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Chapter 26 - Leasing

Chapter 26 - Leasing. What is a Lease? Why Lease? Operating versus Financial Leases Valuing Leases When Do Leases Pay?. The Basics A lease is a contractual agreement between a lessee and lessor.

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Chapter 26 - Leasing

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  1. Chapter 26 - Leasing • What is a Lease? • Why Lease? • Operating versus Financial Leases • Valuing Leases • When Do Leases Pay?

  2. The Basics • A lease is a contractual agreement between a lessee and lessor. • The agreement establishes that the lessee has the right to use an asset and in return must make periodic payments to the lessor. • The lessor is either the asset’s manufacturer or an independent leasing company.

  3. Manufacturer of asset Manufacturer of asset Firm U Lessor Lessee (Firm U) • Uses asset • Owns asset • Uses asset • Owns asset 2. Does not use asset 2. Does not own asset Equity shareholders Equity shareholders Creditors Creditors Buying versus Leasing Buy Lease Firm U buys asset and uses asset; financed by debt and equity. Lessor buys asset, Firm U leases it.

  4. Reasons for Leasing • Good Reasons • Taxes may be reduced by leasing. • The lease contract may reduce certain types of uncertainty. • Transactions costs can be higher for buying an asset and financing it with debt or equity than for leasing the asset. • Bad Reasons • Leasing and accounting income • 100% financing

  5. Operating Leases • Usually not fully amortized. This means that the payments required under the terms of the lease are not enough to recover the full cost of the asset for the lessor. • Usually require the lessor to maintain and insure the asset. • Lessee enjoys a cancellation option. This option gives the lessee the right to cancel the lease contract before the expiration date.

  6. Financial (Capital) Leases The exact opposite of an operating lease. • Do not provide for maintenance or service by the lessor. • Financial leases are fully amortized. • The lessee usually has a right to renew the lease at expiry. • Generally, financial leases cannot be cancelled, i.e., the lessee must make all payments or face the risk of bankruptcy.

  7. Sale and Lease-Back • A particular type of financial lease. • Occurs when a company sells an asset it already owns to another firm and immediately leases it from them. • Two sets of cash flows occur: • The lessee receives cash today from the sale. • The lessee agrees to make periodic lease payments, thereby retaining the use of the asset.

  8. Leveraged Leases • A leveraged lease is another type of financial lease. • A three-sided arrangement between the lessee, the lessor, and lenders. • The lessor owns the asset and for a fee allows the lessee to use the asset. • The lessor borrows to partially finance the asset. • The lenders typically use a nonrecourse loan. This means that the lessor is not obligated to the lender in case of a default by the lessee.

  9. Leveraged Leases Lessor buys asset, Firm U leases it. Manufacturer of asset Lessor borrows from lender to partially finance purchase The lenders typically use a nonrecourse loan. This means that the lessor is not obligated to the lender in case of a default by the lessee Lessor Lessee (Firm U) • Owns asset • Uses asset 2. Does not use asset 2. Does not own asset In the event of a default by the lessor, the lender has a first lien on the asset. Also the lease payments are made directly to the lender after a default. Equity shareholders Creditors

  10. Accounting and Leasing • In the old days, leases led to off-balance-sheet financing. • In 1979, the Canadian Institute of Chartered Accountants implemented new rules for lease accounting according to which financial leases must be “capitalized.” • Capital leases appear on the balance sheet—the present value of the lease payments appears on both sides.

  11. Accounting and Leasing Balance Sheet Truck is purchased with debt Truck $100,000 Debt $100,000 Land $100,000 Equity $100,000 Total Assets $200,000 Total Debt & Equity $200,000 Operating Lease Truck Debt Land $100,000 Equity $100,000 Total Assets $100,000 Total Debt & Equity $100,000 Capital Lease Assets leased $100,000 Obligations under capital lease $100,000 Land $100,000 Equity $100,000 Total Assets $200,000 Total Debt & Equity $200,000

  12. Financial (Capital) Lease A lease must be capitalized if any one of the following is met: • The present value of the lease payments is at least 90-percent of the fair market value of the asset at the start of the lease. • The lease transfers ownership of the property to the lessee by the end of the term of the lease. • The lease term is 75-percent or more of the estimated economic life of the asset. • The lessee can buy the asset at a bargain price at expiry.

  13. Taxes and Leases • The principal benefit of long-term leasing is tax reduction. • Leasing allows the transfer of tax benefits from those who need equipment but cannot take full advantage of the tax benefits of ownership to a party who can. • If the CRA (Canada Revenue Agency) detects one or more of the following, the lease will be disallowed. • The lessee automatically acquires title to the property after payment of a specified amount in the form of rentals. • The lessee is required to buy the property from the lessor. • The lessee has the right during the lease to acquire the property at a price less than fair market value.

