Ch22 Leasing

8/14/2019 Ch22 Leasing

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CHAPTER 22: Leasing

Topics:

22.1 Types of Leases

22.2 Accounting and leasing

22.4 The Cash Flows of Operating Leasing

22.6 NPV Analysis of the Lease-versus-Buy Decision 22.8 Does Leasing Ever Pay: The Base Case

22.9 Reasons for Leasing

(This illustration contains a minor correction of your text. Section22.4 should be operating lease rather than financial lease.)


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22.1 Types of Leases

The Basics

A lease is a contractual agreement between a lessee and lessor.

The agreement establishes that the lessee has the right to use

an asset and in return must make periodic payments to the

lessor.

The lessor is either the assets manufacturer or an independent

leasing company.

Two types:

Operating lease Financial lease

Sale and lease-back

Leverage lease


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Buying versus Leasing

Buy LeaseFirm Ubuys asset and uses asset;financed by debt and equity.

Lessor buys asset, Firm Uleases 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. This means that the

payments required under the terms of the lease are

not enough to recover the full cost of the asset for

the lessor.

Usually require the lessor to maintain and insure theasset.

Lessee usually enjoys a cancellation option. This

option gives the lessee the right to cancel the leasecontract before the expiration date.


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Financial Leases

Most commonly referred to as Capital lease

The opposite of an operating lease.

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

2. Generally fully amortized

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

4. Generally, financial leases cannot be cancelled, i.e., the

lessee must make all payments or face the risk of

bankruptcy.


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Sale and Lease-Back (Read by your own)

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.

Example: Sell you IT assets to HP Financial Services and

lease them back.

You can easily adapt to future needs down the road.


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Leveraged Leases

Lessor buys asset, Firm Uleases it.

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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22.2 Accounting: Financial (Capital) Lease

The accounting treatment of leasing follows CICA 3065

A lease must be capitalized (balance sheet disclosure) if any one of the

following four criteria is met (CICA or GAAP):

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.

Both CRA and IRS will treat a capitalized lease as sales for tax

purposes.

Lessor records leasing as installment sales;

Lessee records leasing on balance sheet and take depreciation on assets.

Please refer to the attached CRA or IRS regulations for further illustration.


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Incremental cashflow approach to lease:

An example

Zee Movers needs to acquire 50 more cars. Each car will

generate $12,000 per year in added sales for the next fiveyears. The firm has a corporate tax rate of 40%. The car

would qualify for a CCA (cost of capital allowance) rate of

40% (rental car). There is no residual value of the car after

five years. Assume that this is an operating lease.

Two options:

(1) Each car can be purchased at a wholesale price of 20,000.

(2) Each car can be leased through an operating leasing withTiger Leasing at a payment of $5,000 each year for five years

(payable at the beginning of each year). Suppose that all the

conditions for operating lease are met.

Buy or lease?


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Example contd: Tax shield on CCA for car

Year UCC CCA1 Tax Shield4

01 $1,600

2 2,560

3 9,600 3,840 1,536

4 5,760 2,304 9225 3,456 1,382 553

Residual at yr 5 2,074 829.6


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Contd: Incremental cashflows of leasing compared with

buying

If the cars are leased, then:1. Lease payment of 5,000 each year. Tax-deductible expenses. Lease payment shield = lease payment * tax rate

If buy, then:

1. OwnershipDepreciate for tax purposes.2. Cash outlay of 20,000 at time 0.

3. Tax deduction due to residual value loss.

Note: The added sales of 12,000 each car apply to both leasing and buying,so the incremental cashflow of added sales for leasing is zero.

Timing of cashflow: (a bit different from the text) Lease rental payment happens in advance

Depreciation happens in arrears


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Contd: Incremental cashflowsTextbook method

Same cashflow, but view things from the aggregate of

(lease-buy):

Lease: Lease payment (outflow) + lease payment tax shield

(inflow)

Effects of Minus Buy: Save on initial purchase price

(inflow), but bypass depreciation tax shields (outflow).


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22.6 NPV Analysis of the Lease-vs.-Buy Decision

Lease payment is like interest payment!Cashflows are

deterministic once the lease contract is entered into.

A lease payment is like the debt service on a secured bond

issued by the lessee. A lessee incurs a liability equal to the

present value of all future lease payments. (Lease displaces

debtDebt displacement)

In practice, 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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What if there is economic residual value left?

To make it compatible with laws, the lease needs to be an

operating lease. One way is to specify sufficiently high residual

value. Lets suppose 5 years later, the cars are returned to Tiger

Leasing with a residual guarantee value of 15%, which is also the

residual economic value. Everything else remains the same.

Whats your answer now?

CF to lease wont change.

Changes in CF to buy:

If you buy, 5 years later you dispose of (sell) the asset for 15%

of purchase price.

You realize some proceeds;

You pay (deduct) taxes if there is capital gains (loss) in asset

disposal. (Depreciation Recapturewhen terminating the pool.)


