CHAPTER 27

LEASING

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 LEARNING OBJECTIVES

• Define the types of leases and how the IRS qualifies leases

• Explain the reasons for leasing and the reasons for not leasing

• Show how to calculate the net advantage of leasing and related

issues

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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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 LEASES AND LEASE TYPES
• A lease is a contractual agreement between two parties: the lessee
and the lessor
• Lessee is the user of an asset in a leasing agreement; the lessee
makes payments to the lessor
• Lessor is the owner of an asset in a leasing agreement; the lessor
receives payments from the lessee

• Lease agreement establishes that the lessee has the right to use
the asset and, in return, must make periodic payments to the
lessor, the owner of the asset

• Some giant lessors in the U.S. include IBM Global Financing,

General Electric, AerCap, and AirFleet Capital
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 LEASING VERSUS BUYING
• Decision to lease or buy amounts to a comparison of alternative
financing arrangements for the use of an asset
• Consider the example below:
• Key difference is that in one case (buy), Sass arranges the financing,
purchases the asset, and holds title to the asset, whereas, in the
other case (lease), the leasing company arranges the financing,
purchases the asset, and holds title to the asset

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 OPERATING LEASES
• Operating lease is usually a shorter-term lease under which the
lessor is responsible for insurance, taxes, and upkeep
• Characteristics of operating leases:
1. Payments received by the lessor are usually not enough to allow
the lessor to fully recover the cost of the asset
• Operating leases are often relatively short-term, so the life of the
lease may be much shorter than the economic life of the asset
2. Frequently requires that the lessor maintain the asset, and the
lessor also may be responsible for any taxes or insurance
• These costs will be passed on, at least in part, to the lessee in the
form of higher lease payments
3. Cancellation option can give the lessee the right to cancel the
lease before the expiration date
• Value of a cancellation clause depends on whether technological or
economic conditions are likely to make the value of the asset to the
lessee less than the present value of the future lease payments 27-6
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 FINANCIAL LEASES
• Financial lease is typically a longer-term, fully amortized lease
under which the lessee is responsible for maintenance, taxes, and
insurance
• Called capital leases by accountants

• Characteristics of financial leases:

1. Payments made under a financial lease (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
2. With a financial lease, the lessee (not the lessor) is usually
responsible for insurance, maintenance, and taxes
• Financial leases are often called triple net leases
3. Financial lease generally cannot be canceled, at least not without
a significant penalty 27-7
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 TYPES OF FINANCIAL LEASES
• Tax-oriented lease (i.e., true lease or tax lease) is a financial lease in
which the lessor is the owner for tax purposes
• Most appropriate when lessee is unable to efficiently use tax credits
or depreciation deductions that come with owning the asset
• Leveraged lease is a financial lease in which the lessor borrows a
substantial fraction of the cost of the leased asset on a nonrecourse
basis, meaning that if the lessee defaults on the lease payments,
the lessor does not have to keep making the loan payments
• Can be quite complicated; primarily used for big-ticket transactions
• Sale and leaseback is a financial lease in which the lessee sells an
asset to the lessor and then leases it back
• Lessee receives cash the from sale of the asset and the lessee
continues to use the asset
• Lessee may have the option to repurchase the leased asset at the
end of the lease 27-8
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 ACCOUNTING AND LEASING
• Before November 1976, leasing was frequently called off-balance-
sheet financing
• Firm could arrange to use an asset through a lease and not
necessarily disclose existence of lease contract on the balance sheet
• Firms were required to report information about leasing activity
only in the footnotes to their financial statements
• In November 1976, the Financial Accounting Standards Board
(FASB) issued its Statement of Financial Accounting Standards No.
13 (FASB 13), “Accounting for Leases”
• Basic idea of FASB 13 is that certain financial leases must be
“capitalized”
• Beginning in 2019, companies are now required to disclose
operating leases on their balance sheets, which is a major change

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 ACCOUNTING AND LEASING
(CONTINUED)
• For accounting purposes, a lease is declared to be a capital lease if
at least one of the following criteria is met:
1. The lease transfers ownership of the property to the lessee by the
end of the term of the lease.
2. The lessee has an option to purchase the asset that is relatively
certain to be used.
3. The lease term is for a major part of the economic life of the
asset.
4. The present value of the lease payments plus any other residual
value equals or exceeds the value of the asset.
5. The asset is so specialized that it is expected to have no
alternative use to the lessor at the end of the lease.

