class 8 leasing

Professor Jawad M. Addoum FIN303: Spring 2013

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School of Business AdministrationUniversity of Miami

Leasing

Corporate Financial Management

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Assigned Readings & Problems

� Reading: EFS Chapter 21, Section 21.1-21.3

� Homework: EFS Chapter 21› Questions/Challenging Questions: 1, 2, 3, 4, 5, 7, 11 (4th

ed)

› Problems: A4 (when text says residual value it means both sales price & terminal book value), A7, B10, B11a, B12, B15 (4th ed)


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Objectives

� In this lecture you will learn:› What a lease is in general

› What the three types of financial leases are

› What the principle reasons are that firms choose to lease rather than buy

› How to calculate the Net Advantage of Leasing (NAL) as compared to buying

› How the possibility of leasing affects the capital budgeting analysis

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Overview� A lease is a contractual agreement between a lessee and

lessor› A contract between two parties: the lessee (the user) and the

lessor (the owner)› The lessee first decides on the asset needed and then negotiates

a lease contract with the lessor› The lessee has the right to use the asset and in return she must

make periodic payments to the lessor

� The principal lessors are Equipment Manufacturers (GMAC), Commercial Banks, Finance Companies, and Leasing Companies

� From the lessee’s standpoint, long-term leasing is similar to buying the equipment with a secured loan› The terms of the lease are comparable to what a banker might

arrange with a secured loan


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� 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 associated with ownership—to a party who can

If corporate taxes were ever repealed, long-term leasing would likely disappear!

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Types of Leases (Leasing Industry)

� Operating Leases› The term of the operating lease is usually significantly less

than the economic life of the asset

› Usually require the lessor to maintain and insure the leased asset (a full-service lease)

› Lessee has the option to cancel the lease prior to contract expiration

In the past, the lessee received an “operator” along with the equipment

Not necessarily the same as operating leases in

accounting!


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� Financial Leases› In general, the lessee may not cancel the lease. She must

make all payments or face the risk of bankruptcy

› The lessee is responsible for maintenance or service (a net lease)

› Lessee has the right to renew the lease on expiration

› Really an alternative method of financing a purchase!

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Types of Financial Leases� In a Direct Lease, the asset is typically new and the lessor is

either an independent lessor or the equipment manufacturer

› If the lessor is an independent leasing company, it must buy the asset from it’s manufacturer

Manufacturer

Lessor Lessee

Buys Equipment

Leases Equipment

Direct Lease with a Leasing Company


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� Sale and Lease-Back of Property› A firm sells an asset it owns to a leasing company and

immediately leases it back› Lessee receives cash› Lessee continues to use the equipment but now makes

payments to a lessor

� Leveraged Lease› Lessor puts up no more than 40-50% of the purchase price› The bulk of the remaining finance comes from creditors who

receive interest payments from the lessor› Lenders typically have no recourse (to the lessor) in the case of

default by the lesseex Lenders do however have a perfected first lien on the assetx In default, the lenders are entitled to seize the asset and any

subsequent lease payments are made directly to the lenders

› Note, the lessor receives all the tax benefits (depreciation) from ownership, not the lenders

10Shareholders Creditors

Provide Capital

Lessor


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The Lease vs. Buy Decision� How should a firm decide whether to lease or buy an asset?

We call this the Net Advantage of Leasing (NAL) to the Lessee?

Calculation Method (Simplified)

› Project the incremental after-tax cash flows with leasing

› Project the incremental after-tax cash flows with buying using secured debt

› Calculate the difference between the lease and buy cash flows

› Discount this difference at the firms after-tax cost of secured debt to calculate the Net Advantage of Leasing (NAL)

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� Example 1: GenTech is a firm that develops vaccines for newly discovered diseases such as SARS. It relies heavily on state-of the-art gene-splicing equipment and is considering whether to lease or buy a new instrument that it needs. The instrument costs $100,000 but will save the firm an additional $60,000 per year through the reduction in outside lab costs. The machine may be depreciated over five years on a straight-line schedule for tax purposes. Alternatively, the instrument may be leased at $24,750 per year for five years. GenTech’s marginal tax rate is 34% and its cost of secured debt pre-tax is 7.57575%. Should GenTech lease or buy the instrument?

x After-tax operating cost savings: (60,000)(1-0.34)=39,600x Depreciation: 100,000/5=20,000x Depreciation tax benefit (with purchase): 20,000(0.34)=6,800x After-tax cost of lease: 24,750(1-0.34)=16,335x After-tax cost of secured debt: 7.57575%(1-0.34)=5%


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13Note: the Operating Cost Savings ($39,600 after tax) cancel out

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Implication: Buy don’t lease!


