Chapter 27

Leasing

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
 Key Concepts and Skills
• Understand basic lease terminology
• Understand the criteria for a capital lease
vs. an operating lease
• Understand the typical incremental cash
flows to leasing
• Be able to compute the net advantage to
leasing
• Understand the good reasons for leasing
and the dubious reasons for leasing

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 Chapter Outline
• Leases and Lease Types
• Accounting and Leasing
• Taxes, the IRS, and Leases
• The Cash Flows from Leasing
• Lease or Buy?
• A Leasing Paradox
• Reasons for Leasing

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 Lease Terminology
• Lease – contractual agreement for use of an
asset in return for a series of payments
• Lessee – user of an asset; makes payments
• Lessor – owner of the asset; receives payments
• Direct lease – lessor is the manufacturer
• Captive finance company – subsidiaries that
lease products for the manufacturer

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 Types of Leases
• Operating lease
– Shorter-term lease
– Lessor is responsible for insurance, taxes, and
maintenance
– Often cancelable
• Financial lease (capital lease)
– Longer-term lease
– Lessee is responsible for insurance, taxes, and
maintenance
– Generally not cancelable
– Specific capital leases
• Tax-oriented
• Leveraged
• Sale and leaseback

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 Lease Accounting
• Leases are governed primarily by FASB 13
• Financial leases are essentially treated as
debt financing
– Present value of lease payments must be
included on the balance sheet as a liability
– Same amount shown on the asset as the
“capitalized value of leased assets”
• Operating leases are still “off-balance-
sheet” and do not have any impact on the
balance sheet itself

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 Criteria for a Capital Lease
• If one of the following criteria is met, then
the lease is considered a capital lease and
must be shown on the balance sheet
– Lease transfers ownership by the end of the
lease term
– Lessee can purchase asset at below market
price
– Lease term is for 75 percent or more of the life
of the asset
– Present value of lease payments is at least 90
percent of the fair market value at the start of
the lease

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 Taxes
• Lessee can deduct lease payments for income tax
purposes
– Must be used for business purposes and not to avoid
taxes
– Term of lease is less than 80 percent of the economic life
of the asset
– Should not include an option to acquire the asset at the
end of the lease at a below market price
– Lease payments should not start high and then drop
dramatically
– Must survive a profits test – lessor should earn a fair
return
– Renewal options must be reasonable and consider fair
market value at the time of the renewal

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 Incremental Cash Flows
NPV = Net Present Value
• Cash Flow : - Cash Inflow
- Cash Outflow
• Cash Flows from the Lessee’s point of view
– After-tax lease payment (outflow)
• Lease payment*(1 – T)
– Lost depreciation tax shield (outflow)
• Depreciation * tax rate for each year
– Initial cost of machine (inflow)
• Inflow because we save the cost of purchasing the asset now
– May have incremental maintenance, taxes, or
insurance

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 Example: Lease Cash
Flows
• ABC, Inc. needs some new equipment. The equipment
would cost $100,000 if purchased and would be
depreciated straight-line over 5 years.
• (Initial Cost – Salvage Value) / Numbers of Economics
• No salvage is expected. Alternatively, the company can
lease the equipment for $25,000 per year. The marginal
tax rate (T) is 40%.
– What are the incremental cash flows?
• After-tax lease payment = 25,000(1 - .4) = 15,000 (outflow years 1 - 5)
• Lost depreciation tax shield = (100,000/5) = 20,000
• 20.000*.4 = 8,000 (outflow years 1 – 5)
• Cost of machine = 100,000 (inflow year 0)
• Total cash outflow = $23,000 per year
• Total cash inflow = $100.000

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 Lease or Buy?
• The company needs to determine whether
it is better off borrowing the money and
buying the asset, or leasing
• Compute the NPV of the incremental cash
flows
• Appropriate discount rate is the after-tax
cost of debt since a lease is essentially the
same risk as a company’s debt

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 Net Advantage to Leasing
(NAL)
• The net advantage to leasing (NAL) is the
same thing as the NPV of the incremental
cash flows
– If NAL > 0, the firm should lease
– If NAL < 0, the firm should buy
• Consider the previous example. Assume
the firm’s cost of debt is 10%.
– After-tax cost of debt = 10(1 - .4) = 6%
– NAL = $3,116
• Should the firm buy or lease? Cause
Positive so LEASE
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 Work the Web Example
• Many people must choose between buying and
leasing a car
• Click on the web surfer to go to Kiplinger’s
– Go to Tools & Calculators: Cars
– Do the calculations for a $30,000 car, 5-year loan at 7%
with monthly payments, and a $3,000 down payment.
The available lease is for 3 years and requires a $550
per month payment with a $1,000 security deposit and
$1,000 other upfront costs.

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 Good Reasons for Leasing
• Taxes may be reduced
• May reduce some uncertainty
• May have lower transaction costs
• May require fewer restrictive
covenants
• May encumber fewer assets than
secured borrowing

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 Dubious Reasons for
Leasing
• Balance sheet, especially leverage ratios, may
look better if the lease does not have to be
accounted for on the balance sheet
• 100% financing – except that leases normally do
require either a down-payment or security deposit
• Low cost – some may try to compare the
“implied” rate of interest to other market rates, but
this is not directly comparable

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 Quick Quiz
• What is the difference between a lessee and a
lessor?
• What is the difference between an operating
lease and a capital lease?
• What are the requirements for a lease to be tax
deductible?
• What are typical incremental cash flows, and how
do you determine the net advantage to leasing?
• What are some good reasons for leasing?
• What are some dubious reasons for leasing?

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 Ethics Issues
• Suppose a manager chooses to lease an
asset (operating lease) rather than buy,
simply to keep the asset off-balance sheet
and thereby avoid reporting the liability?
– Although this may be legal, is there any ethical
implication?
– Are investors able to effectively monitor and
analyze such activity?

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 Comprehensive Problem
• What is the net advantage to leasing for
the following project, and what decision
should be made?
– Equipment would cost $250,000 if purchased
– It would be depreciated straight-line to zero
salvage over 5 years.
– Alternatively, it may be leased for $65,000/yr.
– The firm’s after-tax cost of debt is 6%, and its
tax rate is 40%

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End of Chapter

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