This chapter discusses leasing, including key terminology like lessee and lessor. It explains the difference between operating and capital (financial) leases and the accounting treatment. It also covers lease cash flows, determining the net advantage to leasing versus buying, and reasons for leasing like tax benefits versus dubious reasons like hiding debt. The chapter contains an example of calculating incremental cash flows and net advantage to leasing for a equipment lease.

1. Chapter 27
Leasing
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Key Concepts and Skills
• Understand basic lease terminology
• Understand the criteria for a capital lease
vs. an operating lease
• Understand the typical incremental cash
flows to leasing
• Be able to compute the net advantage to
leasing
• Understand the good reasons for leasing
and the dubious reasons for leasing
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3. Chapter Outline
• Leases and Lease Types
• Accounting and Leasing
• Taxes, the IRS, and Leases
• The Cash Flows from Leasing
• Lease or Buy?
• A Leasing Paradox
• Reasons for Leasing
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4. Lease Terminology
• Lease – contractual agreement for use of an
asset in return for a series of payments
• Lessee – user of an asset; makes payments
• Lessor – owner of the asset; receives payments
• Direct lease – lessor is the manufacturer
• Captive finance company – subsidiaries that
lease products for the manufacturer
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5. Types of Leases
• Operating lease
– Shorter-term lease
– Lessor is responsible for insurance, taxes, and
maintenance
– Often cancelable
• Financial lease (capital lease)
– Longer-term lease
– Lessee is responsible for insurance, taxes, and
maintenance
– Generally not cancelable
– Specific capital leases
• Tax-oriented
• Leveraged
• Sale and leaseback
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6. Lease Accounting
• Leases are governed primarily by FASB 13
• Financial leases are essentially treated as
debt financing
– Present value of lease payments must be
included on the balance sheet as a liability
– Same amount shown on the asset as the
“capitalized value of leased assets”
• Operating leases are still “off-balance-
sheet” and do not have any impact on the
balance sheet itself
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7. Criteria for a Capital Lease
• If one of the following criteria is met, then
the lease is considered a capital lease and
must be shown on the balance sheet
– Lease transfers ownership by the end of the
lease term
– Lessee can purchase asset at below market
price
– Lease term is for 75 percent or more of the life
of the asset
– Present value of lease payments is at least 90
percent of the fair market value at the start of
the lease
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8. Taxes
• Lessee can deduct lease payments for income tax
purposes
– Must be used for business purposes and not to avoid
taxes
– Term of lease is less than 80 percent of the economic life
of the asset
– Should not include an option to acquire the asset at the
end of the lease at a below market price
– Lease payments should not start high and then drop
dramatically
– Must survive a profits test – lessor should earn a fair
return
– Renewal options must be reasonable and consider fair
market value at the time of the renewal
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9. Incremental Cash Flows
• Cash Flows from the Lessee’s point of
view
– After-tax lease payment (outflow)
• Lease payment*(1 – T)
– Lost depreciation tax shield (outflow)
• Depreciation * tax rate for each year
– Initial cost of machine (inflow)
• Inflow because we save the cost of purchasing the asset
now
– May have incremental maintenance, taxes, or
insurance
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10. Example: Lease Cash
Flows
• ABC, Inc. needs some new equipment. The
equipment would cost $100,000 if purchased and
would be depreciated straight-line over 5 years. No
salvage is expected. Alternatively, the company
can lease the equipment for $25,000 per year. The
marginal tax rate is 40%.
– What are the incremental cash flows?
• After-tax lease payment = 25,000(1 - .4) = 15,000 (outflow
years 1 - 5)
• Lost depreciation tax shield = (100,000/5)*.4 = 8,000
(outflow years 1 – 5)
• Cost of machine = 100,000 (inflow year 0)
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11. Lease or Buy?
• The company needs to determine whether
it is better off borrowing the money and
buying the asset, or leasing
• Compute the NPV of the incremental cash
flows
• Appropriate discount rate is the after-tax
cost of debt since a lease is essentially the
same risk as a company’s debt
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12. Net Advantage to Leasing
• The net advantage to leasing (NAL) is the
same thing as the NPV of the incremental
cash flows
– If NAL > 0, the firm should lease
– If NAL < 0, the firm should buy
• Consider the previous example. Assume
the firm’s cost of debt is 10%.
– After-tax cost of debt = 10(1 - .4) = 6%
– NAL = $3,116
• Should the firm buy or lease?
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13. Work the Web Example
• Many people must choose between buying and
leasing a car
• Click on the web surfer to go to Kiplinger’s
– Go to Tools & Calculators: Cars
– Do the calculations for a $30,000 car, 5-year loan at 7%
with monthly payments, and a $3,000 down payment.
The available lease is for 3 years and requires a $550
per month payment with a $1,000 security deposit and
$1,000 other upfront costs.
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14. Good Reasons for Leasing
• Taxes may be reduced
• May reduce some uncertainty
• May have lower transaction costs
• May require fewer restrictive
covenants
• May encumber fewer assets than
secured borrowing
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15. Dubious Reasons for
Leasing
• Balance sheet, especially leverage ratios, may
look better if the lease does not have to be
accounted for on the balance sheet
• 100% financing – except that leases normally do
require either a down-payment or security deposit
• Low cost – some may try to compare the “implied”
rate of interest to other market rates, but this is
not directly comparable
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16. Quick Quiz
• What is the difference between a lessee and a
lessor?
• What is the difference between an operating
lease and a capital lease?
• What are the requirements for a lease to be tax
deductible?
• What are typical incremental cash flows, and how
do you determine the net advantage to leasing?
• What are some good reasons for leasing?
• What are some dubious reasons for leasing?
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17. Ethics Issues
• Suppose a manager chooses to lease an
asset (operating lease) rather than buy,
simply to keep the asset off-balance sheet
and thereby avoid reporting the liability?
– Although this may be legal, is there any ethical
implication?
– Are investors able to effectively monitor and
analyze such activity?
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18. Comprehensive Problem
• What is the net advantage to leasing for
the following project, and what decision
should be made?
– Equipment would cost $250,000 if purchased
– It would be depreciated straight-line to zero
salvage over 5 years.
– Alternatively, it may be leased for $65,000/yr.
– The firm’s after-tax cost of debt is 6%, and its
tax rate is 40%
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19. End of Chapter
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