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Buying versus LeasingBuy Lease

Firm U buys asset and uses asset; financed by debt and equity.

Lessor buys asset, Firm U leases it.

Manufacturer of asset

Equity shareholders

Firm U1. Uses asset

2. Owns asset

Creditors

Manufacturer of asset

Lessor1. Owns asset

2. Does not use asset

Equity shareholders Creditors

Lessee (Firm U)1. Uses asset

2. Does not own asset

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Operating Leases

Usually not fully amortized.Usually require the lessor to maintain

and insure the asset.Lessee enjoys a cancellation option.

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Financial Leases

The exact opposite of an operating lease.

1. Do not provide for maintenance or service by the lessor.

2. Financial leases are fully amortized.

3. The lessee usually has a right to renew the lease at expiry.

4. Generally, financial leases cannot be cancelled.

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Sale and Lease-Back

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.

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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.

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Accounting and Leasing

Leases can lead to off-balance-sheet financing.

Under FASB 13, leases are either classified as capital leases or operating leases.– Operating leases do not appear on the balance

sheet.– Capital leases appear on the balance sheet—the

present value of the lease payments appears on both sides.

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Accounting and Leasing

Balance SheetTruck is purchased with debtTruck $100,000 Debt $100,000Land $100,000 Equity $100,000Total Assets $200,000 Total Debt & Equity $200,000

Operating LeaseTruck DebtLand $100,000 Equity $100,000Total Assets $100,000 Total Debt & Equity $100,000

Capital LeaseAssets leased $100,000 Obligations under capital lease $100,000Land $100,000 Equity

$100,000Total Assets $200,000 Total Debt & Equity $200,000

Consider a firm with two assets: a truck and some land.

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Capital Lease

A lease must be capitalized if any one of the following is met:– 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.

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Taxes, the IRS, and Leases

The principal benefit of long-term leasing is tax reduction.

Leasing allows the transfer of tax benefits from lessee to lessor.

Naturally, the IRS seeks to limit this, especially if the lease appears to be set up solely to avoid taxes.

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Taxes, the IRS, and Leases

The lessee can deduct lease payments if the lease is qualified by the IRS.

1. The term must be less than 30 years.2. There can be no bargain purchase option.3. The lease should not have a schedule of payments that

is very high at the start of the lease and low thereafter. 4. The lease payments must provide the lessor with a fair

market rate of return.5. The lease should not limit the lessee’s right to issue

debt or pay dividends.6. Renewal options must be reasonable and reflect fair

market value of the asset.

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NPV Analysis of theLease-vs.-Buy Decision

A lease payment is like the debt service on a secured bond issued by the lessee.

In the real world, 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.

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Debt Displacement andLease Valuation

Considering the issues of debt displacement allows for a more intuitive understanding of the lease versus buy decision.

Leases displace debt—this is a hidden cost of leasing. If a firm leases, it will not use as much regular debt as it would otherwise. – The interest tax shield will be lost.

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Reasons for Leasing

Good Reasons– Taxes may be reduced by leasing.– The lease contract may reduce certain types of

uncertainty.– Transactions costs can be higher for buying an

asset and financing it with debt or equity than for leasing the asset.

Bad Reasons– Accounting

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Some Unanswered Questions

Are the Uses of Leases and of Debt Complementary?

Why are Leases offered by Both Manufacturers and Third Party Lessors?

Why are Some Assets Leased More than Others?

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Analysis of Leases

Cash Flows– Lease payment

• Tax deductible if criteria are met

– Depreciation tax shield• Depr. Expense * Marginal tax rate

– Equipment (Asset) Cost Discount rate = After-tax cost of debt Decision (output) variable

– 2 alternatives: leasing versus buy-and-borrow• Can compare NPV under both alternatives• If combining cash flows, be sure to lable what the NPV represent:

Advantage to leasing OR Advantage to buy and borrow.