  14. Operating Lease Example : Acme Limo has a client who will sign a lease for 7 years, with lease payments due at the start of each year. The following table shows the NPV of the limo if Acme purchases the new limo for $75,000 and leases it for 7 years.

  15. Financial Leases Example : Greymare Bus Lines is considering a lease. Your operating manager wants to buy a new bus for $100,000. The bus has an 8 year life. The Bus Saleswoman says she will lease Greymare the bus for 8 years at $16,900 per year, but Greymare assumes all operating and maintenance costs. Should Greymare Buy or Lease the bus? Cash flow consequences of the lease contract to Greymare

  16. Financial Leases Example - cont Greymare Bus Lines can borrow at 10%, thus the value of the lease should be discounted at 6.5% or .10 x (1-.35). The result will tell us if Greymare should lease or buy the bus.

  17. Financial Leases Example – A loan with same cash flows as lease

  18. Financial Leases Example - cont The Greymare Bus Lines lease cash flows can also be treated as a favorable financing alternative and valued using APV.

  19. Financial Lease Benefits Value of lease to lessor = Value of lease =

  20. Example • Consider a firm, ClumZee Movers, that wishes to acquire a delivery truck. • The truck is expected to reduce costs by $4,500 per year. • The truck costs $25,000 and has a useful life of five years. • If the firm buys the truck, they will depreciate it straight-line to zero. • They can lease it for five years from Tiger Leasing with an annual lease payment of $6,250 paid at the end of the year. • The firm’s borrowing rate is 7.70% and its marginal tax rate is 34%.

  21. Example Q1: continue Suppose ClumZee movers is actually in the 25% tax bracket and Tiger Leasing is in the 35% tax bracket and a before tax borrowing rate of 7%. If Tiger reduces the lease payment to $6,200, can both firms have a positive NPV?

  22. Summary • There are three ways to value a lease. • Use the real-world convention of discounting the incremental after-tax cash flows at the lessor’s after-tax rate on secured debt. • Calculate the increase in debt capacity by discounting the difference between the cash flows of the purchase and the cash flows of the lease by the after-tax interest rate. The increase in debt capacity from a purchase is compared to the extra outflow at year 0 from a purchase. • Use APV (APV = All-Equity Value + Financing NPV) • They all yield the same answer.

  23. Practice Question 1 Calculate NPV for lessee and lessor • Cost of machine = $85,000 • CCA rate = 30% • Operating costs = $ 10,000 per year maintenance expense • Lease payments = $53,600 per year • Lessor provides maintenance as a part of the lease contract. • Cost of debt (rD) = 15% • After-tax cost of debt, rD(1 ‑TC) = 9% • TC = 40% (for both the lessee and the lessor)

  24. Practice Question 2 • A noncancellable lease contract lasts for 4 years with payments of $37,000 at the end of each year. The lessee pays maintenance expense under either the lease or buy alternatives. If purchased, the $100,000 asset has a CCA rate of 30%. The before‑tax cost of debt is 10% and the corporate tax rate is 40%. What is the value of the lease to the lessee? • If the lease in problem were cancelable, how much must the cancellation option be worth to make the lease alternative better than the purchase alternative?

  25. Chapter 26 - Hedging • Why Manage Risk? • Insurance • Forward and Futures Contracts • SWAPS • How to Set Up A Hedge

  26. Risk Reduction Why risk reduction does not add value 1. Hedging is a zero sum game 2. Investors’ do-it-yourself alternative ?

  27. Risk Reduction Risks to a business • Cash shortfalls • Financial distress • Agency costs

  28. Insurance • Most businesses face the possibility of a hazard that can bankrupt the company in an instant. • Insurance companies have some advantages in bearing risk. • The cost and risk of a loss due to a hazard, however, can be shared by others who share the same risk.

  29. Insurance Example An offshore oil platform is valued at $1 billion. Expert meteorologist reports indicate that a 1 in 10,000 chance exists that the platform may be destroyed by a storm over the course of the next year. How can the cost of this hazard be shared?

  30. Insurance What do you expect the premium of an insurance contract on this oil platform to be? Think of the following: • Administrative costs • Adverse selection • Moral hazard

  31. Insurance – Catastrophe Risk • The loss of an oil platform by a storm may be 1 in 10,000. The risk, however, is larger for an insurance company since all the platforms in the same area may be insured, thus if a storm damages one it may damage all in the same area. The result is a much larger risk to the insurer • Catastrophe Bonds - (CAT Bonds) Allow insurers to transfer their risk to bond holders by selling bonds whose cash flow payments depend on the level of insurable losses NOT occurring.

  32. Insurance – What to Insure Two Possibilities: • Most Common - buy insurance only for large potential losses. • BP case – buy insurance for small risks only.