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Discount Rate & Risk� Lease Payments

› The riskiness of lease payments is nearly identical to that a bank would assume if made a secured loan to the firm and the firm bought the equipment

› The banker’s loan is collateralized by the equipment vs. the lessor owns the equipment

› The term of the bank loan should match the term of the lease

The appropriate level of risk for lease payments is therefore captured by the firm’s cost of borrowing

� Operating Cost Savings› The operating cost savings (or revenue increases) are identical whether

the equipment be leased or purchased

These cash flows “net out” in the NAL calculation

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� Depreciation› The only other cash flow that must be discounted (for now) is the

depreciation tax benefits: common practice is to assume that these cash flows are as risky as the lease payments

Therefore, the risk in the Net Advantage of Leasing calculation is captured in the cost of borrowing (after-tax)!


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Debt Service Parity� Essentially, when we calculate an NAL we compare the

purchase price to the Equivalent Loan implied by the lease payments (after tax) and the lost depreciation tax shields

If the Equivalent Loan is less than the purchase price of the asset, leasing makes economic sense! (and the NAL>0)

� In general, this approach of calculating an equivalent loan is called Debt Service Parity and has many, many applications:› Leasing

› Callable bond refunding

› Assuming vs. calling target debt in an acquisition

� See Appendix III for more discussion including why the discount rate is taken after tax

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Symmetric Taxes

� Every transaction has two sides. In Example 1, we saw that the firm preferred to buy rather than lease. What was the lessor’s valuation of the lease?

� EXAMPLE 1 (Lessor): Assuming that lessor and lessee tax rates are both 34%, the lessor cash flows are:› After-tax lease payments: (24,750)(1-0.34)=16,335

› Depreciation: 100,000/5=20,000

› Depreciation tax benefit: 20,000(0.34)=6,800

› After-tax cost of secured debt: 7.57575%(1-0.34)=5%

Technical Note: For manufacturer lessors, depreciation would be based on manufacturing costs

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The Lessor cash flows are identical in magnitude but opposite in sign!

NOTE: the benefit to the LESSOR is called the NPVL (Net Present Value o f Leasing)


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� The NPV of the leasing deal for the Lessor (NPVL) is the negative of the Net Advantage of Leasing (NAL) for the Lessee!

� Here, leasing is a zero-sum game and has no economic value! The lease payment will be determined by the payment that makes either party just indifferent.

� This result holds whenever:› Both parties are subject to the same interest and tax rates

› Transactions costs are ignored

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Reasons for Leasing: Tax Advantages� TAXES are the most important reason for long-term leasing. If

the corporate income tax were ever repealed, long-term leasing would probably disappear!

� Example 1 (Tax Differences): Suppose that the LESSEE in Example 1 pays NO TAXES but the Lessor pays taxes at 34%. Is there a reason for leasing? Can BOTH parties be better off?

› The lease payments remain at $24,750

› For the Lessee:x After-tax operating cost savings: (60,000)(1-0)=60,000x Depreciation: 100,000/5=20,000x Depreciation tax benefit (with purchase): 20,000(0)=0x After-tax cost of lease: $24,750(1-0)= $24,750x After-tax cost of secured debt: 7.57575%(1-0)= 7.57575 %


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› Therefore, the NAL for the Lessee is:

› For the Lessor, we already saw

With different tax rates, both lessee and lessor may be better off with leasing!


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Reasons for Leasing: Tax Advantages� Wait, if both parties are better off, who is worse off? (Leasing is a

zero-sum game)

UNCLE SAM!

› Tax-driven leasing transactions are nothing more than a reallocation of wealth from the IRS to the private sector

› Depreciation tax shields, which are of no value to the lessee, are passed on the the lessor, who can use them!

