Fundamentals of Corporate Finance/3e,ch24


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Fundamentals of Corporate Finance/3e,ch24

  1. 1. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-1Chapter Twenty-fourLeasing
  2. 2. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-224.1 The Nature of Leases24.2 Types of Leases24.3 A Brief Look at Accounting for Leases24.4 Taxation and Leases24.5 An Evaluation of Leasing24.6 The Role of the Residual Value24.7 Setting Lease Premiums24.8 Alleged Advantages and Disadvantages ofLeasing24.9 Summary and ConclusionsChapter Organisation
  3. 3. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-3Chapter Objectives• Understand the characteristics of the differenttypes of leases.• Explain how leases are recorded in a firm’saccounting records.• Identify the tax implications of leases.• Evaluate a lease by calculating the net advantageof leasing (NAL).• Explain the calculation of lease premiums.• Discuss the advantages and disadvantages ofleases.
  4. 4. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-4Leasing versus BuyingManufacturerof assetManufacturerof assetSass arrangesfinancing and buysasset frommanufacturerSass1. Uses asset2. Owns assetLessor1. Owns asset2. Does not use assetLessee (Sass)1. Uses asset2. Does notown assetSass buys asset and uses asset;financing raised by debtSass leases asset from lessor; thelessor owns the assetSass leases assetfrom lessorLeaseBuy
  5. 5. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-5Leasing• What is a lease?– A lessee (user) enters an agreement in which they makelease payments to the lessor (owner) in return for the useof the leased property/asset.• Who are the major providers of lease finance inAustralia?– Finance companies and banks.• What assets are leased?– Any asset including photocopiers, cars, constructionequipment, computers, shop/office fittings and equipment.
  6. 6. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-6Types of Leases• Operating lease• Financial lease– Sale and leaseback agreement– Leveraged lease
  7. 7. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-7Operating Leases• Short-term lease.• Cancellable prior to the expiry date at little or nocost.• Lessor is responsible for maintenance and upkeepof asset.• The sum of the lease payments does not providefor full recovery of the asset’s costs.• Includes telephones, televisions, computers,photocopiers, cars.
  8. 8. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-8Financial Leases• Long-term lease.• Non-cancellable (without penalty) prior to expirydate.• Lessee is responsible for the maintenance andupkeep of the asset.• Lease period approximates asset’s economic life.• The sum of the lease payments exceeds theasset’s purchase price.• Includes specialist equipment, heavy industrialequipment.
  9. 9. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-9Residual Value Clause• Lease continues for its full termLessee can purchase the asset for its residualvalue, return the asset to the lessor (paying anyshortfall from residual value) or renew the lease.• Lease is cancelled during its initial termLessee must pay outstanding premiums (lessinterest component) plus residual value of asset.
  10. 10. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-10Types of Financial Leases• Sale and leaseback agreementsCompanies sell an asset to another firm andimmediately lease it back. Enables the company toreceive cash and yet maintain use of the asset.• Leveraged leasesThe lessor arranges for funds to be contributed byone or more parties—form of risk-sharing andtransferring tax benefits. Often used to financelarge-scale projects.
  11. 11. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-11A. Statement of Financial Position with Purchase (company finances $100 000 truck with debt)Truck $100 000 Debt $100 000Other assets 100 000 Equity 100 000Total assets $200 000 Debt plus equity $200 000B. Statement of Financial Position with Operating Lease (co. finances truck with an operatinglease)Truck $ 0 Debt $ 0Other assets 100 000 Equity 100 000Total assets $100 000 Debt plus equity $100 000C. Statement of Financial Position with Financial Lease (co. finances truck with a financial lease)Assets under financial Obligations underlease $100 000 financial lease $100 000Other assets 100 000 Equity 100 000Total assets $200 000 Debt plus equity $200 000Leasing and the Statement ofFinancial Position
  12. 12. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-12Criteria for a Financial Lease• AAS17 ‘Accounting for Leases’ states that afinancial lease occurs where substantially all risksand benefits pass to the lessee.• A financial lease must be disclosed on theStatement of Financial Position if at least one ofthe following criteria is met:– the lease term is 75 per cent or more of the estimatedeconomic life of the asset– the present value of the lease payments is at least 90 percent of the fair market value of the asset at the start of thelease.
  13. 13. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-13Leasing and Taxation• Lease premiums paid under a lease contract aretax deductible.• Any payment relating to the ultimate purchase ofthe asset is not deductible.• The residual payment does not qualify as a taxdeduction.• Any profit made on the asset previously leased issubject to capital gains tax.