  33. Hedging with Forwards and Futures Business has risk Business Risk - variable costs Financial Risk - Interest rate changes Goal - Eliminate risk HOW? Hedging & Forward Contracts

  34. Hedging with Forwards and Futures Ex - Kellogg produces cereal. A major component and cost factor is sugar. • Forecasted income & sales volume is set by using a fixed selling price. • Changes in cost can impact these forecasts. • To fix your sugar costs, you would ideally like to purchase all your sugar today, since you like today’s price, and made your forecasts based on it. But, you can not. • You can, however, sign a contract to purchase sugar at various points in the future for a price negotiated today. • This contract is called a “Futures Contract.” • This technique of managing your sugar costs is called “Hedging.”

  35. Hedging with Forwards and Futures 1- Spot Contract - A contract for immediate sale & delivery of an asset. 2- Forward Contract - A contract between two people for the delivery of an asset at a negotiated price on a set date in the future. 3- Futures Contract - A contract similar to a forward contract, except there is an intermediary that creates a standardized contract. Thus, the two parties do not have to negotiate the terms of the contract. The intermediary is the Commodity Clearing Corp (CCC). The CCC guarantees all trades & “provides” a secondary market for the speculation of Futures.

  36. Types of Futures Commodity Futures -Sugar -Corn -OJ -Wheat -Soy beans -Pork bellies Financial Futures -Tbills -Yen -GNMA -Stocks -Eurodollars Index Futures -S&P 500 -Value Line Index -Vanguard Index

  37. Futures Contract Concepts • Not an actual sale • Always a winner & a loser (unlike stocks) • “Settled” every day. (Marked to Market) • Hedge - used to eliminate risk by locking in prices • Speculation - used to gamble • Margin - not a sale - post partial amount

  38. Futures and Spot Contracts The basic relationship between futures prices and spot prices for equity securities.

  39. Futures and Spot Contracts Example The DAX spot price is 3,970.22. The interest rate is 3.5% and the dividend yield on the DAX index is 2.0%. What is the expected price of the 6 month DAX futures contract?

  40. Futures and Spot Contracts The basic relationship between futures prices and spot prices for commodities.

  41. Futures and Spot Contracts Example In July the spot price for coffee was $.7310 per pound. The interest rate was 1.5% per (1.3% per 10 months). The 10 month futures price was $0.8285? What is the net convenience yield?

  42. Homemade Forward Rate Contracts Suppose you know that you will receive $100m in one year. You are worried that interest rates might go down? You can enter a FRA (forward rate agreement) with a bank.

  43. Swaps Friendly Bancorp invested $50 M in debt carrying 8% fixed interest rate and maturing in 5 years. Annual payments are $4m. However, friendly Bancorp is predicting increases in interest rates, so it wants a floating rate. Here is what it can do.

  44. SWAPS Birth 1981 Definition - An agreement between two firms, in which each firm agrees to exchange the “interest rate characteristics” of two different financial instruments of identical principal

  45. How to Set a Hedge? • In practice, the commodity that a firm sells is likely not identical to the one traded on the exchange. • Delta measures the sensitivity of A to changes in the value of B. • Duration is also used in setting hedge. (if two assets have the exact duration, they will be equally affected by change in interest rates).

  46. Ex - Settlement & Speculate Example - You are speculating in Hog Futures. You think that the Spot Price of hogs will rise in the future. Thus, you go Long on 10 Hog Futures (1K is of $30,000 pound). If the price drops .17 cents per pound ($.0017) what is total change in your position?

  47. Commodity Hedge In June, farmer John Smith expects to harvest 10,000 bushels of corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price (hedge). Show the transactions if the Sept spot price drops to $2.80. Show the transactions if the Sept spot price rises to $3.05.

  48. Commodity Speculation You have lived in NYC your whole life and are independently wealthy. You think you know everything there is to know about pork bellies (uncured bacon) because your butler fixes it for you every morning. Because you have decided to go on a diet, you think the price will drop over the next few months. On the CME, each PB K is 38,000 lbs. Today, you decide to short three May Ks @ 44.00 cents per lbs. In Feb, the price rises to 48.5 cents and you decide to close your position. What is your gain/loss? If In Feb the price drops to 40.0 cents, what is your gain/loss?

  49. Margin • The amount (percentage) of a Futures Contract Value that must be on deposit with a broker. • Since a Futures Contract is not an actual sale, you need only pay a fraction of the asset value to open a position = margin. • CME margin requirements are 15% • Thus, you can control $100,000 of assets with only $15,000.

  50. Chapter 32 - Mergers • Sensible Motives for Mergers • Some Dubious Reasons for Mergers • Estimating Merger Gains and Costs • The Mechanics of a Merger • Takeover Battles and Tactics • Mergers and the Economy

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