� How are the spoils of tax shields divided between lessee and lessor? Negotiation! › Relative negotiating power decides how the parties share the wealth› Each party has a reservation value below which they will not participate

in the deal› If lease payments are set so low (high) that the lessor (lessee) has less

than a zero NPVL (NAL) from the leasing transaction, the deal is never consummated

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� CAUTION!! YOU CAN’T ASSUME THAT JUST BECAUSE THE LESSEE HAS A LOWER TAX RATE, SHE SHOULD CHOOSE TO LEASE!!

› The lessor could charge too high a lease payment

› It’s not hard to construct an example where the lease alternative is preferred only if the lessee pays taxes!

Always make the lease-buy decision based on a complete discounted cash flow analysis!


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Other Reasons for Leasing: Risk� The lessee does not own the equipment when the lease expires. At

this time the equipment is said to have RESIDUAL VALUE› There may be substantial uncertainty at the time the equipment is leased

as to what the residual value will be: One risk is obsolescence

› Under a lease contract, the lessor bears this risk

� If the lessee chooses not to lease and instead to buy the equipment, she bears this residual value risk› A small, newly formed firm with principal stockholders who are poorly

diversified may benefit greatly from leasing

› A large, publicly held financial institution may easily bear the risk of the residual valuex Moreover, holding many leases diversifies away much of the equipment-specific

residual value risk

› PREDICTION: large, stable, publicly held corporations are less likely to lease (all else equal)

General principle of efficiency: the party best able to bear a risk should do so!

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Other Reasons for Leasing: Transactions Costs� When the need for equipment is short-term, substantial costs may be

incurred when ownership is transferred› Leasing an executive apartment short term clearly makes more sense

than buying a condominium for a consulting assignment

� On the flip side, leasing generates agency costs› The lessee may misuse or overuse the asset—she has no concern for the

asset’s residual valuex This cost is included, implicitly, in the lease paymentsx If too high, agency costs may eliminate this potential benefit of leasing

› Monitoring and usage metrics and penalties may reduce agency costs. Still, monitoring is expensive and some agency costs remain

› The more sensitive the value of an asset to use and maintenance decisions, the more likely the asset will be purchased

› Car leasing works because mileage and maintenance can be cheaply monitored

Leasing is beneficial for reasons of transactions costs when the costs of purchase and resale exceed the monitoring and remaining agency costs


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Questionable/Bad Reasons for Leasing� A Strong Balance Sheet

› Since the lease liability is hidden with an operating lease (financial accounting), the balance sheet of a firm with an operating lease looks stronger

› A clever financial manager could try to negotiate a lease contract the does not meet the requirements for it to be “booked”

› However, operating leases do appear in a firm’s annual report in the notes. Therefore, assuming (semi-strong form) market efficiency, how leases are classified should not affect firm value

› Investors still figure their impact by reading the notes in the annual report

� Higher Earnings and Higher ROA› In the early years of a lease, lease payments are less than the sum of

depreciation and interest expenses. Therefore, earnings are higher› Again, operating leases do not appear as assets on the balance sheet,

so assets are lower› ROA (Earnings/Assets) is therefore higher› Investors can see through this too!

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The Full Picture� The complete formula for the Net Advantage to

Leasing is:

x P is Purchase Pricex Residual is S-T(S-BN) x WACC is project cost of

capitalx Lease PMT is the lease

paymentx 'Expenses is the increase in

expenses with a lease—often a negative number!

x Dt is depreciation in year t if the asset were purchased. (If depreciation is not straightline, this value changes year to year!)

x r is the pre-tax cost of 100% debt financing

x N is the length of the leasex ITC is the investment tax credit

(if any)

Note: The NPVL formula is just the negative of the NAL: NPVL = - NAL (but with the lessor’s tax rate etc.)


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� New Issue: › Lenders will not treat a loan as fully secured unless it is

“overcollateralized” x For example, the secured lender may fund 80% of the asset’s

value at the secured rate and leave the borrower to find finance for the remaining 20% at an unsecured rate

› Therefore, the rate for discounting lease payments and depreciation tax shields is greater than the after-tax secured loan rate