  14. 14. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-14Example—Lease versus BuyMacca Co. has to decide whether to borrow the$15 000 needed to purchase a new gadgetmachine (with a borrowing cost of 10 per cent) orto lease the machine for $4000 per annum. Ifpurchased, the asset could be depreciated usingthe straight-line method over the three-year life.The company tax rate is 30 per cent.Under the lease agreement, Macca Co. would beresponsible for maintaining the machine.
  15. 15. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-15Example—Lease versus Buy:Repayment Schedule( )[ ]6032$100/101/1-1/00015Repayment3== ..
  16. 16. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-16Example—Lease versus Buy:Tax Subsidises Borrowing
  17. 17. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-17Example—Lease versus Buy:Tax Subsidises Leasing
  18. 18. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-18Example—Lease versus Buy:Net Advantage of Leasing( )[ ] ( )514$35052$538$1-052$5-522$4-984$2costyOpportunit-savingsNet taxNAL052)($5000$15-2.4869000$4costBorrowing-paymentsleaseofPVcostyOpportunit=+====×==The advantage is greater than zero so Macca Co.should lease.
  19. 19. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-19Residual Value• The residual value is the amount for which theasset may be purchased by the lessee from thelessor at the end of the lease term.• The salvage value is the amount the asset can besold for in the market place by the lessee (oncethey have acquired the asset).• In the previous example, assume a residual valueof $2000 and a salvage value of $1500.
  20. 20. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-20Example—Lease the Asset withResidual Value
  21. 21. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-21Example—Borrow to Purchase theAsset with Residual Value
  22. 22. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-22Net Advantage of Leasing( ) ( )( ) ( )576$2550$3-$974costyOpportunit-savingsNet taxNAL550)($3000$15-1.10/000$22.4869000$4costBorrowing-valueresidualPVpay.leasePVcostOpp3====+×=+=
  23. 23. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-23Setting Lease PremiumsLease premiums are paid in advance in Australia.( )payments1-tforfactorannuityPV1valueresidualPV-eAsset valuadvanceinpremiumLease+=
  24. 24. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-24Example—Lease PremiumsKAZ Co. has started a four-year lease of a photocopier whichhas a $70 000 purchase price. Had the company purchasedthe copier, the interest rate quoted on borrowings was 1.5 percent per month. KAZ has agreed with the lessor to a residualvalue of $10 000 at the end of four years.What will be the amount of the lease premiums?
  25. 25. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-25Solution—Lease Premiums( )( )( )( )[ ]( )221884$5532331106650150015111101510001000070payments1forfactorannuityPV1valueresidualPVeAsset valupremiumLease4748../././-.--t-=+=+=+=−
  26. 26. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-26Advantages of Financial Leases• No restrictions on future borrowing.• Can be tailored to suit firm’s needs.• Eliminates the need to raise extra capital.• No unnecessary financial outlay.• May be excluded from the Statement of FinancialPosition.• Facilitates financing capital additions on apiecemeal basis.• Is an allowable cost under government contracting.• Offers tax advantages.
  27. 27. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-27Advantages of Operating Leases• Frees up capital for alternative uses.• Increases the company’s working capital.• Provides greater control due to greater certainty infuture outlays.• Assures more competent upkeep of asset.• Avoids the risk of obsolescence.• Avoids the equipment disposal problem.• Future outlays cost less in real terms due toinflation.
  28. 28. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-28Disadvantages of Leasing• Interest cost often higher.• May not offer the right to the residual value of theasset.• Allows the acquisition of assets without submittingformal capital expenditure procedures.• May cause distortions in the evaluation of interfirmand interdivision performance.• Lacks the prestige associated with ownership.
  29. 29. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-29Good Reasons for Leasing• Taxes may be reduced by leasing.• The lease contract may reduce certain types ofuncertainty that might otherwise decrease thevalue of the firm.• Leasing reduces the impact of obsolescence of anasset on a firm.• Transaction costs may be lower for a leasecontract than for buying the asset.• Leasing may require fewer (if any) restrictivecovenants than secured borrowing.
  30. 30. Copyright  2004 McGraw-Hill AustraliaPty Ltd24-30Bad Reasons for Leasing• The perception of 100 per cent financing.• The apparent low cost.• Using leasing to artificially enhance accountingincome.