Financial Analysis, Planning and Forecasting Theory and Application

1. Financial Analysis, Planning and ForecastingTheory and Application Chapter 15 Leasing: Practices and Theoretical Developments By Cheng F. Lee Rutgers University, USA John Lee Center for PBBEF Research, USA

2. Outline • 15.1 Introduction • 15.2 Types of leasing arrangements and accounting treatments • Three leasing forms • Accounting for leases • 15.3 Cash-flow estimation and valuation methods • 15.4 The Modigliani and Miller propositions and the theoretical considerations of leasing • 15.5 Lease vs. buy decisions under uncertainty: the CAPM approach • 15.6 Options to evaluate salvage values in financial leases • 15.7 Summary and conclusion • Appendix 15A The Application of Adjusted Present Value (APV) Method to Lead versus Buy Decision • Appendix 15B Lease Accounting Updates

3. 15.1 Introduction • Fabozzi (1981) has discussed the conventional reasons for leasing in detail. Here we shall discuss them only briefly. • True lease financing might be cheaper than borrowing or purchasing the asset. This kind of advantage is primarily due to different marginal tax rates faced by the lessor and lessee. • Since leasing generally does not require the firm to make a down payment (as most lending institutions do), the effect is to conserve working capital, although, in general, lease payments are prepaid and in that sense are like a down payment (although generally smaller than those required in most purchase arrangements). • Leasing may preserve the credit and debt capacity of the firm. This, as we shall see, is a result of the accounting conventions in use today. • Leasing can reduce the risk of obsolescence and capital-equipment disposal problems. Almost always the term of the lease is less than the life of the asset, particularly so in the case of leases that are cancelable at certain times at the option of the lessee. • Leasing is more flexible and convenient than buying an asset. Most lessors deal with leasing arrangements on a regular basis and are used to tailoring these arrangements, within reason, to their client’s best interest.

4. 15.2 Types of leasing arrangements and accounting treatments • Three leasing forms a) Direct Leasing b) Sale and Leaseback c) Leveraged Leasing • Accounting for leases a) Capital Lease Treatment b) Accounting for Operating Leases c) Accounting for Leases from the Lessor’s Standpoint

5. 15.2 Types of leasing arrangements and accounting treatments

6. 15.2 Types of leasing arrangements and accounting treatments

7. 15.2 Types of leasing arrangements and accounting treatments

8. 15.2 Types of leasing arrangements and accounting treatments

9. 15.2 Types of leasing arrangements and accounting treatments

10. 15.2 Types of leasing arrangements and accounting treatments

11. 15.3 Cash-flow estimation and valuation methods

12. 15.3 Cash-flow estimation and valuation methods where A = Net cash outflow at t=0, Rt – Ct = Period’s net operating inflows, Dt = Period’s depreciation expense, Sn = Expected salvage value at time n, tc = Ordinary income tax rate, and k = After-tax cost of capital for the firm.

13. 15.3 Cash-flow estimation and valuation methods

14. 15.3 Cash-flow estimation and valuation methods

15. 15.4 The Modigliani and Miller propositions and the theoretical considerations of leasing Vu = Total value of an unleveraged firm, = A perpetual stream of after-tax cash flows, and k = Investor’s required return on equity.

16. 15.4 The Modigliani and Miller propositions and the theoretical considerations of leasing (15.6) (15.7)

17. 15.4 The Modigliani and Miller propositions and the theoretical considerations of leasing

18. 15.4 The Modigliani and Miller propositions and the theoretical considerations of leasing

19. 15.4 The Modigliani and Miller propositions and the theoretical considerations of leasing where C = Net initial outlay, c = Applicable corporate tax rate, Rt = Cash flows before depreciation and taxes, Dt = Depreciation expense accruing in time t, = A weighted discount rate, weighted according to the risk of the component flows, and n = The life of the project.

20. 15.4 The Modigliani and Miller propositions and the theoretical considerations of leasing (15.10) where L0 = Lease payment at day 1, Lt = Lease payment at the end of time period t, Ft = Executory costs paid by the lessor, Pj = Purchase price of asset at end of lease term, D = Depreciation expense in time period t, i = Discount rate for a riskless cash flow, k = Discount rate for a risky cash flow, and j = term of lease.