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 TAXES, THE IRS, AND LEASES
• Lessee can deduct lease payments for income tax purposes if the
lease is deemed to be a true lease by the IRS
• IRS guidelines require that a lease be primarily for business
purposes and not merely for purposes of tax avoidance

• Generally, a lease is a contract that gives the lessee the right to

control the use of a specific asset for a set period of time in
exchange for payments made to the lessor

• Lessee has the “right to control” if, during the lease, the lessee:
1. Has the right to essentially all the economic benefits from the use
of the asset.
2. Has the right to direct the use of the asset.
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 THE INCREMENTAL CASH FLOWS
• Consider the decision confronting the Tasha Corporation, which
manufactures pipe. Business has been expanding, and Tasha currently
has a five-year backlog of pipe orders for the Trans-Missouri Pipeline.
• International Boring Machine Corporation (IBMC) makes a pipe-boring
machine that can be purchased for $10,000. Tasha has determined
that it needs a new machine, and the IBMC model will save Tasha
$6,000 per year in reduced electricity bills for the next five years.
• Tasha has a corporate tax rate of 21%. We assume that five-year
straight-line depreciation will be used for the pipe-boring machine;
after five years, the machine will be worthless. Johnson Leasing
Corporation has offered to lease the same pipe-boring machine to
Tasha for lease payments of $2,500 paid at the end of each of the next
five years. With the lease, Tasha would remain responsible for
maintenance, insurance, and operating expenses.
• Susan Smart has been asked to compare the direct incremental cash
flows from leasing to the cash flows associated with buying. 27-12
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 THE INCREMENTAL CASH FLOWS
(CONTINUED)
• Because Tasha will get the machine either way, the $6,000 savings
will be realized regardless of whether they lease or buy, so this cost
savings (and any other operating costs or revenues) can be ignored
• Ms. Smart concludes that there are only three important cash flow
differences between leasing and buying:
1. If the machine is leased, Tasha must make a lease payment of
$2,500 each year. However, lease payments are fully tax
deductible, so the aftertax lease payment would be $2,500 × (1
− .21) = $1,975. This is a cost of leasing instead of buying.
2. If the machine is leased, Tasha does not own it and cannot
depreciate it for tax purposes. The depreciation would be
$10,000/5 = $2,000 per year. A $2,000 depreciation deduction
generates a tax shield of $2,000 × .21 = $420 per year. Tasha loses
this valuable tax shield if it leases, so this is a cost of leasing.
3. If the machine is leased, Tasha does not have to spend $10,000
today to buy it. This is a benefit from leasing. 27-13
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 INCREMENTAL CASH FLOWS FOR TASHA
CORP. FROM LEASING INSTEAD OF BUYING

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 LEASE OR BUY?
• We now must decide whether getting $10,000 today and then
paying back $2,395 per year for five years is a good idea by using
the following process:
• Find incremental aftertax cash flows from leasing instead of buying
• Use these cash flows to calculate aftertax interest rate on the lease
• Compare this rate to the company’s aftertax borrowing cost and
choose the cheaper source of financing
• Suppose Tasha were to borrow $10,000 today and promise to make
aftertax payments of $2,395 per year for the next five years
• Rate for a five-year annuity with payments of $2,395 per year and a
present value of $10,000 is 6.325%
• Suppose Tasha can arrange a five-year loan with its bank at a rate of
7.1%. Should Tasha sign the lease or should it go with the bank?
• Because Tasha is in a 21% tax bracket, the aftertax interest rate
would be 7.1% × (1 − .21) = 5.609%
• Based on this analysis, Tasha should buy rather than lease 27-15
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 THREE POTENTIAL PITFALLS
• Three potential problems with the interest rate that we calculated
on the lease:
1. We can interpret this rate as the internal rate of return, or IRR, on
the decision to lease rather than buy; but doing so can be
confusing
• Normally, the higher the IRR, the better; but we decided that leasing
was a bad idea here.
• The reason is that the cash flows are not conventional; the first cash
flow is positive and the rest are negative, which is the opposite of
the conventional case
2. We calculated the advantage of leasing instead of buying
• We could have done the opposite and come up with the advantage
of buying instead of leasing; if we did this, the cash flows would be
the same, but the signs would be reversed.
3. Our interest rate is based on the net cash flows of leasing instead
of buying. There is another rate that is sometimes calculated
based solely on the lease payments. 27-16
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 NPV ANALYSIS
• NPV analysis is straightforward; discount the cash flows back to the
present at Tasha’s aftertax borrowing rate of 5.609% as follows:
NPV = $10,000 − $2,395 × (1 − 1/1.056095) / .05609
= − $196.83

