ACF 302: Week 6

Leasing
Berk and DeMarzo Chapter 25

Lecture

1
 2

25.1 The Basics of Leasing

I OWN the I have the
equipment right to USE
the
equipment.

Lease

Lessor Lessee
25.1 The Basics of Leasing 3

• Lessee
• The party in a lease liable for periodic payments in
exchange for the right to use the asset
• Lessor
• The party in a lease who is entitled to the lease payments
in exchange for lending the asset

• Most leases involve little or no upfront payment.

• The lessee commits to make regular lease payments for the
term of the contract.
• At the end of the contract term, the lease specifies who will
retain ownership of the asset and at what terms.
 4

Why Leasing?
• Leasing is an important and widely used financing
solution.
• It allows companies to access and use property and
equipment without incurring large cash outflows at
the start.
• It also provides flexibility and enables lessees to
address the issue of obsolescence and residual
value risk.
• Sometimes, leasing is the only way to obtain the
use of a physical asset that is not available for
purchase.
 5

Examples of Lease Transactions (1 of 4)

• Sales-Type Lease
• A type of lease in which the lessor is the manufacturer
(or primary dealer) of the asset.

• Direct Lease
• A type of lease in which the lessor is not the
manufacturer but is often an independent company that
specializes in purchasing assets and leasing them to
customers.
 6

Examples of Lease Transactions (2 of 4)

• Sale and Lease-Back
• Describes a type of lease in which a firm already owns
an asset it would prefer to lease.
• The firm receives cash from the sale of the asset and
then makes lease payments to retain the use of the
asset.
 7

Examples of Lease Transactions (3 of 4)

• Leveraged Leases
• A lease in which the lessor borrows from a bank or other
lender to obtain the initial capital to purchase an asset,
using the lease payments to pay interest and principal
on the loan.
 8

Examples of Lease Transactions (4 of 4)

• Special-Purpose Entity (SPE)
• A separate business partnership created by a lessee for
the sole purpose of obtaining a lease.
• Synthetic Lease
• A lease commonly uses a SPE and is designed to obtain
specific accounting and tax treatments.
 9

Lease Payments and Residual Values (1 of 4)

• Residual Value
• An asset’s market value at the end of a lease.
• The cost of a lease will depend on the asset’s residual value.
 10

Lease Payments and Residual Values (2 of 4)

• Assume your business needs a new $20,000 forklift
and you are considering leasing the forklift for four
years.
• The estimated residual value of the forklift in four years
is $6000.
 Lease Payments and Residual Values (3 of 4)
• If lease payments of amount L are made monthly, then the
lessor’s cash flows from the transaction are as follows:

– Note that lease payments are typically made at the beginning of

each payment period.

11
 12

Lease Payments and Residual Values (4 of 4)

• How much should be the cost of leasing?

• In a perfect market, the cost of leasing is equivalent to

the cost of purchasing and reselling the asset.

• Purchase Price = PV(Lease Payments) + PV(Residual Value)

→
PV (Lease Payments) = Purchase Price − PV (Residual Value)
 13

Textbook Example 25.1 (1 of 3)

Lease Terms in a Perfect Market
Problem
Suppose the purchase price of the forklift is $20,000,
its residual value in four years is certain to be $6000,
and there is no risk that the lessee will default on the
lease. If the risk-free interest rate is a 6% APR with
monthly compounding, what would be the monthly
lease payment for a four-year lease in a perfect
capital market?
 14

Textbook Example 25.1 (2 of 3)

Solution
T = 48 months (4 years)

Because all cash flows are risk free, we can discount them using the risk-free
interest rate of r = 6%/12 = 0.5%

PV(Lease Payments) = Purchase Price - PV(Residual Value)

PV(Lease Payments) = 20000 -6000/(1+0.005)48 = 15277.41

What monthly lease payment L has this present value? We can

interpret the lease payments as an annuity. Because the first lease
payment starts today, we can view the lease as an initial payment of L
plus a 47-month annuity of L. Thus, we need the annuity formula!
 Textbook Example 25.1 (3 of 3)
1 1
𝑃𝑉 𝐿𝑒𝑎𝑠𝑒 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 = 𝐿 + 𝐿 × 1 − 𝑡−1
𝑟 1+𝑟

1 1
PV(Lease Payments) = L × 1 + 𝑟 1 − 1+𝑟 𝑡−1

Solving for L, we get

15,277.41
L= = $357.01per month
1  1 
1+ −
0.005  1.00547 
1

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 16

Leases Versus Loans (1 of 3)

• As an alternative, you could obtain a four-year loan
for the purchase price and buy the forklift outright. If
M is the monthly payment for a fully amortizing loan,
the lender’s cash flows will be as follows:
 17

Leases Versus Loans (2 of 3)

• If the loan is fairly priced, the loan payments would be such that

PV (Loan Payments) = Purchase Price

• With a standard loan, the entire cost of the asset

is financed.
• With a lease, only the cost of the economic depreciation of the
asset during the term of the lease is financed.
• This causes the loan payments to be higher than the
lease payments.
 18

Textbook Example 25.2 (1 of 2)

Loan Payments in a Perfect Market
Problem
Suppose that you purchase the forklift for $20,000 by
borrowing the purchase price using a four year annuity
loan.
What would the monthly loan payment be in a perfect
capital market where the risk-free interest rate is a 6%
APR with monthly compounding, assuming no risk of
default?
How does this compare with the lease payment of
Example 25.1?
 19

Textbook Example 25.2 (2 of 2)

Solution
Because all cash flows are risk free, we can discount them using the risk-free
interest rate of 6%/12 = 0.5% per month.
Because loan payments are made at the end of each month, using the
annuity formula to value the loan payments, Eq. 25.2 becomes

1  1 
M  1 −  = 20,000
0.005  1.00548 

Solving for M gives the loan payments of 469.7 per month

Of course, while the lease payments are lower, with the lease, we have the use
of the forklift for four years only. With the loan, we own the forklift for its
entire lifetime.
 20

Pay attention! (1 of 2)
• Lease payments are made at the beginning of each period

• Loan payments are made at the END of the month

• This changes the annuity formula!