21. 15.4 The Modigliani and Miller propositions and the theoretical considerations of leasing where Mt = Payment of interest and principal on the loan during period t, and At = Amortization of the loan for tax purposes in period t.

22. 15.4 The Modigliani and Miller propositions and the theoretical considerations of leasing (15.11) (15.12) (15.13)

23. 15.4 The Modigliani and Miller propositions and the theoretical considerations of leasing (15.14) where Pt = Lease payment at time t, c = The lessor’s marginal tax rate, Bt = Depreciation expense on the asset at time t, RD = Before-tax cost of debt, (1 - c)RD = Investor’s after-tax required return on debt, and  = Lessee’s marginal tax rate.

24. 15.4 The Modigliani and Miller propositions and the theoretical considerations of leasing (15.15) (15.16) (15.16) (15.17)

25. 15.4 The Modigliani and Miller propositions and the theoretical considerations of leasing (15.18) (15.19) (15.19)

26. 15.5 Lease vs. buy decisions under uncertainty: the CAPM approach (15.20) where Lit = Lease payment at time t, Xit = Asset’s purchase price, and dit = Economic depreciation of the asset in time t.

27. 15.5 Lease vs. buy decisions under uncertainty: the CAPM approach (15.21) E(Rit) = Rf - Bit[E(Rm) - Rf] (15.22) Lit = Xit [Rf - Bit (E(Rm) - Rf) + E(dit)] (15.23)

28. 15.5 Lease vs. buy decisions under uncertainty: the CAPM approach (15.24) E(Vij) = 1 + Rf + Bj (E(Rm) - Rf). (15.25) (15.26)

29. 15.5 Lease vs. buy decisions under uncertainty: the CAPM approach (15.27) (15.28) (15.29)

30. 15.5 Lease vs. buy decisions under uncertainty: the CAPM approach (15.30) (15.31) (15.32)

31. 15.6 Options to evaluate salvage values in financial leases (15.33) (15.34)

32. 15.6 Summary In this chapter we have uncovered many of the interesting facets of leasing. The conventional rationales for leasing deal primarily with reducing the risk of making use of an asset vis-à-vis that of actually owning said asset, and with maintaining greater borrowing capacity than would otherwise be possible. The latter rationale is subject to greater question, given the recent emphasis, in the field of leasing accounting, on making these fixed obligations known to all viewers of the firm’s financial statements, rather than allowing quasi-debt instruments to be, for the most part, hidden in footnotes. There still should exist some concern, however, as to the effects that leases have on the various financial statements, for bond covenants and other restrictions may become binding if leases that could conceivably be treated in more than one way for accounting purposes are not optimally treated. The risk factor, the element of lease contracts that attracts most of the attention, raises the question of whether compensating returns must be made between the agreeing parties, while the existence of the various forms of leasing arrangements testify toward a willingness on the parts of these parties to engage in leasing activities, with the knowledge that such risk transfers exist.

33. 15.6 Summary In the area of lease valuation we found that the minimum discount rate applied to the cash flows of a leasing scheme was the risk-free rate, and not some other rate deflated by the interest-tax-break percentage so that this figure would be less than the risk-free rate. In confronting the problem of valuation under conditions of market equilibrium, whether it is the specification of Modigliani and Miller, or of the more specialized CAPM framework, we found no rationale for leasing in competitive markets. Even including the often troublesome market imperfection known as taxation, this result was seen to hold, and no abnormal returns were found to be possible through leasing, due to the competitive element of the market. Unfortunately, the types of taxation considered in these market-equilibrium models generally avoid those irregular tax considerations such as investment tax credits, the inclusion of which greatly complicates the analysis because the element of negotiation is involved. All is not lost though, as the Myers et al. formulation shows where such subsidies are taken account of in a general form. With the existence of specialized leasing companies, either as a subsidiary of a manufacturer or as a separate entity altogether, we find it difficult to accept the restrictive view that leasing offers no net benefit to selected lessor-lessee consortiums. As such, the lease-versus-buy decision does require separate analysis for each leasing opportunity, and analysts must consider each proposal (lease versus buy) separately if they believe there are differences between the net costs and/or benefits from leasing and those of legal ownership.

