exp 482 corporate financial policy clifford w. smith, jr. winter 2007 handout 6 * covers readings on...
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EXP 482Corporate Financial Policy
Clifford W. Smith, Jr. Winter 2007 Handout 6 * Covers readings on course outline through Smith/Wakeman (1984)
Just about any asset that can be purchased can also be leased.
Two parties to the contract
– the lessee is the user of the asset– the lessor is the owner of the asset
The largest group of lessors are the original equipment manufacturers (e.g. IBM, Xerox) but there are also many third party-leasing companies.
Leasing
Operating Lease (maintenance or service lease)
– short-term (less than 5 years)– not fully amortized– lessor supplies maintenance or service– often cancelable
Financial Lease (capital lease)
– long-term and fully amortized– lessee supplies service and maintenance– usually not cancelable
Types of Leases
Leasing
Modigliani/Miller theorem implies that with
no taxes,
no contracting costs,
and a fixed investment policy,
leasing policy does not affect firm value.
Leases contain options
– option to cancel or extend
– option to purchase
We can price these options with Black/Scholes model, but B/S requires M/M assumptions.
This approach cannot tell you why a lease is cancelable because all important effects of leasing are assumed away.
Traditional Approaches to Leasing
Leasing affects tax liability.
– Differential tax rates
– ITCs: Pan AM
– Double-dip leasing
Taxes are very important to understand leasing behavior, but the analysis here is frequently a mechanical application of tax rules in the capital budgeting decision.
Traditional Approaches to Leasing
Term must be less than 30 years.
Lessee should not have option to buy for less than fair market value.
No early balloon payments.
Lessor must make fair market return absent tax benefits.
Lessor should not limit lessee's ability to pay dividends or issue debt.
Renewal option must reflect fair market value.
Avoiding Constructive Sale Rules
Asset characteristics
Lessee characteristics
Lessor characteristics
Typical contract provisions
Questions to be Answered About Leasing
What Type of Assets are Most Commonly Leased?
Asset Characteristics
Period of use in relation to useful life.
Sensitivity to use and maintenance decisions
– Owners internalize the costs of these decisions. Since a lessee does not have a claim on the residual value of the asset, he has incentives to abuse or under maintain the asset.
– Adverse selection in leasing decisions
Controlling Asset Abuse
Penalty clause (security deposit)
Option to buy
Third party monitoring of maintenance
Service lease
Metering
Asset Characteristics
Firm specific assets
– Production facilities vs. office space
– Transportation and construction equipment vs. autobody stamping dies
Leasing and Firm Specific Assets
Suppose GM wants to build an R&D facility. A group of doctors come to GM and say, "We have high tax rates, and you don't. Let us buy the building and lease it to you."
Time 0 10 years 20 years
Value to GM 20 10 0
OpportunityCost 18 9 0
Klein, Crawford and Alchian ("Vertical integration, appropriable rents, and the competitive contracting process") discuss cases where ownership rights are important (i.e. leasing would be expensive).
The Fisher autobody case.
How can you solve the GM problem?
– Don't lease
– Include option to renew or option to extend lease in the lease contract
Leasing and Firm Specific Assets
Lessee Characteristics
Tax incentives to lease
Capital structure issues
– Leases are senior claims and can create claim dilution. Limited in bond contracts. Amortizing lease payments helps bondholders monitor outstanding senior claims.
– Leases have characteristics similar to secured debt. Can reduce underinvestment problem.
– Long-term noncancelable leases commit the firm to use the asset over the life of the lease. Can reduce asset substitution problem.
Compensation-related issues
– Leasing can affect return on invested capital and payments to bonus pool
– If lease is fully amortized, this problem is reduced
– Specialization in risk bearing
Lessee Characteristics
Lessor Characteristics
Tax incentives to lease
Leasing and market power
Lessor Characteristics
Tax incentives to lease
Leasing and market power
– How do you maximize profits if you face a downward sloping demand curve for your product?
P
Q
Leasing and Market Power
First-degree price discrimination is not legal under US antitrust laws (Robinson/Patman Act)
Often the more inelastic demanders use asset more intensively than the elastic demanders.
– One solution: Tie-in sales - IBM sold early computers and required that all purchasers use only IBM punch cards.
– Tie-in sales are now also in violation of antitrust laws.
An alternative solution: Lease and charge metering fee.
– Metering fees have passed the antitrust test because there is an economic justification for them in addition to price discrimination (i.e. curbing the asset abuse problem).
For some time, Xerox and IBM only leased their products, they did not sell them. Why?
Does this mean that a producer would never want to both lease and sell its product?
Leasing and Market Power
Lessor Characteristics
Comparative advantage in disposing of asset
– At one time, Kodak handled all short-term cancelable leases (rentals) in house but Citibank handled most long-term noncancelable leases.
Bonding quality by manufacturer
– Lease with option to cancel
Contract Provisions
Deposits and penalty clauses
Option to buy asset or extend lease
Restrictions on subleasing
Service vs. net lease
Capital vs. operating lease
Metering
Bonding of maintenance by third parties
Investment Opportunity Set
Financial Architecture Leverage High Low Maturity Long Short Priority DiffuseConcentrated Conversional Rights Low High Leasing High Low
Compensation Level of Pay Low High Conditional Pay Low High
Assets inPlace
GrowthOpportuniti
es
Firm Characteristics Leasing Policy
Growth Options (Merck) LowerLeverage LowerCredence Goods (Eastern) LowerProduct Warranties (Yugo) LowerFuture Product Support (Yugo/Wang) LowerSupplier Financing (Campeau) LowerClosely Held Firm HigherSize –Regulation ?Firm Specific Assets LowerInvestment Tax Credits HigherMarginal Corporate Tax Rate ?Marginal Personal Tax Rate ?
Benchmarking Corporate Leasing Policy