Leasing and its uses

1. Leasing

2. Leasing
• 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.
• Direct Lease – Lessor is an independent company how buys the asset
from the manufacturer and then leases
• Sales- type Lease- Manufacturer is the lessor

3. Buy vs Lease

4. Operating Leases
• Usually not fully amortized
• Have a life that is less than the economic life of the asset
• Usually require the lessor to maintain and insure the asset
• Can often be canceled by the lessee before the expiration date

5. 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 canceled

6. Sale and Leaseback
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.

7. Leveraged Lease
A leveraged lease is another type of financial lease.
A three-sided arrangement among 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.

8. Leveraged Lease
Lessor buys asset,
Firm U leases it. Lessor borrows from lender to
partially finance purchase
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.
In the event of a default by the lessor,
the lender has a first lien on the asset.
Also, the lease payments are made
directly to the lender after a default.

9. Accounting and Leasing
In the old days, leases led to off-balance sheet financing.
Today, leases are either classified as capital leases or operating
leases.
• Operating leases do not appear on the balance sheet.
• Capital leases appear on the balance sheet—the present value
of the lease payments appears on both sides.

10. Capital Lease in Balance Sheets

11. 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.

12. Taxes, the IRS, and Leases
• The principal benefit of long-term leasing is tax reduction.
• Leasing allows the transfer of tax benefits from those who need
equipment but cannot take full advantage of the tax benefits of
ownership to a party who can.
• Naturally, the IRS seeks to limit this, especially if the lease
appears to be set up solely to avoid taxes.

13. Taxes, the IRS, and Leases
The lessee can deduct lease payments if the lease is qualified by the
IRS.
1. The term of the lease must be less than 30 years.
2. There can be no bargain purchase option.
3. The lease should not have a schedule of payments that is very
high at the start of the lease and low thereafter.
4. The lease payments must provide the lessor with a fair market rate
of return.
5. The lease should not limit the lessee’s right to issue debt or pay
dividends.
6. Renewal options must be reasonable and reflect fair market value
of the asset.

14. The Cash Flows of Leasing
Consider the decision confronting the Wadia company, which manufactures pipe. Business
has been expanding, and Wadia currently has a five year backlog of pipe orders for the
Barauni Malda Pipeline.
The international Boring Machine Company (IBMC) makes a pipe-boring machine that can
be purchased for INR 10000. Wadia has determined that it needs a new machine, and the
IBMC model will save Wadia INR 6000 per year in reduced electricity bills for the next five
years. These savings are known with certainty because Wadia has a long term electricity
purchase agreement with State Power Distribution Firms.
Wadia has a corporate tax rate of 34 percent. We assume that five-year straight line
depreciation is used for the pipe boring machine, and the machine is worthless after five
years.
However, Falguni Leasing Corporation has offered to lease the same pipe boring machine
to Wadia for INR 2500 per year for 5 years. With the lease, Wadia would remain responsible
for maintenance, insurance and operating expenses.
Analyze the incremental cashflows and suggest the best option.

15. The Cash Flows of Leasing - I
Cash Flows: Buy
Year 0 Years 1-5
Cost of truck −10,000
Aftertax savings 6,000 × (1 − .34) = 3,960
Depreciation tax benefit _______ 2,000 × (.34) = 680
−10,000 4,640
Cash Flows: Lease
Year 0 Years 1-5
Lease payments −2,500 × (1−.34) = −1,650
Aftertax savings 6,000 × (1−.34) = 3,960
2,310

16. The Cash Flows of Leasing - II
Cash Flows: Leasing Instead of Buying
Year 0 Years 1–5
10,000 −1,650 − 680 = −2,330
We could also view the cash flows as buying minus
leasing, which would simply change the signs on the
cash flows.
Year 0 Years 1–5
-10,000 1,650 + 680 = 2,330

17. A Detour for 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.

18. NPV Analysis of the Lease-versus-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 benefits and the lease payments at the aftertax interest rate
on secured debt issued by the lessee.

19. NPV Analysis of the Lease-versus-Buy
Decision - I
• 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
10,000 −1,650 − 680 = −2,330
NPV = 10000 - 2330*PVIA(0.05,5) = -87.68
Because the net present value of the incremental cashflows
from leasing relative to buying is negative, Wadia prefers to
buy.

20. 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.

