Chapter 21 – Lease Analysis -- Chapter 21 – Lease Analysis -- TermsTerms

Lessee The person using the asset

Lessor.

The person who owns the asset

Operating LeaseOperating Lease

Also called service lease or service contract

The lessor maintains the asset

Financial LeaseFinancial Lease

Also called a capital lease Lessee maintains the asset Lessee may negotiate terms of sale with

the manufacturer, with the lessor acting as a creditor with a secured position

Leveraged LeaseLeveraged Lease

Lessor uses borrowed money to finance the lease

Lessor typically needs the tax-deductible interest or the depreciation expense

Lender is in a low tax bracket Tax laws are tightening -- Passive loss

rules

Sale and LeasebackSale and Leaseback

Owner sells the asset to a third party and then leases it back

Reasons for leasingReasons for leasing Increased availability of financing

Lessor has a more secured position and typically this: Makes the lease less risky from the lessor

point of view Makes the lease easier and quick Allows a higher amount to be “borrowed” May allow the company around

restrictive covenants on debt

Reasons for leasingReasons for leasing Shift of ownership risk

serviceability obsolescence residual value

Flexibility With cancellation provisions the lessee has

an option to put the asset back to the lessor

Reasons for leasingReasons for leasing

Tax Advantages A lease can transfer depreciation savings to

the lessor who may be in a higher tax bracket

A lease payment may be higher than depreciation expense and transfer benefit to the lessee

Reasons for leasingReasons for leasing

Accounting benefits Within generally accepted accounting

guidelines leases can still provide some form of “off-balance sheet” financing

This “off-balance sheet financing” does not appear on the balance sheet as debt -- but instead in the footnotes

Reasons for leasingReasons for leasing

Circumvent the decision process Government unit, for example, may have

restrictions on capital expenditures but fewer restrictions on leasing

Lower cost: The net present value of leasing may be less than the net present value of owning

Reasons for leasingReasons for leasing

Reimbursement When the asset is purchased the firm may

not be reimbursed for the cost on financing When the asset is leased, and the lease

payment is reimbursed, the financing cost is in the lease payment

Common with hospitals

Taxes and LeasingTaxes and Leasing

The IRS has guideline for determining if a lease is really and installment sale

When the lease does not meet these guidelines, the agreement is not a lease and the tax benefits shift

Cash flow analysis of LeasesCash flow analysis of Leases

Cost to lease Present value of the lease payments --

discounted at the after tax cost of debt

Cash Flow Analysis of LeasesCash Flow Analysis of Leases Cost to buy

Present value of the after tax operating cost of ownership: if highly predictable, use the after tax cost of debt

Present value of the after tax depreciation expense: highly predictable, use the after tax cost of debt

Present value of the net terminal salvage value: not very predictable, use the weighted average cost of capital

Cost to Lease or BuyCost to Lease or Buy Cost to lease

n

= [(1 – T)Lt] (1 + kd)t

t=0

Cost to buy n

= I0 + [(1-T)OCt - T•Dept] (1+kd)t

t=0

- Net terminal value (1+Ko)n

Financial Statement Impact Financial Statement Impact of Leasesof Leases

You can acquire the use of assets without showing the correlating financing cost by “structuring the deal” as an operating lease rather than a capital lease.

Current Leasing PracticeCurrent Leasing Practice Ang and Peterson

Those who use more debt also use more leasing

Sharp and Ngyun Leases are more common with cash-poor

firms

Current Leasing PracticeCurrent Leasing Practice Krishnan and Moyer

Firms more likely to lease in industries with high bankruptcy cost

Mehran, et. al Companies with high CEO ownership are

more likely to lease Smith and Wakeman

Identify eight variable that correlate with leasing