Lease

1-1

Leasing & It’s Different Types.

1-2

Lease Financing Lease -- A contract under which one party, the lessor (owner) of an asset, agrees to grant the use of that asset to another, the lessee, in exchange for periodic rental payments.

Examples of familiar leases Apartments

Houses

Offices

Automobiles

1-3

Lease Financing Typically, a company first decides on the asset that it needs. It then negotiates a lease contract with a lessor for use of that asset. The lease agreement establishes that the lessee has the right to use the asset and, in return, must make periodic payments to the lessor, the owner of the asset. The lessor is usually either the asset’s manufacturer or an independent leasing company. If the lessor is an independent leasing company, it must buy the asset from a manufacturer. The lessor then delivers the asset to the lessee, and the lease goes into effect.

1-4

Issues in Lease Financing ◆

◆ ◆

Advantage: Advantage Use of an asset without purchasing the asset Obligation: Obligation Make periodic lease payments Contract specifies who maintains the asset ◆ ◆

◆

Cancelable or noncancelable lease? ◆

◆

Full-service lease -- lessor pays maintenance Net lease -- lessee pays maintenance costs Operating lease (short-term, cancelable) vs. financial lease (longer-term, noncancelable)

Options at expiration to lessee

1-5

Operating lease ◆

◆

Usually a shorter-term lease under which the lessor is responsible for insurance, taxes, and upkeep. May be cancelable by the lessee on short notice.

1-6

Operating lease With an operating lease, the payments received by the lessor are usually not enough to allow the lessor to fully recover the cost of the asset. A primary reason is that operating leases are often relatively short-term. Therefore, the life of the lease may be much shorter than the economic life of the asset. For example, if you lease a car for two years, the car will have a substantial residual value at the end of the lease, and the lease payments you make will pay off only a fraction of the original cost of the car. The lessor in an operating lease expects to either lease the asset again or sell it when the lease terminates.

1-7

Operating lease A second characteristic of an operating lease is that it frequently requires that the lessor maintain the asset. The lessor may also be responsible for any taxes or insurance. Of course, these costs will be passed on, at least in part, to the lessee in the form of higher lease payments.

1-8

Operating lease The third, and perhaps most interesting, feature of an operating lease is the cancellation option. This option can give the lessee the right to cancel the lease before the expiration date. If the option to cancel is exercised, the lessee returns the equipment to the lessor and ceases to make payments. The value of a cancellation clause depends on whether technological and/or economic conditions are likely to make the value of the asset to the lessee less than the present value of the future lease payments under the lease.

1-9

Financial lease Typically a longer-term, fully amortized lease under which the lessee is responsible for maintenance, taxes, and insurance. Usually not cancelable by the lessee without penalty.

1-10

Financial lease A financial lease is the other major type of lease. In contrast to the situation with an operating lease, the payments made under a financial lease (plus the anticipated residual, or salvage, value) are usually sufficient to fully cover the lessor’s cost of purchasing the asset and pay the lessor a return on the investment. For this reason, a financial lease is sometimes said to be a fully amortized or full-payout lease, whereas an operating lease is said to be partially amortized. Financial leases are often called capital leases by the accountants.

1-11

Financial lease With a financial lease, the lessee (not the lessor) is usually responsible for insurance, maintenance, and taxes. It is also important to note that a financial lease generally cannot be canceled, at least not without a significant penalty. In other words, the lessee must make the lease payments or face possible legal action.

1-12

Types of Leasing Sale and Leaseback -- The sale of an asset with the agreement to immediately lease it back for an extended period of time. ◆

The lessor realizes any residual value.

◆

There may be a tax advantage as land is not depreciable, but the entire lease payment is a deductible expense.

◆

Lessors: Lessors insurance companies, institutional investors, finance companies, and independent companies.

1-13

Types of Leasing Direct Leasing -- Under direct leasing a firm acquires the use of an asset it did not previously own. ◆

The firm often leases an asset directly from a manufacturer (e.g., IBM leases computers and Xerox leases copiers).

◆

Lessors: Lessors manufacturers, finance companies, banks, independent leasing companies, specialpurpose leasing companies, and partnerships.

1-14

Types of Leasing Leverage Leasing -- A lease arrangement in which the lessor provides an equity portion (usually 20 to 40 percent) of the leased asset’s cost and third-party lenders provide the balance of the financing. ◆ ◆ ◆ ◆ ◆

Popular for big-ticket assets such as aircraft, oil rigs, and railway equipment. Normally, there are three parties involved i.e. Lessee, Lessor & the Lender. The role of the lessor changes as the lessor is borrowing funds itself to finance the lease for the lessee (hence, leveraged lease). lease Loan is secured against the mortgage of the Asset & Lease Installments. Any residual value belongs to the lessor as well as any net cash inflows during the lease.