34. Appendix 15A. The Application of Adjusted Present Value (APV) Method to Lead versus Buy Decision (15.35) where Rt = pretax operating cash revenue gathered by the project during time period t Ct = pretax operating cash expenses due to the project during time period t dept = additional depreciation due to the project during time period t = the market rate of return on unlevered flows of the indicated risk class. r = the interest rate paid on debt = corporate tax rate

35. Appendix 15A. The Application of Adjusted Present Value (APV) Method to Lead versus Buy Decision Table 15.A.1

36. Appendix 15A. The Application of Adjusted Present Value (APV) Method to Lead versus Buy Decision Table 15.A.2

37. Appendix 15A. The Application of Adjusted Present Value (APV) Method to Lead versus Buy Decision

38. Appendix 15A. The Application of Adjusted Present Value (APV) Method to Lead versus Buy Decision Table 15.A.3.

39. Appendix 15B. LEASE ACCOUNTING UPDATES • US GAAP leasing standards were established in 1976 with the issuance of FASB 13. Recently, FASB issued FASB topic 842 in 2016, which becomes effective for public corporations in 2019 (though early adoption is permitted). Prior to this accounting update FASB Topic 840 was the accounting standard in effect. Historically, only capital leases were required to be listed on the lessee’s balance sheet. Operating lease payments only had to be disclosed in the footnotes of the financial statements. However, in 2016, FASB and IASB issued updates to GAAP and IFRS codifications that require the majority of leases to be listed as an asset along with a corresponding liability on the lessee’s balance sheet.

40. Appendix 15B. LEASE ACCOUNTING UPDATES • These and were issued in response to criticism that previous standards did not meet the needs of financial statement users because they did not always provide a faithful representation of leasing transactions. Since criticism was primarily aimed at the treatment of leases for the lessee, the treatment of lease accounting for lessors was not materially changed (though minor changes were made in order to align lessor guidance with lessee guidance).

41. Appendix 15B. LEASE ACCOUNTING UPDATES 15B.1 Key Updates & Changes to Leasing Standards Under US GAAP • Under the new standards for operating leases under GAAP, a lessee is required to recognize a right-of-use asset and lease liability measured at the present value of lease payments within the balance sheet, recognize a single lease cost allocated over the lease term on a generally straight-line basis, and classify all cash payments within operating activities in the statement of cash flows. The lessee is permitted to make an accounting policy election to not recognize lease assets or liabilities if the term of the lease is 12 months or less and does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise.

42. Appendix 15B. LEASE ACCOUNTING UPDATES Notably, GAAP still retains a distinction between operating leases and finance leases. As such, the effect of leases in the income statement and the statement of cash flows is substantially unchanged from previous GAAP standards. The amendments within FASB’s GAAP update are effective for fiscal years beginning after December 15, 2018 for public business entities and early application is permitted.

43. Appendix 15B. LEASE ACCOUNTING UPDATES 15B.2 Revised Criteria for Determination of Operating vs. Capital Lease • Under the new GAAP standards, lessees classify leases as operating leases or finance leases. Classification as an operating lease or finance lease by the lessee depends on whether the lessee meets Group I criteria. If the lease meets any of the criteria it is classified as a finance lease. If the lessee does not meet any of the criteria it is classified as an operating lease. Under GAAP, there also exists Group II criteria, however, the criteria only have bearing on the lessor’s treatment of the lease; as this appendix is focused primarily on the treatment on leases by the lessee, they will not be discussed. The Group I criteria are as follows:

44. Appendix 15B. LEASE ACCOUNTING UPDATES • The lease transfers ownership of the leased asset to the lessee at the end of the lease term • The lessee has an option to purchase the asset and is reasonably certain to exercise • The lease term is for a major part of the asset’s life; guidance is greater than or equal to 75% of the asset’s life • The sum of the present value of lease payments and the present value of residual value the lessee guarantees meets the criterion of being substantially all of the asset’s fair value; substantially all of the asset’s fair value is defined as greater than or equal to 90% of the asset’s fair value • The leased asset is of a specialized nature; such an asset would be prohibitively expensive for the lessor to repurpose for use by another user or have no alternative use to the lessor.

