B.

Tech CSBS Sem VI

2CSBSPE6105 : Advance Finance

Unit-3:
Leasing Contracts

Prepared by : Prof. Ravi Raval

Contents
1. What is a lease?
2. Why lease?
• Sensible reasons
• Dubious reasons
3. Operating leases
4. Valuing financial leases
5. Why do financial leases pay?
6. Leveraged leases

Reference: Chap 25 of Principles of Corporate

Finance by Richard A. Brealey, Stewart C.
Myers, Franklin Allen (Page # 654-668)
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 What is a lease?
Slide 27

 Short lived rentals: car, bike, boat

 Longer term rentals (in corporate finance): Trucks, machinery, aircraft, warehouse, ship,
aircraft
• Extends for a year or so
• Involves a series of payment (1.5 lacks/month)
 Every lease involves two parties: Lessor (owner) and Lessee (user)

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 What is a lease?
 Monthly or semiannual payments, with the first payment usually due as soon as the contract is
signed.
 The payments are usually level, but their time pattern can be tailored to the user’s needs. (e.g: 1
lack for first year, 2.5 lack / subsequent year(s))
 Lease terminated?
 Purchase the equipment or
 Take out a new lease
 Types of leases:
1) Operating leases: short-term, cancelable during the contract period
2) Capital, financial or full-payout leases: Extends to economic life of asset, cannot be canceled or lessor is reimbursed
for any losses.
3) Full service or rental lease: lessor promises to maintain and insure the equipment and to pay any property taxes due
on it.
4) Net Leases: the lessee agrees to maintain the asset, insure it, and pay any property taxes.
5) Direct lease: The lessee identifies the equipment, arranges for the leasing company to buy it from the manufacturer,
and signs a contract with the leasing company.
6) Sale and lease back: sell an asset you already owns and lease it back (e.g HSBC building sold at £1.09 billion 4and
 Why lease?
 Sensible reasons: leased asset and deducts its depreciation from
taxable income.
1) Short term leases are convenient: Rent a car
for a month. (saves RTO registration, insurance, 6) Leasing and Financial Distress: If a lessee
resale negotiation etc.) defaults on a lease payment, you might think
that the lessor could pick up the leased asset and
2) Cancellation options are valuable: Some take it home. But if the bankruptcy court
leases that appear expensive really are fairly decides that the asset is “essential” to the
priced once the option to cancel is recognized. lessee’s business, it affirms the lease. Then the
3) Maintenance Is Provided: Under a full-service bankrupt firm can continue to use the asset. It
lease, the user receives maintenance and other must continue to make the lease payments,
services (results in higher lease payment). however. This can be good news for the lessor,
4) Standardization Leads to Low Administrative who is paid while other creditors cool their
and Transaction Costs: You can also use a heels.
simple, standard lease contract. This 7) Avoiding the alternative minimum tax: Red-
standardization makes it possible to “lend” blooded financial managers want to earn lots of
small sums of money without incurring large money for their shareholders but report low
investigative, administrative, or legal costs. profits to the tax authorities. Tax law in the
5) Tax Shields Can Be Used: The lessor owns the United States allows this. 5
 Why lease?
 Dubious reasons: Its bank balance ends up the same whether
1) Leasing Avoids Capital Expenditure it leases or buys and borrows. It has the bus
Controls: In many companies lease in either case, and it incurs a $100,000
proposals are scrutinized as carefully as liability in either case. What’s so special
capital expenditure proposals, but in others about leasing?
leasing may enable an operating manager to 3) Leases May Be Off-Balance-Sheet
avoid the approval procedures needed to Financing: In some countries financial
buy an asset For example, city hospitals leases are off balance sheet financing; that
have sometimes found it politically more is, a firm can acquire an asset, finance it
convenient to lease their medical equipment through a financial lease, and show neither
than to ask the city government to provide the asset nor the lease contract on its
funds for purchase. balance sheet.
2) Leasing Preserves Capital: If Greymare 4) Leasing Affects Book Income: Leasing can
Bus Lines leases a $100,000 bus rather than make the firm’s balance sheet and income
buying it, it does conserve $100,000 cash. It statement look better by increasing book
could also (1) buy the bus for cash and (2) income or decreasing book asset value, or
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 Operating leases
Case study: The boyfriend of the daughter of the CEO of Establishment Industries takes her to the senior prom in a
pearly white stretch limo. The CEO is impressed. He decides Establishment Industries ought to have one for VIP
transportation. Establishment’s CFO prudently suggests a one-year operating lease instead and approaches Acme
Limolease for a quote.
Table 25.1 shows Acme’s analysis. Suppose it buys a new limo for $75,000 that it plans to lease out for seven years
(years 0 through 6). The table gives Acme’s forecasts of operating, maintenance, and administrative costs, the latter
including the costs of negotiating the lease, keeping track of payments and paperwork, and finding a replacement
lessee when Establishment’s year is up. For simplicity we assume zero inflation and use a 7% real cost of capital. We
also assume that the limo will have zero salvage value at the end of year 6

