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CHAPTER 19

Lease Financing

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Parties to a lease transaction

Lessee: uses the asset and makes the lease payments.

Lessor: owns the asset and receives the payments.

The lease decision is a financing decision for the lessee and an investment decision for the lessor.

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Types of leases Operating lease

Short-term and normally cancellable Maintenance usually included

Capital (financial) lease Long-term and normally noncancellable Maintenance usually not included Fully amortized

Combination lease Sale and leaseback

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Tax treatment of lease payments Leases are classified by the IRS as

either guideline or nonguideline. For a guideline lease, the entire

lease payment is deductible to the lessee.

For a nonguideline lease, only the imputed interest payment is deductible.

Lease vs. buy analysis

In evaluating a lease from the lessee’s perspective, typically the decision to acquire the asset has been made: the asset has NPV > 0 if purchased. Now, we determine if leasing is cheaper than buying.

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Relevant cash flows

In determining the after-tax cash flows (ATCFs) associated with each alternative, common CFs (including sales revenue) are disregarded.

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Lease impact on firm’s capital structure

Leasing is a substitute for debt: a dollar of lease obligations is equivalent to a dollar of debt obligations.

As such, leasing uses up a firm’s debt capacity.

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Lessee’s discount rate Leasing is similar to debt financing. If a firm has a 40% tax rate and could

finance purchase of the asset with a 10% loan, the discount rate for evaluating the lease is the after-tax interest rate:

10%(1 - T) = 10%(1 - 0.4) = 6.0%.

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Lessor’s analysis

To the lessor, writing the lease is an investment.

Therefore, the lessor must compare the return on the lease investment with the return available on alternative investments of similar risk.

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Analysis indicates owning is often less costly than leasing. Why, then, is leasing so popular?

Provision of maintenance services. Risk reduction for the lessee.

Project life Residual value Operating risk

The lessor might be better able to bear these risks.