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A Full Example� EXAMPLE 3: North American Coal Company (NACCO) is considering

the purchase or lease of an electric shovel costing $10M. NACCO would use each shovel for 10 years and expect the shovel to be worth $500,000 at that time. The asset would require straight-line depreciation over ten years to a terminal value of $500,000. A finance company has offered to lease the shovel for annual payments of $1.745M payable at the end of each of 10 years. Alternatively, NACCO could purchase the shovel› Like any real world firm, NACCO cannot borrow 100% of the purchase

through a secured loan. The secured lender will lend 80% of the asset’s value at the secured rate of 11.5%. The remaining 20%, if borrowed, must be financed at an unsecured rate of 14%. The cost of 100% debt financing is therefore:

12%=(0.80)(11.5%)+(0.20)(14%)

› The project’s WACC is 15%› Depreciation is straight line implying Dt=$950,000 (=10,000,000-

500,000)/10)› NACC pays taxes at a 40% rate implying T Dt= $380,000 (=0.40(950,000))› There is no ITC or additional expenses with the lease ('Expenses=0)


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CALCULATOR SOLUTION

PMT = (1í0.40)(1,745,000)+380,000 NAL = 10,000,000í500,000/(1.15)10 í9,930,644= 1,427,000 = í54,237

N = 10FV = 0I = (1í0.40)0.12 = 7.2%

PV Ö 9,930,644

PMT

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Is Leasing Economically Feasible?

� Let’s rewrite the net advantage of leasing as:

x Let NAL(PMTBE,Lessee)=0 define the Lessee’s Breakeven Lease payment

� Let’s also write the NPV of leasing for the lessor as:

x Let NPVL(PMTBE,Lessor)=0 define the Lessor’s Breakeven Lease payment

� A mutually profitable leasing opportunity exists when:

PMTBE,Lessor< PMTBE,Lessee

Technical Notes: We are assuming that the WACC for the lessee and lessor are the same. What does this imply? We are also ignoring 'Expense and ITC


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More Reality: Payment Timing

� Most leases require lease payments in advance

� Our formula for the Net Advantage of Leasing changes to:

Note: The NPVL formula is just the negative of the NAL: NPVL = - NAL (but with the lessor’s tax rate etc.)

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Leasing and Capital Budgeting� Leasing and Capital Budgeting decision interact with each other

� It is possible for a project to have a negative NPV but a sufficiently positive NAL such that the project becomes economically feasible!

� An approximate formula is:

Calculation Method› Perform a standard NPV analysis of a project

› If NPV>0 definitely proceed with the project, but still see whether there is an advantage to lease financing—whether NAL>0

› If NPV<0 don’t give up immediately. Calculate the NAL. If NPV+NAL>0 proceed with the project using lease financing


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Major points to remember� As always, know how to work the assigned homework problems as well as the

types of numerical examples in the notes� What is a lease in general?� What is financial lease? What is an operating lease?� What are three types of financial leases? Describe them.� What is the correct discount rate for valuing a leasing opportunity?”� What are the principle reasons firms choose to lease rather than buy?� In perfect capital markets, does leasing matter? Why?� What are some bad/questionable reasons firms lease?� How can a firm calculate the Net Advantage of Leasing (NAL) as compared

to buying?� How does the timing of lease payments affect the calculation of NAL?� How does the possibility of leasing affect the capital budgeting analysis?

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In-class Problem� C&S, Inc. an international builder of high-rise office buildings, must

choose whether to lease or buy a new construction crane. The crane costs $1.5 M and has a 7-year useful life. In 7 years, the crane could be scrapped for $200,000 after tax. C&S could buy the crane with 100% bank finance secured by the crane at a loan rate of 11%. Alternatively, SF Leasing, Inc. has offered to lease the crane to C&S for 7 years for an annual payment of $250,000 paid in arrears. The crane may be depreciated for tax purposes on a straight-line basis over 7 years to a $200,000 terminal value. There are no expense differences between leasing and buying ('E=0). If the lessee’s (C&S’s) marginal tax rate is 40% and its WACC is 18%,

› What is the net advantage to leasing (NAL)?

› What is the NAL if the lease payments are in advance?