21. Optimal Debt Level
• Cashflows of Buying instead of Leasing
• Increase in Optimal level of debt occurs in year 0 because the firm
learns that the guaranteed cashflows are coming from Year 1.
• The increase in debt level is the discounted value of future riskless
cashflows
2330
1.05
+
2330
1.052 +
2330
1.053+
2330
1.054 +
2330
1.055 = 10,087.68
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Net CFs from Buying instead of Leasing -10,000 2,330 2,330 2,330 2,330 2,330

22. Calculation of Optimal debt level if wadia
purchases instead of leases
year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Outstanding balance of Loan 10,087.68 8,262.06 6,345.16 4,332.42 2,219.03 -0.01
Interest 764.2124 625.9089 480.6903 328.2108 168.1074
tax deduction on interest 259.8322 212.809 163.4347 111.5917 57.15652
After tax interest expense 504.3802 413.0999 317.2556 216.6191 110.9509
extra cash that buying firm generates over leasing firm
2330 2330 2330 2330 2330
Repayment of Loan 1,825.62 1,916.90 2,012.74 2,113.38 2,219.05

23. Does Leasing Ever Pay?
• We previously looked at the lease-buy decision in the point of lessee,
Wadia.
• Lets look at the decision in the point of Lessor, Falguni Leasing
year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Cost for Machine -10000
Depreciation ax Benefit 680 680 680 680 680
After tax Lease Payments 1650 1650 1650 1650 1650
Total -10000 2330 2330 2330 2330 2330
NPV = -10000 + 2330*PVIA(0.05,5) = 87.68
The value is exactly opposite of the NPV of Wadia

24. NPV of Wadia and Falguni
• NPV of Wadia is -87.68 and NPV of Falguni is 87.68
• As long as both the parties are subjected to (i) same interest and tax
rates and (ii) no transaction costs , there can be no leasing deal that
benefits both parties.
• However, there is a lease payment for which both parties will
calculate an NPV of Zero.
• Given that Wadia would be indifferent to Leasing or buying and
Falguni would be indifferent to leasing or not leasing.

25. Reasons for Leasing
Good Reasons
• 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.
Bad Reasons
• Accounting
• One hundred percent financing

26. Tax Arbitrage
• Assume, if Wadia pays no taxes and the lease payments are
decreased to 2475 from 2500, then the value of lease to wadia is
• NPV=10000- 2475 * PVIA( 7.575%,5)= 6.55
year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Cost for Machine 10000
Lease payment -2475 -2475 -2475 -2475 -2475

27. NPV of Falguni
• Assume, lease payments are decreased to 2475 from 2500, Falguni
still pay the tax of 34% and the interest arte is 9%
• Cashflows to Falguni are
• The value of Lease to Falguni is NPV= -10,000+2313.50 * PVIAF(5%,5)= 16.24
• As a consequence of different tax rate both Lessor (Falguni) and Lesse (Wadia) gains i.e.,
has positive NPV.
year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Cost for Machine -10000
Depreciation ax Benefit 680 680 680 680 680
After tax Lease Payments 1633.5 1633.5 1633.5 1633.5 1633.5
Total -10000 2313.5 2313.5 2313.5 2313.5 2313.5

28. Reservation payment for Lessee
• It is the payment that make the value of Lease zero i.e., NPV=0
• This implies that the value of the Lease= 10,000-Lmax*PVIA( 7.5755%,5)
• The Value of the lease is equal to zero when
Lmax= 10,000/PVIA( 7.5755%,5)= 2476.62
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Cost for Machine 10000
Lease payment -Lmax -Lmax -Lmax -Lmax -Lmax

29. Reservation payment for Lessor
• Similarly, Lmin is the payment that makes the value of the lease to the
lessor zero
• This implies that
Value of the Lease= -10,000+ 680 * PVIA (5%,5) + 0.66*Lmin*PVIA( 5%,5)
• The Value of the lease is equal to zero when
Lmin= {10,000/0.66*PVIA( 5%,5)}- {680/0.66}= 2469.32
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Cost for Machine -10000
Depreciation tax Benefit 680 680 680 680 680
After tax Lease Payments 0.66*Lmin 0.66*Lmin 0.66*Lmin 0.66*Lmin 0.66*Lmin

30. Example
• Wolfson Corporation has decided to purchase a new machine that costs
$3.2 million. The machine will be depreciated on a straight-line basis and
will be worthless after four years. The corporate tax rate is 35 percent. The
Sur Bank has offered Wolfson a four-year loan for $3.2 million. The
repayment schedule is four-yearly principal repayments of $800,000 and
an interest charge of 9 percent on the outstanding balance of the loan at
the beginning of each year. Both principal repayments and interest are
due at the end of each year. Cal Leasing Corporation offers to lease the
same machine to Wolfson. Lease payments of $950,000 per year are due
at the beginning of each of the four years of the lease.
• 1) Should Wolfson lease the machine or buy it with bank financing?
• 2) What is the annual lease payment that will make Wolfson indifferent to
whether it leases the machine or purchases it?