Lease Terminology • Lease – contractual agreement for use of an asset in return for a series of payments • Lessee – user of an asset; makes payments • Lessor – owner of the asset; receives payments • Direct lease – lessor is the manufacturer • Captive finance company – subsidiaries that lease products for the manufacturer
Types of Leases • Operating lease • Shorter-term lease • Lessor is responsible for insurance, taxes and maintenance • Often cancelable • Financial lease (capital lease) • Longer-term lease • Lessee is responsible for insurance, taxes and maintenance • Generally not cancelable • Specific capital leases • Tax-oriented • Sale and leaseback
Lease Accounting • Leases are governed primarily by FASB 13 • Financial leases are essentially treated as debt financing • Present value of lease payments must be included on the balance sheet as a liability • Same amount shown on the asset as the “capitalized value of leased assets” • Operating leases are still “off-balance-sheet” and do not have any impact on the balance sheet itself
Criteria for a Capital Lease • If one of the following criteria is met, then the lease is considered a capital lease and must be shown on the balance sheet • Lease transfers ownership by the end of the lease term • Lessee can purchase asset at below market price • Lease term is for 75 percent or more of the life of the asset • Present value of lease payments is at least 90 percent of the fair market value at the start of the lease
Taxes • Lessee can deduct lease payments for income tax purposes • Must be used for business purposes and not to avoid taxes • Term of lease is less than 80 percent of the economic life of the asset • Should not include an option to acquire the asset at the end of the lease at a below market price • Lease payments should not start high and then drop dramatically • Must survive a profits test – lessor should earn a fair return • Renewal options must be reasonable and consider fair market value at the time of the renewal
Incremental Cash Flows • Cash Flows from the Lessee’s point of view • After-tax lease payment (outflow) • Lease payment*(1 – tC) • Lost depreciation tax shield (outflow) • Depreciation * tax rate for each year • Initial cost of machine (inflow) • Inflow because we save the cost of purchasing the asset now • May have incremental maintenance, taxes, insurance, or salvage value
Example: Lease Cash Flows • ABC, Inc. needs some new equipment. The equipment would cost $100,000 if purchased and would be depreciated straight-line over 5 years. No salvage is expected. Alternatively, the company can lease the equipment for $26,300 per year. The marginal tax rate is 40%. • What are the incremental cash flows? • After-tax lease payment = 26,300(1 - .4) = 15,780 (outflow years 1 - 5) • Lost depreciation tax shield = (100,000/5)*.4 = 8,000 (outflow years 1 – 5) • Cost of machine = 100,000 (inflow year 0)
Lease or Buy? • The company needs to determine whether it is better off borrowing the money and buying the asset or leasing • Compute the NPV of the incremental cash flows • Appropriate discount rate is the after-tax cost of debt since a lease is essentially the same risk as a company’s debt
Net Advantage to Leasing • The net advantage to leasing (NAL) is the same thing as the NPV of the incremental cash flows • If NAL > 0, the firm should lease • If NAL < 0, the firm should buy • Consider the previous example. Assume the firm’s cost of debt is 10%. • After-tax cost of debt = 10(1 - .4) = 6%
NAL = $100,000 - $15,780(PVIFA6%,5) • - $8,000(PVIFA6%,5) • NAL = -$170.01 • Do not lease the machine • What is NAL to lessor?
Differential taxes • Lessee pays no tax • Return = 10% • NAL = $100,000 - $26,300(PVIFA10%,5) • NAL = $302.31 • Lease the machine
Maximum Lease Payment • NAL = $0
Good Reasons for Leasing • Taxes may be reduced • May reduce some uncertainty • May have lower transaction costs • May require fewer restrictive covenants • May encumber fewer assets than secured borrowing
Dubious Reasons for Leasing • Balance sheet, especially leverage ratios, may look better if the lease does not have to be accounted for on the balance sheet • 100% financing – except that leases normally do require either a down-payment or security deposit • Low cost – some may try to compare the “implied” rate of interest to other market rates, but this is not directly comparable