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 Operating leases
The present value of all costs, partially offset by the value of depreciation tax shields, is
$98,150. Now, how much does Acme have to charge to break even?
Acme can afford to buy and lease out the limo only if the rental payments forecasted over
six years have a present value of at least $98,150. The problem, then, is to calculate a six-year
annuity with a present value of $98,150. We follow common leasing practice and assume rental
payments in advance.
As Table 25.1 shows, the required annuity is $26,190, that is, about $26,000. 8 This
annuity’s present value (after taxes) exactly equals the present value of the after-tax costs of
owning and operating the limo. The annuity provides Acme with a competitive expected rate of
return (7%) on its investment. Acme could try to charge Establishment Industries more than
$26,000, but if the CFO is smart enough to ask for bids from Acme’s competitors, the winning
lessor will end up receiving this amount.
Lease or buy? Need a car for a day/week => rent it. Need one for 5 years => buy it. What to
do for the grey area (between 1 week – 5 years)
“buy it if the equivalent annual cost of ownership and operation is less than the best lease rate you can
get from an outsider” In other words, buy if you can “rent to yourself ” cheaper than you can rent from 8
 Valuing Financial Leases
• Financial leases extend over most of the economic life of the leased equipment. They are not
cancelable.
• Case study:
Imagine yourself in the position of Thomas Pierce III, president of Greymare Bus Lines. Your firm was established by
your grandfather, who was quick to capitalize on the growing demand for transportation between Widdicombe and
nearby townships. The company has owned all its vehicles from the time the company was formed; you are now
reconsidering that policy. Your operating manager wants to buy a new bus costing $100,000. The bus will last only eight
years before going to the scrap yard. You are convinced that investment in the additional equipment is worthwhile.
However, the representative of the bus manufacturer has pointed out that her firm would also be willing to lease the bus
to you for eight annual payments of $16,900 each. Greymare would remain responsible for all maintenance, insurance,
and operating expenses. Table shows the direct cash-flow consequences of signing the lease contract.

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 Valuing Financial Leases
• What are the consequences?
1. Greymare does not have to pay for the bus. This is equivalent to a cash inflow of $100,000.
2. Greymare no longer owns the bus, and so it cannot depreciate it. Therefore it gives up a
valuable depreciation tax shield. In previous Table, we have assumed depreciation would be
calculated using five-year tax depreciation schedules.
3. Greymare must pay $16,900 per year for eight years to the lessor. The first payment is due
immediately.
4. However, these lease payments are fully tax-deductible. At a 35% marginal tax rate, the lease
payments generate tax shields of $5,920 per year. You could say that the after-tax cost of the
lease payment is $16,900 - $5,920 = $10,980.
• We must emphasize that table assumes that Greymare will pay taxes at the full 35% marginal
rate. If the firm were sure to lose money, and therefore pay no taxes, lines 2 and 4 would be left
blank. The depreciation tax shields are worth nothing to a firm that pays no taxes, for example.
• The previous table also assumes the bus will be worthless when it goes to the scrap yard at the
end of year 7. Otherwise there would be an entry for salvage value lost.
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 Valuing Financial Leases
• Who really owns the leased asset?
• To a lawyer or a tax accountant, that would be a silly question: The lessor is clearly the legal owner
of the leased asset. That is why the lessor is allowed to deduct depreciation from taxable income.
• From an economic point of view, you might say that the user is the real owner, because in a financial
lease, the user faces the risks and receives the rewards of ownership.
Greymare cannot cancel a financial lease. If the new bus turns out to be hopelessly costly and
unsuited for Greymare’s routes, that is Greymare’s problem, not the lessor’s. If it turns out to be a
great success, the profit goes to Greymare, not the lessor.
• In many respects, a financial lease is equivalent to a secured loan. The lessee must make a series
of fixed payments; if the lessee fails to do so, the lessor can repossess the asset. Thus we can
think of a balance sheet like this:
as being
economically
equivalent to a
balance sheet like
this:

