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CHAPTER 22: Leasing

CHAPTER 22: Leasing. Topics: 22.1 Types of Leases 22.2 Accounting and leasing 22.4 The Cash Flows of Operating Leasing 22.6 NPV Analysis of the Lease-versus-Buy Decision 22.8 Does Leasing Ever Pay: The Base Case 22.9 Reasons for Leasing

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CHAPTER 22: Leasing

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  1. CHAPTER 22: Leasing Topics: • 22.1 Types of Leases • 22.2 Accounting and leasing • 22.4 The Cash Flows of Operating Leasing • 22.6 NPV Analysis of the Lease-versus-Buy Decision • 22.8 Does Leasing Ever Pay: The Base Case • 22.9 Reasons for Leasing (This illustration contains a minor correction of your text. Section 22.4 should be operating lease rather than financial lease.)

  2. 22.1 Types of Leases • 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. • Two types: • Operating lease • Financial lease • Sale and lease-back • Leverage lease

  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. 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 usually enjoys a cancellation option. This option gives the lessee the right to cancel the lease contract before the expiration date.

  5. Financial Leases • Most commonly referred to as “Capital lease” • The opposite of an operating lease. • Do not provide for maintenance or service by the lessor. • Generally 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.

  6. Sale and Lease-Back (Read by your own) • 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. • Example: Sell you IT assets to HP Financial Services and lease them back. • You can easily adapt to future needs down the road.

  7. 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.

  8. Leveraged Leases Lessor buys asset, Firm U leases it. Manufacturer of asset Lessor Lessee (Firm U) • Owns asset • Uses asset 2. Does not use asset 2. Does not own asset Equity shareholders Creditors

  9. 22.2 Accounting: Financial (Capital) Lease • The accounting treatment of leasing follows CICA 3065 • A lease must be capitalized (balance sheet disclosure) if any one of the following four criteria is met (CICA or GAAP): • 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. • Both CRA and IRS will treat a capitalized lease as sales for tax purposes. • Lessor records leasing as installment sales; • Lessee records leasing on balance sheet and take depreciation on assets. • Please refer to the attached CRA or IRS regulations for further illustration.

  10. 22.4 The Cash Flows of (Operating) Leasing • Capital leasing is (generally) no different from sales. • Same budgeting process as sales • Lessor: asset sale • Lessee: asset on balance sheet, dep. tax shield • Operating leasing • Lessor: asset on balance-sheet • takes depreciation and enjoys tax-deduction of depreciation • Lessee: Off-balance-sheet • lease payment tax-deductible

  11. Incremental cashflow approach to lease: An example Zee Movers needs to acquire 50 more cars. Each car will generate $12,000 per year in added sales for the next five years. The firm has a corporate tax rate of 40%. The car would qualify for a CCA (cost of capital allowance) rate of 40% (rental car). There is no residual value of the car after five years. Assume that this is an operating lease. Two options: (1) Each car can be purchased at a wholesale price of 20,000. (2) Each car can be leased through an operating leasing with Tiger Leasing at a payment of $5,000 each year for five years (payable at the beginning of each year). Suppose that all the conditions for operating lease are met. Buy or lease?

  12. Example cont’d: Tax shield on CCA for car

  13. Cont’d: Incremental cashflows of leasing compared with buying • If the cars are leased, then: • Lease payment of 5,000 each year. Tax-deductible expenses. • Lease payment shield = lease payment * tax rate • If buy, then: • Ownership—Depreciate for tax purposes. • Cash outlay of 20,000 at time 0. • Tax deduction due to residual value loss. Note: The added sales of 12,000 each car apply to both leasing and buying, so the incremental cashflow of added sales for leasing is zero. • Timing of cashflow: (a bit different from the text) • Lease rental payment happens in advance • Depreciation happens in arrears

  14. Cont’d: Incremental Cashflows: Lease minus buy Note: (3) = (1) – (2)

  15. Cont’d: Incremental cashflows—Textbook method • Same cashflow, but view things from the aggregate of (lease-buy): • Lease: Lease payment (outflow) + lease payment tax shield (inflow) • Effects of “Minus Buy”: Save on initial purchase price (inflow), but bypass depreciation tax shields (outflow).

  16. 22.6 NPV Analysis of the Lease-vs.-Buy Decision • Lease payment is like interest payment!—Cashflows are deterministic once the lease contract is entered into. • A lease payment is like the debt service on a secured bond issued by the lessee. A lessee incurs a liability equal to the present value of all future lease payments. (Lease displaces debt—“Debt displacement”) • In practice, many companies discount both the depreciation tax shields and the lease payments at the after-tax interest rate on secured debt issued by the lessee.