• NPV from leasing instead of buying is −$196.83, verifying our earlier

conclusion that leasing is a bad idea

• Net advantage to leasing (NAL) is the NPV that is calculated when

deciding whether to lease an asset or to buy it
• Most popular means of lease analysis in the real world, based on
survey responses

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 LEASE EVALUATION

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 A LEASING PARADOX
• Evaluate the lease from viewpoint of Tasha’s lessor, Johnson Leasing
• There is a $10,000 outflow today for the purchase of the machine
• Johnson depreciates the machine at a rate of $10,000/5 = $2,000
per year, so the depreciation tax shield is $2,000 × .21 = $420 each
year
• Johnson receives a lease payment of $2,500 each year, on which it
pays taxes; aftertax lease payment received is $1,975, and the total
cash flow to Johnson is $2,395 per year

• Cash flows to Johnson are exactly opposite of cash flows to Tasha

• In any leasing arrangement, one party must inevitably lose (or both
parties exactly break even). Why, then, would leasing take place?
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27-19
 IT’S THE LEASE WE CAN DO

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 GOOD REASONS FOR LEASING
• Tax advantages
• Most economically justifiable reason for long-term leasing is tax
deferral
• Lease contract allows lessor to take advantage of the depreciation
and interest tax shields that cannot be used by lessee
• Firm in a high tax bracket will want to act as lessor, while low tax
bracket firms will be lessees

• Reduction of uncertainty
• Reduction of uncertainty is the motive for leasing most cited by
corporations
• Value of property at lease expiration is residual (or salvage) value
• Lease contract is method of transferring uncertainty over residual
value from the lessee to the lessor
27-21
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 GOOD REASONS FOR LEASING
(CONTINUED)
• Lower transaction costs
• For example, a person who lives in Los Angeles but must do business
in New York for two days would find it cheaper to rent a hotel room
for two nights instead of buying a condominium for two days (and
then selling it)
• May be major reason for short-term leases (operating leases), but is
probably not major reason for long-term leases

• Fewer restrictions and security requirements

• Unlike secured loans, where the borrower will generally agree to a
set of restrictive covenants, spelled out in the indenture, or loan
agreement, such restrictions are not generally found in lease
agreements
• With a secured loan, the borrower may have to pledge other assets
as security, but with a lease, only the leased asset is so encumbered
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 DUBIOUS REASONS FOR LEASING
• 100 percent financing
• It is often claimed that an advantage to leasing is that it provides
100% financing, whereas secured equipment loans require an
initial down payment
• A firm can borrow the down payment from another source that
provides unsecured credit
• Leases do usually involve a down payment in the form of an
advance lease payment (or security deposit)

• Low cost
• Unscrupulous lessors can encourage lessees to base leasing
decisions on the “interest rate” implied by the lease payments,
which is often called the implicit or effective rate
• Rate is not meaningful in leasing decisions and has no legal
meaning 27-23
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 SELECTED CONCEPT QUESTIONS
• What are the differences between an operating lease and a
financial lease?
• For accounting purposes, what constitutes a capital lease?
• Why is the IRS concerned about leasing?
• What are the cash flow consequences of leasing instead of buying?
• What is the relevant discount rate for evaluating whether or not to
lease an asset? Why?
• Why do we say that leasing is a zero-sum game?
• Explain why the existence of differential tax rates may be a good
reason for leasing.

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 END OF CHAPTER
CHAPTER 27

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