Legal ownership can make a big difference when a financial lease expires because the lessor gets
the asset. Once a secured loan is paid off, the user owns the asset free and clear. 11
 Valuing Financial Leases
• Leasing and the internal revenue service
 Lessee takes benefit of lease payment in taxation, lessor use depreciation shield in tax but must report installment
in tax.
 However, the Internal Revenue Service is suspicious by nature and will not allow the lessee to deduct the entire
lease payment unless it is satisfied that the arrangement is a genuine lease and not a disguised installment purchase
or secured loan agreement.
• A First Pass at Valuing a Lease Contract
 Two general points about leases and equivalent loans.
1. First, if you can devise a borrowing plan that gives the same cash flow as the lease in every future period but a
higher immediate cash flow, then you should not lease. If, however, the equivalent loan provides the same future
cash outflows as the lease but a lower immediate inflow, then leasing is the better choice.
2. Second, our example suggests two ways to value a lease:
a) Hard way. Construct a table like Table given here showing the equivalent loan.
b) Easy way. Discount the lease cash flows at the after-tax interest rate that the firm would pay on an equivalent loan. Both
methods give the same answer—in our case an NPV of - $700.

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 When do financial leases pay?
 As long as lessor and lessee are in the same tax bracket, allows the lessor to take advantage of depreciation and
every cash outflow to the lessee is an inflow to the interest tax shields that are of no use to the lessee.
lessor, and vice versa. However, because the depreciation is accelerated and
 The lessor can win only at the lessee’s expense. But the interest rate is positive, the government suffers a net
both lessee and lessor can win if their tax rates differ. loss in the present value of its tax receipts as a result of
 Suppose that Greymare paid no tax ( Tc = 0). Then the the lease.
only cash flows of the bus lease would be:  Now you should begin to understand the
circumstances in which the government incurs a loss
on the lease and the other two parties gain. Other
things being equal, the combined gains to lessor and
lessee are highest when
 These flows would be discounted at 10%, because rD(1 -  The lessor’s tax rate is substantially higher than
Tc ) = rD when Tc = 0. The value of the lease is: the lessee’s.
 The depreciation tax shield is received early in the
 = 100 - 99.18 = +.82, or $820 lease period.
 In this case there is a net gain of $700 to the lessor (who  The lease period is long and the lease payments
has the 35% tax rate) and a net gain of $820 to the are concentrated toward the end of the period.
lessee (who pays zero tax). This mutual gain is at the  The interest rate rD is high—if it were zero, there
expense of the government. On the one hand, the would be no advantage in present value terms to
government gains from the lease contract because it can postponing tax.
tax the lease payments. On the other hand, the contract 13
 Leveraged leases
 Big-ticket leases are usually leveraged leases.
 In this example, the leasing company (or a
syndicate of several leasing companies) sets up a
special-purpose entity (SPE) to buy and lease a
commercial aircraft.
 The SPE raises up to 80% of the cost of the
aircraft by borrowing, usually from insurance
companies or other financial institutions. The
leasing company puts up the remaining 20% as
the equity investment in the lease
 Once the lease is up and running, lease payments begin gets the purchase price if the lessee’s purchase option is
and depreciation and interest tax shields are generated. exercised, and takes back the aircraft otherwise (an
All (or almost all) of the lease payments go to debt early buy-out option).
service. The leasing company gets no cash inflows until  The debt in a leveraged lease is nonrecourse. The
the debt is paid off, but does get all depreciation and lenders have first claim on the lease payments and on
interest deductions, which generate tax losses that can the aircraft if the lessee can’t make scheduled
be used to shield other income. payments, but no claim on the leasing company. Thus
 By the end of the lease, the debt is paid off and the tax the lenders must depend solely on the airline lessee’s
shields exhausted. At this point the lessee has the credit and on the airplane as collateral.
option to purchase the aircraft. The leasing company 14