Lease financing FN 744 (Elimring Moshi) +2557-14112-062


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Lease financing FN 744 (Elimring Moshi) +2557-14112-062

  1. 1. 1CHAPTER 19Lease Financing
  2. 2. 2Who are the two parties toa lease transaction?□ The lessee, who uses the asset andmakes the lease, or rental, payments.□ The lessor, who owns the asset andreceives the rental payments.□ Note that the lease decision is afinancing decision for the lessee andan investment decision for the lessor.
  3. 3. 3What are the five primarylease types?□ Operating lease□ Short-term and normally cancelable□ Maintenance usually included□ Financial lease (Capital Lease)□ Long-term and normally noncancelable□ Maintenance usually not included□ Sale and leaseback□ Combination lease□ "Synthetic" lease
  4. 4. 4How are leases treated for taxpurposes?□ Leases are classified by the IRS aseither guideline or nonguideline.□ For a guideline lease, the entire leasepayment is deductible to the lessee.□ For a nonguideline lease, only theimputed interest payment isdeductible.□ Why should the IRS be concernedabout lease provisions?
  5. 5. 5How does leasing affect afirm’s balance sheet?□ For accounting purposes, leases areclassified as either capital oroperating.□ Capital leases must be shown directlyon the lessee’s balance sheet.□ Operating leases, sometimes referredto as off-balance sheet financing,must be disclosed in the footnotes.□ Why are these rules in place?
  6. 6. 6What impact does leasing haveon a firm’s capital structure?□ Leasing is a substitute for debt.□ As such, leasing uses up a firm’s debtcapacity.□ Assume a firm has a 50/50 targetcapital structure. Half of its assets areleased. How should the remainingassets be financed?
  7. 7. 7Assume that Lewis Securities plansto acquire some new equipment having a6-year useful life.□ If the equipment is leased:□ Firm could obtain a 4-year lease whichincludes maintenance.□ Lease meets IRS guidelines to expenselease payments.□ Rental payment would be $260,000 at thebeginning of each year.
  8. 8. 8Other Information for Lease□ Equipment cost: $1,000,000.□ Loan rate on equipment = 10%.□ Marginal tax rate = 40%.□ 3-year MACRS life.□ If company borrows and buys, 4 yearmaintenance contract costs $20,000at beginning of each year.□ Residual value at t = 4: $200,000.
  9. 9. 9Time Line: After-Tax Cost ofOwning (In Thousands)0 1 2 3 4AT loan pmt -60 -60 -60 -1,060Dep Shld 132 180 60 28Maint -20 -20 -20 -20Tax sav 8 8 8 8RV 200Tax -80NCF -12 60 108 -12 -912
  10. 10. 10□ Note the depreciation shield in eachyear equals the depreciation expensetimes the lessee’s tax rate. For Year 1,the depreciation shield is$330,000(0.40) = $132,000.□ The present value of the cost ofowning cash flows, when discountedat 6%, is-$591,741.
  11. 11. 11Why use 6% as the discountrate?□ Leasing is similar to debt financing.□ The cash flows have relatively low risk;most are fixed by contract.□ Therefore, the firm’s 10% cost of debt is agood candidate.□ The tax shield of interest paymentsmust be recognized, so the discountrate is:10%(1 - T) = 10%(1 - 0.4) = 6.0%.
  12. 12. 12Time Line: After-Tax Cost ofLeasing (In Thousands)PV cost of leasing @ 6% = -$572,990.0 1 2 3 4Lease pmt -260 -260 -260 -260Tax sav 104 104 104 104NCF -156 -156 -156 -156
  13. 13. 13What is the net advantage toleasing (NAL)?□ NAL = PV cost of leasing - PV cost ofowning= - $572,990 - (-$591,741)= $18,751.□ Should the firm lease or buy theequipment? Why?
  14. 14. 14□ Note that we have assumed thecompany will not continue to use theasset after the lease expires; that is,project life is the same as the term ofthe lease.□ What changes to the analysis wouldbe required if the lessee planned tocontinue using the equipment afterthe lease expired? more…
  15. 15. 15If the equipment is purchased at theend of the lease for its residual value,$200,000 this $200,000 will bedepreciated with the same scheduleas if it were purchased new—3 yearsMACRS. This gives an outflow of$200,000 at the end of the lease andthen 4 years of depreciation taxsavings.
  16. 16. 16Assume the RV could be $0 or $400,000, with anexpected value of $200,000. How could this risk bereflected?□ The discount rate applied to theresidual value inflow (a positive CF)should be increased to account forthe increased risk.□ All other cash flows should bediscounted at the original 6% rate.(More...)
  17. 17. 17□ If the residual value were included asan outflow (a negative CF) in the costof leasing cash flows, the increased riskwould be reflected by applying alower discount rate to the residualvalue cash flow.□ Again, all other cash flows haverelatively low risk, and hence would bediscounted at the 6% rate.
  18. 18. 18Effect of Increased Residual ValueUncertainty□ The lessor owns the equipment whenthe lease expires.□ Therefore, residual value risk is passedfrom the lessee to the lessor.□ Increased residual value risk makes thelease more attractive to the lessee.
  19. 19. 19How should the lessor analyzethe lease transaction?□ To the lessor, writing the lease is aninvestment.□ Therefore, the lessor must compare thereturn on the lease investment with thereturn available on alternativeinvestments of similar risk.
  20. 20. 20Assume the following data forConsolidated Leasing, the lessor:□ $280,000 rental payment instead of$260,000.□ All other data are the same as for thelessee.
  21. 21. 21Time Line: Lessor’s Analysis (InThousands)0 1 2 3 4Cost -1,000Dep Shld 132 180 60 28Maint -20 -20 -20 -20Tax sav 8 8 8 8Lse pmt 280 280 280 280Tax -112 -112 -112 -112RV 200RV tax -80NCF -844 288 336 216 148
  22. 22. 22□ The NPV of the net cash flows, whendiscounted at 6%, is $25,325.□ The IRR is 7.46%.□ Should the lessor write the lease?Why?
  23. 23. 23Find the lessor’s NPV if thelease payment were $260,000.□ With lease payments of $260,000, thelessor’s cash flows would be equal, butopposite in sign, to the lessee’s NAL.□ Thus, lessor’s NPV = -$18,751.□ If all inputs are symmetrical, leasing is azero-sum game.□ What are the implications?
  24. 24. 24What impact would a cancellation clause have onthe lease’s riskiness from the lessee’s standpoint?From the lessor’s standpoint?□ A cancellation clause would lower therisk of the lease to the lessee but raisethe lessor’s risk.□ To account for this, the lessor wouldincrease the annual lease payment orelse impose a penalty for earlycancellation.
  25. 25. 25Other Issues in Lease Analysis□ Do higher residual values make leasingless attractive to the lessee?□ Is lease financing more available or“better” than debt financing?□ Is the lease analysis presented hereapplicable to real estate leases? Toauto leases?(More...)
  26. 26. 26□ Would spreadsheet models be usefulin lease analyses?□ What impact do tax laws have on theattractiveness of leasing? Considerthe following provisions:□ Investment tax credit (when available)□ Tax rate differentials between the lesseeand the lessor□ Alternative minimum tax (AMT)
  27. 27. 27Numerical analyses often indicate that owning isless costly than leasing. Why, then, is leasing sopopular?□ Provision of maintenance services.□ Risk reduction for the lessee.□ Project life□ Residual value□ Operating risk□ Portfolio risk reduction enables lessor tobetter bear these risks.