1) A lease is a contractual agreement where a lessee pays a fee to a lessor to use an asset owned by the lessor. 2) There are different types of leases including operating leases, financial leases, sale-and-leaseback, leveraged leases, and capital leases. 3) When evaluating the lease versus buy decision for an asset, the key cash flows to consider are the lease payments, tax benefits of depreciation if buying, and potential debt displacement effects if leasing.

1. Leasing
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2. 9.1 Types of Leases
• The Basics
– A lease is a contractual agreement between a
lessee and lessor.
– The lessor owns the asset and for a fee allows the
lessee to use the asset.
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3. Buying versus Leasing
Buy Lease
Firm U buys asset and uses asset; Lessor buys asset, Firm U leases it.
financed by debt and equity.
Manufacturer of asset Manufacturer of asset
Firm U Lessor Lessee (Firm U)
1. Uses asset 1. Owns asset 1. Uses asset
1. Owns asset 2. Does not use asset 2. Does not own asset
Equity shareholders Creditors Equity
shareholdersz Creditors
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4. Differences leasing and borrowing
• Lease payments are fully tax-deductible, but
only the interest portion of the loan.
• The lessee does not own the asset and cannot
depreciate it for tax purposes.
• In the event of a default, the lessor cannot
force bankruptcy.
• The lessee does not obtain title to the asset at
the end of the lease (absent some additional
arrangement).
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5. Operating Leases
• Usually not fully amortized
• Usually require the lessor to maintain
and insure the asset
• Lessee enjoys a cancellation option
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6. Financial Leases
Essentially opposite of an operating lease.
1. Do not provide for maintenance or service by
the lessor.
2. Financial leases are fully amortized.
3. The lessee usually has a right to renew the lease
at expiry.
4. Generally, financial leases cannot be cancelled.
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7. Sale and Lease-Back
• A particular type of financial lease
• Occurs when a company sells an asset it
already owns to another firm and
immediately leases it from them.
• Two sets of cash flows occur:
– The lessee receives cash today from the sale.
– The lessee agrees to make periodic lease
payments, thereby retaining the use of the asset.
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8. Leveraged Leases
• A leveraged lease is another type of financial
lease.
• A three-sided arrangement between the
lessee, the lessor, and lenders:
– The lessor owns the asset and for a fee allows the
lessee to use the asset.
– The lessor borrows to partially finance the asset.
– The lenders typically use a nonrecourse loan. This
means that the lessor is not obligated to the lender in
case of a default by the lessee.
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9. Leveraged Leases
Lessor buys asset, Firm U leases it.
Lessor borrows from lender to
Manufacturer partially finance purchase
of asset
The lenders typically use a
nonrecourse loan. This
means that the lessor is not
Lessor Lessee (Firm U) obligated to the lender in
1. Owns asset 1. Uses asset case of a default by the
2. Does not use asset 2. Does not own asset
lessee.
In the event of a default by
the lessor, the lender has a
first lien on the asset. Also,
Equity the lease payments are
shareholders Creditors made directly to the lender
after a default.
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10. Capital Lease
• A lease must be capitalized if any one of the
following is met:
– 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.
– The lease transfers ownership of the property to the
lessee by the end of the term of the lease.
– The lease term is 75 percent or more of the estimated
economic life of the asset.
– The lessee can buy the asset at a bargain price at
expiry.
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11. 9.4 The Cash Flows of Leasing
Consider a firm, ClumZee Movers, that wishes to
acquire a delivery truck.
The truck is expected to reduce costs by $4,500 per
year.
The truck costs $25,000 and has a useful life of 5
years.
If the firm buys the truck, they will depreciate it
straight-line to zero.
They can lease it for 5 years from Tiger Leasing with
an annual lease payment of $6,250. 21-11