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Contd: Add residual guarantee to valuation

Year 0 1 2 3 4 5

Depreciation schedule 4000 6400 3840 2304 1382Residual book 2074

Residual guarantee (1)

After-tax cashflows from buying the assetAsset cost -20,000

Depreciation tax shield 1600 2560 1536 921.6 552.8

AT Residual cashflow (2)

Net cash from buying -20,000 1,600 2,560 1,536 922 3,182

Notes: (1) Residual guarantee =

(2) AT Residual cashflow =


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Contd: Solution

After-tax rental payment -3000 -3000 -3000 -3000 -3000

Net cash from buying -20000 1600 2560 1536 922 3182

Lease minus buy 17000 -4600 -5560 -4536 -3922 -3182

NPV -1301

IRR 9.60%

Decision?

Please refer to the spreadsheet in the course webpage.


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22.8 Does Leasing Ever Pay: The Base Case

Cashflow to Tiger Leasing (the lessor) is just the opposite of that to

Zee Movers (the lessee) in the leasing: Lease minus sell (for the case of no residual value)

Year 0 1 2 3 4 5

Negative of Asset sale -20,000

AT lease income 3000 3000 3000 3000 3000

Dep. tax shield 1600 2560 1536 921.6 552.8

Residual tax shield 829.6Net CF -17,000 4600 5560 4536 3922 1382

NPV: Same tax rate and same discount rate: -6.21!


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A zero-sum game for lessee and lessor if

Both are at the same corporate tax bracket

Both borrow and lend at the same rate

No transaction costs

No leasing would ever occur!


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22.9 Reasons for Leasing

Taxes may be reduced by leasing in operating leasing.

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

Leasing allows the transfer of tax benefits from those (lessee)

who need equipment but cannot take full advantage of the tax

benefits of ownership to a party (lessor) who can.

The lease contract may reduce certain types of uncertainty

(the residual value risk at the end of the contract is borne by

the lessor, and it may be in a better position to bear this risk)

Transactions costs can be higher for buying an asset and

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


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An Illustration of Benefit of Tax Reduction: Tax Arbitrage

Back to the example where theres no economic residual.

Suppose Zee (the LESSEE) is still in the 40% tax bracket, but TigerLeasing (the LESSOR) is in the 30% tax bracket instead. Canleasing happen in this case? (i.e., Can both firms have a positive

NPV?)

Whats changed? For Lessee, nothing is changed: same tax rate, same interest rate,

same paymentSame incremental cashflow in Lease vs. buydecision. + NPV.

For Lessors Lease vs. selldecision, after-tax cashflow is nowchanged

AT lease income

Depreciation and residual tax shield

AT discount rate as well!

T b td L ll ( id l t )


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Tax arb. contd: Lease vs. sell (no residual guarantee)

Year 0 1 2 3 4 5

Depreciation 4000 6400 3840 2304 1,382

Residual 2,074After-tax cash flows from leasing

After-tax rental income 3500 3500 3500 3500 3500

Depreciation tax shield 1200 1920 1152 691 415

Residual tax shield 622Net cash from leasing 3,500 4,700 5,420 4,652 4,191 1,037

Selling Asset proceeds 20,000

Diff: Lease minus sell -16,500 4,700 5,420 4,652 4,191 1,037

NPV $91.16

Notes: 1. Depreciation tax shield and lease payment is now

calculated at tax rate of 30%.

2. Discount rate for NPV is:


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Tax arb. contd: Reservations and Negotiations

What is the smallest lease paymentthat Lessor (Tiger Leasing)

will accept? Set their NPV to zero (break-even) and solve for thepayment.

What is the highest lease paymentthat Lessee (Zee Movers) can

pay? Set their NPV to zero (break-even) and solve for thepayment.

As long as the highest payment from the lessee is larger than the

smallest payment for the lessor, it is feasible to lease. Feasible lease payment: [lessors smallest lease payment, lessees

largest lease payment]

D i ti f ti t L


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Derivation of reservation payment: Lessee

Three components:

PV of Depreciation (and residual loss) Tax Shield

PV of AT lease paymentAnnuity (in advance) Equipment cost at time 0

Set 321 = 0. (Answer: $5002)

For Zee Movers:


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Contd


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Derivation of reservation payment: Lessor

Three components:

1. PV of Depreciation (and, if any, residual loss) Tax Shield

2. PV of AT lease paymentAnnuity (in advance)

3. Equipment proceeds at time 0

Set 1+2 -3 = 0.

Repeat the same exercise for Tiger Leasing.

Note that tax rate, and hence AT discount rate, are different.

Answer: $4970.

Lease will happen with a lease payment in [4970, 5002].


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Review Questions

How would you evaluate a capital lease through incremental

cashflow approach? Give the incremental cashflow from theperspective of lease vs. buy.

Assigned problems: #22. 1, 2-6, 8, 11 (Assume operating

leasing for incremental cashflow analysis )

Documents

Ch22 Leasing