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APPENDIX I: Types of Leases (Financial Accounting)� Statement of Financial Accounting Standards No. 13 ( FAS 13)

creates two classes of Leases: Capital Leases and Operating Leases

� Capital Leases› Appear on the firm’s balance sheet

x The present value of the lease payments appear as a Liabilityx The same value appears as an Asset

› FAS 13 requires a lease be classified as a capital lease if any one of the follow hold:x The present value of the lease payments equals or exceeds 90% of the fair

market value of the asset at the start of the leasex The lease transfers ownership to the lessee by the end of the leasex The lease term is 75% or more the economic life of the assetx The lessee can purchase the asset at below fair market price when the lease

expires (Bargain Purchase Price Option)

� Operating Leases› All other leases are classified as Operating Leases

› Operating leases are off-Balance Sheet Financing

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� Questionable Strategies› Since the lease liability is hidden with an operating lease,

the balance sheet of a firm with an operating lease looks stronger

› A clever financial manager could try to negotiate a lease contract the does not meet the requirements for it to be “booked”

› However, operating leases do appear in a firm’s annual report in the notes. Therefore, assuming (semi-strong form) market efficiency, how leases are classified should not affect firm value


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APPENDIX II: Taxes, Leases, & IRS� The key driver of leasing is the relative tax advantage of letting the lessor recognize the

tax benefits of ownership� The IRS’ role is tax collection. Consequently, it seeks to ensure some semblance of a

legitimate business purpose for a lease� In order for the the lessee to deduct lease payments for income tax purposes, the lease

must qualify under IRS rules› Prior to major lease transaction, all interested parties typically obtain an opinion from the IRS

� Rules:› Lease must be less than 30 years and not exceed 80% of the asset’s useful life including all

renewal and extension periods› Lease should not have an option to acquire below the asset’s fair market value (otherwise, lessee

has something like an equity claim on the residual value)› Lease may not have early “balloon” payments as they are evidence the lease is an attempt to

avoid taxes, not a legitimate business transactionx Essentially a way to accelerate depreciation

› Lease payments themselves must provide the lessor with a fair market return. The profit from the lease for the lessor should not stem solely from the deal’s tax benefits

› Lease should not limit the right of lessee to pay dividends or issue debt› Renewal options must be reasonable and reflect the fair market value of the asset› Lessee may not pay for any portion of the asset or guarantee any loans for its purchase

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APPENDIX III: Debt Service Parity� Why use the After-Tax Cost of Secured Debt?� To see why, let’s consider a parallel situation: suppose the firm has a series of secured

loan obligations equal to the NAL cash flows (excluding the Year 0 initial equipment cost)› Consider Debt Service Parity: how much money could the firm borrow and have these NAL cash

flows fully repay the principal and interest? › If the firm can get more cash from this Equivalent Loan than it takes to buy the equipment, the

NAL is negative and its cheaper to buy

� Let’s revisit Example 1: › After-tax cost of secured debt: 7.57575%(1-0.34)=5%› The net cash flows (excluding Year 0) are $23,135 after-tax, per year for five years

› We can “prove” this is correct if $23,135 for five years is sufficient to amortize the Equivalent Loan $100,162.46—exactly


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� Indeed, the following table shows the equivalent loan is fully amortized by the NAL flows (excluding Year 0)

� The correct discount rate in the NAL calculation is therefore the after-tax cost of secured debt!

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APPENDIX IV: Debt Displacement & Leasing� Our approach to valuing leases is to 1) compare the lease to

a comparable loan and 2) choose whichever source of finance is cheaper!

› This gives an apples-to-apples comparison of the two

› But only debt finance is considered

� Would a firm with a target debt ratio regularly choose to finance equipment purchases with only debt? No!

› Over the longer run, firms typically seek to maintain a target leverage ratio

� But a lease is a form of secured borrowing

� IMPLICATION: If a firm regularly uses lease finance, it must also periodically issue equity and repay debt. This is called DEBT DISPLACEMENT


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� EXAMPLE: Suppose a firm has an initial balance sheet as follows, showing its target D/E ratio of 6:4 or 150%

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› Consider the balance sheet after the firm Buys a machine for $100,000 (and leverage rebalances)

› Instead, suppose the firm Leases (and the firm is exactly indifferent between leasing and buying)


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› Because a lease is equivalent to a loan, the firm offsets, the $100,000 increase in debt by x Issuing $40,000 of new equity and x Paying off $40,000 of old outstanding debt

› This recapitalization leaves the capital structure at its optimal ratio:x D/E=(100,000+560,000)/440,000=660,000/440,000=150%

class 8 leasing

Documents

net lease lessee

lessor leveraged lease

fullservice lease lessee

lease contract

leasing companies

possibility of leasing

independent lessor

cash lessee