12. The Cash Flows of Leasing
• Cash Flows: Buy
Year 0 Years 1-5
Cost of truck –$25,000
After-tax savings 4,500×(1-.34) = $2,970
Depreciation Tax Shield _ 5,000×(.34) = $1,700
–$25,000 $4,670
• Cash Flows: Lease
Year 0 Years 1-5
Lease Payments –6,250×(1-.34) = –$4,125
After-tax savings 4,500×(1-.34) = $2,970
–$1,155
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13. The Cash Flows of Leasing
Cash Flows: Leasing Instead of Buying
Year 0 Years 1-5
$25,000 –$1,155 – $4,670 = –$5,825
We could also view the cash flows as buying
minus leasing, which would simply change the
signs on the cash flows.
The discount rate is the aftertax rate on the firm’s
secured debt.
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14. 9.5 A Detour on Discounting and Debt
Capacity with Corporate Taxes
• Present Value of Riskless Cash Flows
– In a world with corporate taxes, firms should discount
riskless cash flows at the aftertax riskless rate of
interest.
• Optimal Debt Level and Riskless Cash Flows
– In a world with corporate taxes, one determines the
increase in the firm’s optimal debt level by
discounting a future guaranteed aftertax inflow at the
aftertax riskless interest rate.
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15. 9.6 NPV Analysis of the Lease-vs.-Buy
Decision
• A lease payment is like the debt service
on a secured bond issued by the lessee.
• In the real world, many companies
discount both the depreciation tax
shields and the lease payments at the
aftertax interest rate on secured debt
issued by the lessee.
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16. NPV Analysis of the Lease-vs.-Buy
Decision
• There is a simple method for evaluating leases: discount
all cash flows at the aftertax interest rate on secured debt
issued by the lessee. Suppose that rate is 5 percent.
NPV Leasing Instead of Buying
Year 0 Years 1-5
$25,000 –$1,155 – $4,670 = – $5,825
CF0 $25,000 I 5
CF1 –$5,825 NPV –$219.20
F1 5
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17. NPV Analysis of the Lease-vs.-Buy
Decision
NPV Buying Instead of Leasing
Year 0 Years 1-5
– $25,000 $4,670 – $1,155 = $5,825
CF0 –$25,000 I 5
CF1 $5,825 NPV $219.20
F1 5
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18. 9.7 Debt Displacement and Lease
Valuation
• Considering the issues of debt displacement
allows for a more intuitive understanding of
the lease versus buy decision.
• Leases displace debt—this is a hidden cost of
leasing. If a firm leases, it will not use as much
regular debt as it would otherwise.
• The interest tax shield will be lost.
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19. Debt Displacement and Lease Valuation
• The debt displaced by leasing results in forgone
interest tax shields on the debt that ClumZee
movers did not take on when they leased instead of
bought the truck.
• Suppose ClumZee agrees to a lease payment of
$6,250 before tax. This payment would support a
loan of $25,219.20 (see the next slide).
• In exchange for this, they get the use of a truck
worth $25,000.
• Clearly the NPV is a negative $219.20, which agrees
with our earlier calculations. 21-19

20. Debt Displacement and Lease Valuation
Calculate the increase in debt capacity by discounting
the difference between the cash flows of the
purchase and the cash flows of the lease using the
aftertax interest rate.
After-Tax Lease Payments –6,250×(1 –.34) = –$4,125
Forgone Depreciation Tax Shield –5,000×(.34) = –$1,700
–$5,825
N I/Yr PV PMT FV
5 5 $25,219.20 –$5,825 0
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21. 21.8 Does Leasing Ever Pay: The Base
Case
• In the above example, ClumZee Movers chose to buy,
because the NPV of leasing was a negative $219.20
• Note that this is the opposite of the NPV that Tiger
Leasing would have:
• Cash Flows: Tiger Leasing
Year 0 Years 1–5
Cost of truck –$25,000
Depreciation Tax Shield 5,000×(.34) = $1,700
Lease Payments 6,250×(1-.34) = $4,125
–$25,000 $5,825
CF0 –$25,000 I 5
CF1 $5,825 F1 5 NPV $219.20 21-21

22. 9.9 Advantage and Disadvantage for
Leasing
• Advantage
– Taxes may be reduced by leasing.
– The lease contract may reduce certain types of
uncertainty.
– Transactions costs can be higher for buying an
asset and financing it with debt or equity than for
leasing the asset.
• Disadvantage
– Accounting methods of accounting for leases vs.
the financial cash flows.
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