  17. Example cont’d: NPV of leasing Assume that Zee can either borrow or lend at 11% interest rate. What is the NPV of the lease? AT discount rate = NPV = 17,000– 4,600/1.066 – 5,560 /1.0662 – 4,536 /1.0663 -3,922/1.0664-1382/1.0665 = 6.21 • Lease or buy?

  18. What if there is economic residual value left? • To make it compatible with laws, the lease needs to be an operating lease. One way is to specify sufficiently high residual value. Let’s suppose 5 years later, the cars are returned to Tiger Leasing with a residual guarantee value of 15%, which is also the residual economic value. Everything else remains the same. What’s your answer now? • CF to lease won’t change. • Changes in CF to buy: • If you buy, 5 years later you dispose of (sell) the asset for 15% of purchase price. • You realize some proceeds; • You pay (deduct) taxes if there is capital gains (loss) in asset disposal. (Depreciation Recapture when terminating the pool.)

  19. Cont’d: Add residual guarantee to valuation Notes: (1) Residual guarantee = (2) AT Residual cashflow =

  20. Cont’d: Solution Please refer to the spreadsheet in the course webpage.

  21. 22.8 Does Leasing Ever Pay: The Base Case • Cashflow to Tiger Leasing (the lessor) is just the opposite of that to Zee Movers (the lessee) in the leasing: • Lease minus sell (for the case of no residual value) NPV: Same tax rate and same discount rate: -6.21!

  22. A zero-sum game for lessee and lessor if • Both are at the same corporate tax bracket • Both borrow and lend at the same rate • No transaction costs  No leasing would ever occur!

  23. 22.9 Reasons for Leasing • Taxes may be reduced by leasing in operating leasing. • The principal benefit of long-term leasing is tax reduction. • Leasing allows the transfer of tax benefits from those (lessee) who need equipment but cannot take full advantage of the tax benefits of ownership to a party (lessor) who can. • The lease contract may reduce certain types of uncertainty (the residual value risk at the end of the contract is borne by the lessor, and it may be in a better position to bear this risk) • Transactions costs can be higher for buying an asset and financing it with debt or equity than for leasing the asset.

  24. An Illustration of Benefit of Tax Reduction: Tax Arbitrage Back to the example where there’s no economic residual. Suppose Zee (the LESSEE) is still in the 40% tax bracket, but Tiger Leasing (the LESSOR) is in the 30% tax bracket instead. Can leasing happen in this case? (i.e., Can both firms have a positive NPV?) • What’s changed? • For Lessee, nothing is changed: same tax rate, same interest rate, same payment Same incremental cashflow inLease vs. buy decision. + NPV. • For Lessor’s Lease vs. sell decision, after-tax cashflow is now changed • AT lease income • Depreciation and residual tax shield • AT discount rate as well!

  25. Tax arb. cont’d: Lease vs. sell (no residual guarantee) Notes: 1. Depreciation tax shield and lease payment is now calculated at tax rate of 30%. 2. Discount rate for NPV is:

  26. Tax arb. cont’d: Reservations and Negotiations • What is the smallest lease payment that Lessor (Tiger Leasing) will accept? Set their NPV to zero (break-even) and solve for the payment. • What is the highest lease payment that Lessee (Zee Movers) can pay? Set their NPV to zero (break-even) and solve for the payment. • As long as the highest payment from the lessee is larger than the smallest payment for the lessor, it is feasible to lease. • Feasible lease payment: [lessor’s smallest lease payment, lessee’s largest lease payment]

  27. Derivation of reservation payment: Lessee Three components: • PV of Depreciation (and residual loss) Tax Shield • PV of AT lease payment—Annuity (in advance) • Equipment cost at time 0 Set 3 – 2 – 1 = 0. (Answer: $5002) For Zee Movers:

  28. Cont’d

  29. Derivation of reservation payment: Lessor Three components: • PV of Depreciation (and, if any, residual loss) Tax Shield • PV of AT lease payment—Annuity (in advance) • Equipment proceeds at time 0 Set 1+2 -3 = 0. • Repeat the same exercise for Tiger Leasing. • Note that tax rate, and hence AT discount rate, are different. • Answer: $4970. • Lease will happen with a lease payment in [4970, 5002].

  30. Review Questions • How would you evaluate a capital lease through incremental cashflow approach? Give the incremental cashflow from the perspective of lease vs. buy. • Assigned problems: #22. 1, 2-6, 8, 11 (Assume operating leasing for incremental cashflow analysis.)

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