1-15

Accounting and Tax Treatment of Leases ◆ ◆

In the past, leases were “off-balance-sheet” items and hid the true obligations of some firms. The lessee can deduct the full lease payment in a properly structured lease. To be a “true lease” the requirements are: ◆ Lessor must have a minimum “at-risk” (inception and throughout lease) of 20% or more of the acquisition cost. ◆ The remaining life of the asset at the end of the lease period must be the longer of 1 year or 20% of original estimated asset life. ◆ An expected profit to the lessor from the lease contract apart from any tax benefits.

1-16

Accounting Treatment of Leases ◆

In November 1976, the Financial Accounting Standards Board (FASB) issued its Statement of Financial Accounting Standards No. 13 (FASB 13), “Accounting for Leases.” The basic idea of FASB 13 is that certain financial leases must be “capitalized.” Essentially, this requirement means that the present value of the lease payments must be calculated and reported along with debt and other liabilities on the right-hand side of the lessee’s balance sheet. The same amount must be shown as the capitalized value of leased assets on the left-hand side of the balance sheet.

1-17

Reporting of a Lease on the Balance Sheet. ◆

It is difficult, if not impossible, to give a precise definition of what constitutes a financial lease or an operating lease. For accounting purposes, a lease is declared to be a capital lease, and must therefore be disclosed on the balance sheet, if at least one of the following criteria is met:

1-18

Reporting of a Lease on the Balance Sheet.

1. The lease transfers ownership of the property to the lessee by the end of the term of the lease. 2. The lessee can purchase the asset at a price below fair market value (bargain purchase price option) when the lease expires. 3. The lease term is 75 percent or more of the estimated economic life of the asset. 4. 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. If one or more of the four criteria are met, the lease is a capital lease; otherwise, it is an operating lease for accounting purposes.

1-19

Should Lease be Hidden? ◆

◆

There are several alleged benefits from “hiding” financial leases. One of the advantages of keeping leases off the balance sheet has to do with fooling financial analysts, creditors, and investors. The idea is that if leases are not on the balance sheet, they will not be noticed. Financial managers who devote substantial effort to keeping leases off the balance sheet are probably wasting time. Of course, if leases are not on the balance sheet, traditional measures of financial leverage, such as the ratio of total debt to total assets, will understate the true degree of financial leverage. As a consequence, the balance sheet will appear “stronger” than it really is. But it seems unlikely that this type of manipulation would mislead many people.

1-20

◆

TAXES, THE IRS, AND LEASES

The lessee can deduct lease payments for income tax purposes if the lease is deemed to be a true lease by the Internal Revenue Service. The tax shields associated with lease payments are critical to the economic viability of a lease, so IRS guidelines are an important consideration. Essentially, the IRS requires that a lease be primarily for business purposes and not merely for purposes of tax avoidance. In broad terms, a lease that is valid from the IRS’s perspective will meet the following standards:

1-21

TAXES, THE IRS, AND LEASES 1. The term of the lease must be less than 80 percent of the economic

life of the asset. If the term is greater than this, the transaction will be regarded as a conditional sale. 2. The lease should not include an option to acquire the asset at the end of the lease term at a price below the asset’s then–fair market value. This type of bargain option would give the lessee the asset’s residual scrap value, implying an equity interest. 3. The lease should not have a schedule of payments that are very high at the start of the lease term and thereafter very low. If the lease requires early “balloon” payments, this will be considered evidence that the lease is being used to avoid taxes and not for a legitimate business purpose. The IRS may require an adjustment in the payments for tax purposes in such cases. 4. The lease must survive a profits test, meaning that the lessor must have the reasonable expectation of making a profit without considering income taxes. 5. Renewal options must be reasonable and reflect the fair market value of the asset at the time of renewal. This requirement can be met by, for example, granting the lessee the first option to meet a competing outside offer.

1-22

Economic Rationale for Leasing ◆

Leasing allows higher-income taxable companies to own equipment (lessor) and take accelerated depreciation, while a marginally profitable company (lessee) would prefer the advantages afforded by leases.

◆

Thus, leases provide a means of shifting tax benefits to companies that can fully utilize those benefits.

◆

Other non-tax issues: issues economies of scale in the purchase of assets; different estimates of asset life, salvage value, or the opportunity cost of funds; and the lessor’s expertise in equipment selection and maintenance.

1-23

“Should I Lease or Should I Buy?” Analyze cash flows and determine which alternative has the lowest (present value) cost to the firm. Example: ◆

Basket Wonders (BW) is deciding between leasing a new machine or purchasing the machine outright.

◆

The equipment, which manufactures Easter baskets, costs $74,000 and can be leased over seven years with payments being made at the beginning of each year.

1-24

“Should I Lease or Should I Buy?” ◆

The lessor calculates the lease payments based on an expected return of 11% over the seven years. (Ignore possible residual value of equipment to lessor.)

◆

The lease is a net lease. lease

◆

The firm is in the 40% marginal tax bracket.

◆

If bought, the equipment is expected to have a final salvage value of $7,500.

1-25

“Should I Lease or Should I Buy?” ◆

The purchase of the equipment will result in a depreciation schedule of 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76% for the first six years (5-year property class) based on a $74,000 depreciable base.

◆

Loan payments are based on a 12% loan with payments occurring at the beginning of each period.

