Corporate Financial Management 3e Emery Finnerty Stowe Modified for course use by Arnold R. Cowan

1. 21 Leasing and Other Asset-Based Financing Corporate Financial Management 3e Emery Finnerty StoweModified for course use by Arnold R. Cowan

2. Lease Financing • A lease is a rental agreement that extends for one year or longer. • The owner of the asset (the lessor) grants exclusive use of the asset to the lessee for a fixed period of time. • In return, the lessee makes fixed periodic payments to the lessor. • At termination, the lessee may have the option to either renew the lease or purchase the asset.

3. Types of Leases • Full-service lease • Lessor responsible for maintenance, insurance, and property taxes. • Net lease • Lessee responsible for maintenance, insurance, and property taxes.

4. Types of Leases • Operating lease • short-term • may be cancelable • Financial lease • long-term • similar to a loan agreement

5. Types of Lease Financing • Direct leases • Sale-and-lease-back agreements • Leveraged leases

6. Manufacturer/ Lessor Lease Lease Sale of Asset Direct Lease Lessee or Manufacturer/ Lessor Lessee Lessor

7. Sale of Asset Lease Sale-and-Lease-Back Lessor Lessee

8. Sale of Asset Manufacturer Lease Equity Lender Single Purpose Leasing Company Lien Lessee Loan Equity Investor Leveraged Lease

9. Synthetic Leases • Firms have used synthetic leases to get the use of assets but keep debt off their balance sheets. • An unrelated financial institution invests some equity and sets up a special-purpose-entity that buys the assets and leases it to the firm under an operating lease. • Since the Enron bankruptcy, firms have been reluctant to use synthetic leases.

10. Enron provided some or all of the 3%. 3 2 Lending Group Partnership or Special Purpose Entity Enron sells assets, gets debt off the balance sheet and recognizes a gain on the sale. Enron Equity Investor 5 4 Enron guarantees the loan. Sometimes with now-worthless Enron shares. Outside investors inject at least 3% of the funding so that Enron doesn’t have to claim it as a subsidiary. Enron’s Murky Deals Enron used outside partnerships to move assets off its balance sheet and monetize assets. But the company was deeply involved with funding those partnerships. 1 Banks provided the other 97% of the financing.

11. Enron’s Partnerships • Reasons for setting up SPEs: • By setting up partnerships, partly owned by the company, Enron could draw in capital from outside investors. • If structured properly (the tax code requires that at least 3% of the partnership equity be obtained from outside investors), the partnerships could also be kept separate from Enron.

12. Enron’s Partnerships • As a result, any debt incurred by the partnership could be kept off the company's balance sheet. • As an added bonus, Enron often recognized a gain on the sale of the assets.

13. Why did Enron want debt off their balance sheet? • The simple answer is that Enron feared that too much debt would damage its credit rating.

14. Why did Enron want debt off their balance sheet? • A more complex answer lies with agency costs. Enron executives headed and partly owned some of the partnerships, which provided a huge source of outside income for those involved. • Enron’s former CFO, Andrew Fastow, made more than $30 million from two partnerships that he ran. • If you were a shareholder in a SPE buying an asset from your employer, where would your loyalties lie?

15. How Widespread Was This at Enron? • There were hundreds, and perhaps even thousands, of these partnerships. • The exact number isn't known. • In all, Enron had about 3,500 subsidiaries and affiliates, many of them limited partnerships and limited-liability companies, which are a sort of hybrid between corporations and partnerships.

16. How Did They Get Away With It? • The company and its board of directors claimed that allowing executives to be involved with the outside partnerships gave it the advantage of speed. • Enron claimed that it set up safeguards to protect itself, but in retrospect they were clearly inadequate.

17. Advantages of Leases • Efficient use of tax deductions and tax credits of ownership • Reduced risk • Reduced cost of borrowing • Bankruptcy considerations • Tapping new sources of funds • Circumventing restrictions • debt covenants • off-balance sheet financing

18. Disadvantages of Leasing • Lessee forfeits tax deductions associated with asset ownership. • Lessee usually forgoes residual asset value.

19. Valuing Financial Leases • Basic approach is similar to debt refunding. • Lease displaces debt. • Missed lease payments can result in the lessor • claiming the asset. • filing lawsuits. • forcing firm into bankruptcy. • Risk of a firm’s lease payments are similar to those of its interest and principal payments.

20. Equivalent Ways to Analyze • Net Advantage to Leasing (NAL) approach: • Lease if NAL > 0. • The Internal Rate of Return (IRR) approach: • Lease if IRR of leasing < after-tax cost of debt financing.

21. Leases Analysis Example • The Emerson Co. needs the use of a special purpose stamping machine for the next 10 years. • The machine costs $6 million, has a life of 10 years, and a salvage value of $300,000. • Emerson can lease this machine from the General Supply Co. for 10 years, with annual year-end lease payments of $1.05 million. Emerson’s tax rate is 40%.

22. Leases Analysis Example • If Emerson were to buy the machine, it would finance 80% of the purchase price with a 11.5% secured installment loan, with the remainder being borrowed as unsecured installment debt at 14% interest. • The after-tax required return on the asset is 15%. • Evaluate this leasing opportunity.

23. Leasing Displaces Borrowing Suppose initially that the Emerson Co. has net assets worth $50 million, and a debt ratio of 50%. Compute the debt ratio if Emerson uses: • Conventional financing for the stamping machine. • Leases the stamping machine. How would the target debt ratio be restored?

