
 Portfolio risk reduction enables lessor to better bear these
risks.
 Many leases written to different firms reduce risks

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