45. Appendix 15B. LEASE ACCOUNTING UPDATES • Notice that the only difference to the Group I criteria between the old GAAP leasing standards and the new GAAP leasing standards for the lessee is the addition of the fifth criteria, that the leased asset is of a specialized nature (making it slightly more difficult to classify a lease as an operating lease). In sum, it is classified as a capital lease if the following conditions are met: • The title transfers. • If the title does not transfer, and there is a bargain purchase option than it is classified as capital lease. • If the title doesn't transfer, there is no bargain purchase option, and the lease term is larger than 75% of the expected useful life, than it is also classified as capital lease.

46. Appendix 15B. LEASE ACCOUNTING UPDATES • If the title doesn't transfer, there is no bargain purchase option, the lease term is not larger than 75% of the expected useful life, and present value of lease payments is larger than 90% of FMV, than it is classified as capital lease. • If the title doesn't transfer, there is no bargain purchase option, the lease term is not larger than 75% of the expected useful life, present value of lease payments is smaller than 90% of FMV, and the asset is of a specialized nature, than it is classified as capital lease. • If all conditions mentioned in items 1-5 are not followed than it is classified as operating lease.

47. Appendix 15B. LEASE ACCOUNTING UPDATES • Prior to the updated U.S. GAAP standards on leases, operating leases were kept off the balance sheet. Instead, lessees were required to list the lease obligations in the footnotes to their financial statements. As a result of the updated standards and the requirements that lessees report the present value of operating leases as an asset and corresponding liability on the balance sheet, companies are likely to appear more leveraged than previously. Stated in another way, companies’ financial statements are more likely to report their actual leverage and make comparisons of firms’ leverage easier for investors.

48. Appendix 15B. LEASE ACCOUNTING UPDATES 15B.3 Updates to Leasing Standards Under IFRS • Under the new IFRS standards for leases, the lessee does not differentiate between operating leases or finance leases. Rather, under IFRS, lessees treat all leases as if they were a U.S. GAAP finance lease, whereby lessees report interest expense and amortization expenses for all leases. There does exist Group I criteria, which are the same as the U.S. GAAP Group I criteria listed previously. However, the existence of the Group I criteria has no bearing upon the lessee and are solely for use by the lessor. Like the new U.S. GAAP standards, IFRS also maintains an exemption for reporting leases on the balance sheet if they are less than a year in duration.

49. Appendix 15B. LEASE ACCOUNTING UPDATES • Additionally, under the updated IFRS standards, a lessee may elect to treat leased assets with a value of less than $5,000 as rental agreements. For example, if a lessee leased a car with value of $3,000 and a useful life of 2 years, the lessee does not have to recognize a lease asset or a lease liability. • The lease figure initially reported as the amount of lease assets and lease liabilities on the balance sheet is the present value of lease payments. The associated expense with the lease will be split on the income statement, with the portion representing amortization or principal being embedded in operating income and the balance embedded within interest expense.

50. Appendix 15B. LEASE ACCOUNTING UPDATES 15B.4 Impacts of New Leasing Standards to Financial Statements & Ratios • The new leasing standards are expected to effect the statements and ratios. The most important impact from the new standards, under both IFRS and GAAP, will be the requirement to recognize a right-to-use asset along with a corresponding liability on the balance sheet. This will serve to increase reported leverage for most companies, as recognizing an asset and liability from leases will cause leverage metrics such as the debt-to-assets ratio to increase. As an illustration of the degree of the impact from the change in the treatment of operating leases under GAAP, we can analyze the impact on reported leverage ratios by capitalizing JCPenney’s operating leases.