1-26

Determining the PV of Cash Outflows for the Lease 0

11%

1

2

3

4

5

6

L L L L L L L This is an annuity due that equals $74,000 today. $74,000.00 = L (PVIFA 11%, 11 11% 7) (1.11) $66,666.67 = L (4.712) $14,148.27 = L ◆

The lessor will charge BW $14,148.27, $14,148.27 beginning today, for seven years until expiration of the lease contract.

1-27

Determining the PV of Cash Outflows for the Lease 0

1

2

3

4

5

6

7

L

L B

L B

L B

L B

L B

L B

B

B = Tax-shield benefit (Inflow) = $ 5,659.31 L = Lease payment (Outflow) = $ 14,148.27

Net cash outflows at t = 0:

$ 14,148.27

Net cash outflows at t = 1 to 6: $ 8,488.96 Net cash outflows at t = 7:

$ -5,659.31

1-28

Determining the PV of Cash Outflows for the Lease Comments for the previous slide: slide ◆ Since the lease payments are prepaid, the company is not able to deduct the expenses until the end of each year. ◆

The lessee, BW, BW can deduct the entire $14,148.27 as an expense each year. Thus, the net cash outflows are given as the difference between lease payments (outflow) and tax-shield benefits (inflow).

◆

The difference in risk between the lease and the purchase (using debt) is negligible and the appropriate before-tax cost is the same as debt, 12%.

1-29

Determining the PV of Cash Outflows for the Lease Calculating the Present Value of Cash Outflows for the Lease ◆

The after-tax cost of financing the lease should be equivalent to the after-tax cost of debt financing.

◆

After-tax cost = 12% ( 1 - .4 ) = 7.2%. 7.2%

◆

The discounted present value of cash outflows: $14,148.27 x (PVIF 7.2%, 1) = $13,198.01 $ 8,488.96 x (PVIFA 7.2%, 6) = 40,214.34 $ -5,659.31 x (PVIF 7.2%, 7) = -3,478.56 Present Value $ 49,933.79

1-30

Determining the PV of Cash Outflows for the Term Loan 0

12%

1

2

3

4

5

6

TL TL TL TL TL TL TL This is an annuity due that equals $74,000 today. $74,000.00 = TL (PVIFA 12%, 12 12% 7) (1.12) $66,071.43 = TL (4.564) $14,477.42 = TL ◆

BW will make loan payments of $14,477.42, $14,477.42 beginning today, for seven years until full payment of the loan.

1-31

Determining the PV of Cash Outflows for the Term Loan End of Year

Loan Payment

Loan Balance* Balance

Annual Interest

0 1 2 3 4 5 6

$14,477.42 14,477.42 14,477.42 14,477.42 14,477.42 14,477.42 14,477.43

$59,522.58 52,187.87 43,972.99 34,772.33 24,467.59 12,926.28 0

--$7,142.71 6,262.54 5,276.76 4,172.68 2,936.11 1,551.15

Loan balance is the principal amount owed at the end of each year.

1-32

Determining the PV of Cash Outflows for the Term Loan End of Year

Annual Interest

Annual Depreciation* Depreciation

0 1 2 3 4 5 6 7

--$7,142.71 6,262.54 5,276.76 4,172.68 2,936.11 1,551.15 0

$ 0 14,800.00 23,680.00 14,208.00 8,524.80 8,524.80 4,262.40 0

Tax-Shield Benefits** Benefits --$ 8,777.08 11,977.02 7,793.90 5,078.99 4,584.36 2,325.42 -3,000.00***

* Based on schedule given on Slide 21-26. ** .4 x (annual interest + annual depreciation). *** Tax due to recover salvage value, $7,500 x .4.

1-33

Determining the PV of Cash Outflows for the Term Loan End of Loan Tax-Shield Year Payment Benefit 0 1 2 3 4 5 6 7

Cash Outflow* Outflow

Present Value** Value

$14,477.42 --$14,477.42 $14,477.42 14,477.42 $ 8,777.08 5,700.34 5,317.48 14,477.42 11,977.02 2,500.40 2,175.80 14,477.42 7,793.90 6,683.52 5,425.26 14,477.42 5,078.99 9,398.43 7,116.66 14,477.42 4,584.36 9,893.06 6,988.06 14,477.43 2,325.42 12,152.01 8,007.18 - 7,500.00*** -3,000.00 - 4,500.00 - 2,765.98 * Loan payment - tax-shield benefit. ** Present value of the cash outflow discounted at 7.2%. *** Salvage value that is recovered when owned.

1-34

Determining the PV of Cash Outflows for the Term Loan ◆

◆

◆

The present value of costs for the term loan is $46,741.88. $46,741.88 The present value of the lease program is $49,933.79. $49,933.79 The least costly alternative is the term loan. loan Basket Wonders should proceed with the term loan rather than the lease. Other considerations: considerations The tax rate of the potential lessee, timing and magnitude of the cash flows, discount rate employed, and uncertainty of the salvage value and their impacts on the analysis.