24. Initial Capitalization Conventional Debt $ 25 M Financial Lease Obligation $ 0 M Total Debt $25 M Equity $25 M Total $50 M Debt Ratio 50% Leasing Displaces Borrowing

25. Conventional Financing Conventional Debt $ 28 M Financial Lease Obligation $ 0 M Total Debt $25 M Equity $28 M Total $56 M Debt Ratio 50% Leasing Displaces Borrowing

26. Lease Financing Conventional Debt $ 2 5 M Financial Lease Obligation $ 6 M Total Debt $ 31 M Equity $25 M Total $56 M Debt Ratio 5 5.36% Leasing Displaces Borrowing

27. Debt Ratio Restored Conventional Debt $ 22 M Financial Lease Obligation $ 6 M Total Debt $28 M Equity $28 M Total $56 M Debt Ratio 50% Leasing Displaces Borrowing

28. Analyzing Leases • TheNet Advantage to Leasing(NAL) equals the purchase price (P) minus the present value of the incremental after-tax cash flows (CFAT) associated with the lease. NAL = P – PV(CFATs)

29. Analyzing Leases - the Discount Rate • The discount rate should be the lessee’s after-tax cost of similarly secured debt. • Since the lease obligation is not overcollateralized, the secured debt rate should reflect this. • Fully secured means the asset is worth more than 25% of the loan. • $80M loan on $100M asset: $20/$80 = 25% • Use weighted average of secured and unsecured debt rates if necessary.

30. Analyzing Leases - the Cash Flows • Cost of asset (saving) • Lease payments (cost) • Incremental differences in operating and other expenses (cost or savings) • Depreciation tax shelter (foregone benefit) • Expected net residual value (foregone benefit) • Investment tax credits (foregone benefit)

31. Net Advantage to Leasing Dt= year t depreciation deduction DEt= year t cash expense savings from leasing ITC = investment tax credit, if available CFt = lease payment in year t N = life of lease (in years) P = purchase price of asset r = asset’s after-tax required return r′ = cost of debt (secured & unsecured) Salvage = net salvage value T = lessee’s marginal income tax rate

32. Net Advantage to Leasing • We save paying the purchase price P. • We lose the ITC and salvage value. • We pay the lease payment CF; this may be partly offset by savings on operating and other cash expenses (E) and by tax deductibility. • We lose the depreciation tax shield TD. • Discount main cash flows at the after-tax cost of debt.

33. Net Advantage to Leasing • For the Emerson Co., • P = $6 million • CFt = $1.05 million per year for 10 years • Dt = ($6,000,000 - $300,000) / 10 = $570,000 per year for 10 years • DEt = 0, ITC = 0 • r = 15% • r′ = 80%(11.5%) + 20%(14%) = 12.0%

34. Net Advantage to Leasing

35. The IRR Approach • For Emerson’s leasing opportunity, the IRR is 7.58%. • The after-tax cost of debt financing is 12%×(1– 0.40) = 7.20%. • Since the IRR (the cost of lease financing) is greater than the after-tax cost of debt financing, Emerson should not lease the machine.

36. Break-Even Lease Payments • The break-even lease payments can be computed by setting the NAL to zero. • In the case of Emerson’s lease, the annual break-even payments are $1,039,206. • Since the lease contract calls for payments of $1,050,000; the leasing alternative is not preferred.

37. NPV of Lease to the Lessor • In a perfect market with no tax, leasing is a zero-sum game. • The NPV of the lease to the lessor will be - (NAL to the lessee). • If lessee and lessor have the same marginal income tax rates, leasing is still a zero sum game in an otherwise perfect market.

38. NPV of Lease to the Lessor where T′ = lessor’s marginal income tax rate.

39. NPV of Lease to the Lessor

40. Effect of Tax Asymmetries • Suppose lessee’s (Emerson’s) tax rate is zero. Also assume that the before-tax required return on the asset for the lessee is 17.50%. • The NAL to Emerson is then $7,460. • The NPV to the lessor is still $45,068. • Thus, both parties gain from the leasing arrangement.

41. Tax Treatment of Financial Leases • IRS has guidelines for distinguishing between true leases and • installment sales agreements. • secured loans. • If lessor meets these guidelines: • lessor can claim tax deductions and credits of asset ownership. • lessee can deduct full amount of lease payment for tax purposes.

42. IRS Guidelines for Financial Leases • Term of lease < 80% of asset’s useful life. • Lessor must maintain an equity investment of at least 10% of asset’s original cost. • Exercise price of the purchase option must equal the asset’s fair market value at the time the option is exercised. • Lessee does not pay any portion of the asset’s purchase price. • Lessor must hold title to the property.

43. Accounting Treatment of Financial Leases • SFAS 13 requires lessees to capitalize all leases that meet any one of the following: • Lease transfers ownership of asset to lessee before the lease expires. • Lessee has option to purchase asset at a bargain price. • Term of lease is greater than or equal to 75% of assets useful economic life. • PV of lease payments is ≥ 90% of asset value.

44. Project Financing • Desirable when • Project can stand alone as an economic unit. • Project will generate enough revenue (net of operating costs) to service project debt. • Examples: • Mines & mineral processing facilities • Pipelines • Oil refineries • Paper mills

45. Project Financing Arrangements • Completion undertaking • Purchase, throughput, or tolling agreements • Cash deficiency agreements

46. Advantages and Disadvantages of Project Financing • Advantages • Risk sharing • Expanded debt capacity • Lower cost of debt • Disadvantages • Significant transaction costs and legal fees • Complex contractual agreements • Lenders require a higher yield premium

47. Limited Partnership Financing • Another form of tax-oriented financing. • Allows the firm to “sell” the tax deductions and credits associated with asset ownership to the limited partners. • Income (or loss) for tax purposes flows through to the partners. • Limited partners are passive investors. • General partner operates the limited partnership and has unlimited liability.