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Understanding Leasing: Benefits and Financial Implications in Corporate Finance

This chapter from "Principles of Corporate Finance" by Brealey and Myers delves into leasing as a strategic financial option. It covers key concepts such as the definitions of operating and financial leases, valuation methods, and the practical reasons to lease, including convenience, tax benefits, and cost-effectiveness. Through real-world examples, such as Acme Limo and Greymore Bus Lines, the material illustrates the cash flow consequences and comparisons between leasing and buying assets. This comprehensive overview aids in making informed leasing decisions in corporate finance.

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Understanding Leasing: Benefits and Financial Implications in Corporate Finance

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  1. Principles of Corporate Finance Brealey and Myers Sixth Edition • Leasing Slides by Matthew Will Chapter 25 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

  2. Topics Covered • What is a Lease? • Why Lease? • Operating Leases • Valuing Financial Leases • When Do Financial Leases Pay?

  3. Lease Terms • Operating Leases • Financial Leases • Rental Lease • Net lease • Direct lease • Leveraged lease

  4. Why Lease? • Sensible Reasons for Leasing • Short-term leases are convenient • Cancellation options are valuable • Maintenance is provided • Standardization leads to low costs • Tax shields can be used • Avoiding the alternative minimum tax

  5. Why Lease? • Dubious Reasons for Leasing • Leasing avoids capital expenditure controls • Leasing preserves capital • Leases may be off balance sheet financing • Leasing effects book income

  6. 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 our for 7 years.

  7. Operating Lease Example - cont 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 our for 7 years.

  8. Financial Leases Example Greymore 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 Greymore the bus for 8 years at $16,900 per year, but Greymore assumes all operating and maintenance costs. Should Greymore buy or lease the bus?

  9. Financial Leases Example - cont Greymore 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 Greymore the bus for 8 years at $16,900 per year, but Greymore assumes all operating and maintenance costs. Should Greymore buy or lease the bus? Cash flow consequences of the lease contract to Greymore

  10. Financial Leases Example - cont Greymore 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 Greymore the bus for 8 years at $16,900 per year, but Greymore assumes all operating and maintenance costs. Should Greymore buy or lease the bus? • Cash flow consequences of the lease contract to Greymore: • Greymore saves the $100,000 cost of the bus. • Loss of depreciation benefit of owning the bus. • $16,900 lease payment is due at the start of each year. • Lease payments are tax deductible.

  11. Financial Leases Example - cont Greymore Bus Lines Balance Sheet without lease Equivalent lease balance sheet

  12. Financial Leases Example - cont Greymore 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 Greymore should lease or buy the bus.

  13. Financial Leases Example - cont Greymore 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 Greymore should lease or buy the bus.

  14. Financial Leases Example - cont Greymore Bus Lines lease cash flows can also be thought of as loan equivalent cash flows.

  15. Financial Leases Example - cont Greymore Bus Lines lease cash flows can also be thought of as loan equivalent cash flows.

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

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