McGraw-Hill/IrwinMcGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
2626Leasing
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Key Concepts and Skills
Understand basic lease terminology Understand the criteria for a capital lease vs.
an operating lease Understand the typical incremental cash
flows to leasing Be able to compute the net advantage to
leasing Understand the good reasons for leasing and
the dubious reasons for leasing
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Chapter Outline
Leases and Lease Types Accounting and Leasing Taxes, the IRS, and Leases The Cash Flows from Leasing Lease or Buy? A Leasing Paradox Reasons for Leasing
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Lease Terminology
Lease – contractual agreement for use of an asset in return for a series of payments
Lessee – user of an asset; makes payments Lessor – owner of the asset; receives
payments Direct lease – lessor is the manufacturer Captive finance company – subsidiaries that
lease products for the manufacturer
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Types of Leases Operating lease
Shorter-term lease Lessor is responsible for insurance, taxes, and maintenance Often cancelable
Financial lease (capital lease) Longer-term lease Lessee is responsible for insurance, taxes, and
maintenance Generally not cancelable Specific capital leases
Tax-oriented Leveraged Sale and leaseback
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Lease Accounting
Leases are governed primarily by FASB 13 Financial leases are essentially treated as
debt financing Present value of lease payments must be
included on the balance sheet as a liability Same amount shown on the asset as the
“capitalized value of leased assets” Operating leases are still “off-balance-
sheet” and do not have any impact on the balance sheet itself
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Criteria for a Capital Lease
If one of the following criteria is met, then the lease is considered a capital lease and must be shown on the balance sheet Lease transfers ownership by the end of the lease
term Lessee can purchase asset at below market price Lease term is for 75 percent or more of the life of
the asset Present value of lease payments is at least 90
percent of the fair market value at the start of the lease
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Taxes Lessee can deduct lease payments for income tax
purposes Must be used for business purposes and not to avoid taxes Term of lease is less than 80 percent of the economic life of
the asset Should not include an option to acquire the asset at the end
of the lease at a below market price Lease payments should not start high and then drop
dramatically Must survive a profits test – lessor should earn a fair return Renewal options must be reasonable and consider fair
market value at the time of the renewal
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Incremental Cash Flows
Cash Flows from the Lessee’s point of view After-tax lease payment (outflow)
Lease payment*(1 – T)
Lost depreciation tax shield (outflow) Depreciation * tax rate for each year
Initial cost of machine (inflow) Inflow because we save the cost of purchasing the asset now
May have incremental maintenance, taxes, or insurance
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Example: Lease Cash Flows
ABC, Inc. needs some new equipment. The equipment would cost $100,000 if purchased, and would be depreciated straight-line over 5 years. No salvage is expected. Alternatively, the company can lease the equipment for $25,000 per year. The marginal tax rate is 40%. What are the incremental cash flows?
After-tax lease payment = 25,000(1 - .4) = 15,000 (outflow years 1 - 5)
Lost depreciation tax shield = (100,000/5)*.4 = 8,000 (outflow years 1 – 5)
Cost of machine = 100,000 (inflow year 0)
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Lease or Buy?
The company needs to determine whether it is better off borrowing the money and buying the asset, or leasing
Compute the NPV of the incremental cash flows
Appropriate discount rate is the after-tax cost of debt since a lease is essentially the same risk as a company’s debt
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Net Advantage to Leasing
The net advantage to leasing (NAL) is the same thing as the NPV of the incremental cash flows If NAL > 0, the firm should lease If NAL < 0, the firm should buy
Consider the previous example. Assume the firm’s cost of debt is 10%. After-tax cost of debt = 10(1 - .4) = 6% NAL = 3,116
Should the firm buy or lease?
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Work the Web Example
Many people have to choose between buying and leasing a car
Click on the web surfer to go to Kiplinger’s Go to Tools: Spending Tools Do the calculations for a $30,000 car, 5-year loan at
7% with monthly payments, and a $3,000 down payment. The available lease is for 3 years and requires a $550 per month payment with a $1,000 security deposit and $1,000 other upfront costs.
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Good Reasons for Leasing
Taxes may be reduced May reduce some uncertainty May have lower transaction costs May require fewer restrictive
covenants May encumber fewer assets than
secured borrowing
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Dubious Reasons for Leasing
Balance sheet, especially leverage ratios, may look better if the lease does not have to be accounted for on the balance sheet
100% financing – except that leases normally do require either a down-payment or security deposit
Low cost – some may try to compare the “implied” rate of interest to other market rates, but this is not directly comparable
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Quick Quiz What is the difference between a lessee and a
lessor? What is the difference between an operating lease
and a capital lease? What are the requirements for a lease to be tax
deductible? What are typical incremental cash flows and how
do you determine the net advantage to leasing? What are some good reasons for leasing? What are some dubious reasons for leasing?
McGraw-Hill/IrwinMcGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
End of Chapter
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Comprehensive Problem
What is the net advantage to leasing for the following project, and what decision should be made? Equipment would cost $250,000 if purchased It would be depreciated straight-line to zero
salvage over 5 years. Alternatively, it may be leased for $65,000/yr. The firm’s after-tax cost of debt is 6%, and its
tax rate is 40%
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