 21

Pay attention! (2 of 2)
• Lease (L) payments are made at the beginning of each period

1 1
𝑃𝑉 𝐿𝐸𝐴𝑆𝐸 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 = 𝐿 + 𝐿 × 1 − 𝑡−1
𝑟 1+𝑟

• Loan (M) payments are made at the END of the month

1 1
𝑃𝑉 𝐿𝑂𝐴𝑁 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 = 𝑀 × 1 − 𝑡
𝑟 1+𝑟
 22

Leases Versus Loans (3 of 3)

• By the Law of One Price, in a perfect market, the cost of
leasing and then purchasing the residual value of the
asset is equivalent to the cost of borrowing to purchase
the asset.

PV (Lease Payments) + PV (Residual Value) = PV (Loan Payments)

 23

End-of-Term Lease Options (1 of 4)

• So far we have assumed that the asset is returned
at the end of the Lease. But there are 4 other
alternatives:

• 1) Fair Market Value (FMV) Lease

• A type of lease that gives the lessee the option to
purchase the asset at its fair market value at the
termination of the lease
• With perfect capital markets, there is no difference
between an FMV lease and a lease in which the
assets are retained by the lessor.
 24

End-of-Term Lease Options (2 of 4)

• 2) $1 Out Lease
• A type of lease in which ownership of the asset transfers
to the lessee at the end of the lease for a nominal cost
of $1
• Because the lessee has effectively purchased the asset
by making the lease payments, this type of lease is in
many ways equivalent to financing the asset with a
standard loan.
• Also known as Finance Lease
 25

End-of-Term Lease Options (3 of 4)

• 3 ) Fixed Price Lease
• A type of lease in which the lessee has the option to
purchase the asset at the end of the lease for a fixed
price that is set upfront in the lease contract
• This type of lease is very common for consumer
leases.
• Because the lessee has an option to purchase, the
lessor will set a higher lease rate to compensate for
the value of this option.
 26

End-of-Term Lease Options (4 of 4)

• 4) Fair Market Value Cap Lease
• A type of lease in which the lessee can purchase the
asset at the minimum of its fair market value and a fixed
price or “cap”
• Similar to a fixed price lease, although the option is
easier to exercise because the lessee does not have
to find a similar asset elsewhere to buy when the
fixed price exceeds the market value
 27

Textbook Example 25.3 (1 of 3)

Lease Payments and End-of-Lease Options
Problem
Compute the lease payments for the forklift lease of
Example 25.1 if the lease is (a) a fair market value
lease, (b) a $1.00 out lease, or (c) a fixed price lease
that allows the lessee to buy the asset at the end of
the lease for $4000 (this is an OPTION!).
 Textbook Example 25.3 (2 of 3)
Solution
a) With the FMV lease, the lessee can buy the forklift for its fair market value of $6000
at the end of the lease. The lessor obtains a residual value of $6000, either from the
forklift itself or from the payment from the lessee. Thus, the lease payments will be
unchanged from Example 25.1, or $357 per month.
B ) With the $1.00 out lease, the lessor receives essentially no residual value. Thus, the
lease payments themselves will have to compensate the lessor for the full $20,000
purchase price. The lease payments are therefore
20000
𝐿= 1 1 =467.36
1+0.005 1−
1.00547

These payments are slightly less than the loan payments of $470 per month
calculated in Example 25.2 because the lease payments occur at the beginning-rather
than the end-of the month.

28
 29

Textbook Example 25.3 (3 of 3)

c) With the fixed price lease, because the forklift will be worth $6000
for certain, the lessee will exercise the option to purchase it for $4000.
As a result, the lessor will receive only $4000 at the end of the lease.
For the lease to have an NPV of zero, the present value of the lease
payments must be $4000
$20,000 − 48
= $16,851.61.
1.005
Therefore, the lease payment will be
16,851.61
L= = $393.79 per month
1  1 
1+ −
0.005  1.005 47 
1

This payment exceeds that of the FMV lease due to the lessee’s
ability to buy the asset at a discount at the end of the lease.
 30

Other Lease Provisions (1 of 2)

• Leases may have many other provisions.
• Provisions that give valuable options to the lessee raise
the amount of the lease payments, while provisions that
restrict these options will lower them.
 31

Other Lease Provisions (2 of 2)

• Examples of other lease provisions
• Early cancellation options that allow the lessee to end
the lease early (perhaps for a fee)
• Buyout options that allow the lessee to purchase the
asset before the end of the lease term
• Clauses may allow the lessee to trade in and upgrade
the equipment to a newer model at certain points in the
lease
 32

25.2 Accounting, Tax, and Legal

Consequences of Leasing (1 of 5)
• Lease Accounting
• For lessees, the Financial Accounting Standards Board
(FASB), distinguishes two types of leases based on the
lease terms, and this classification determines the
lease’s accounting treatment.
• Operating Lease.
• Capital Lease.
 33

25.2 Accounting, Tax, and Legal

Consequences of Leasing (2 of 5)
• Lease Accounting
• Operating Lease
• A type of lease, viewed as a rental for accounting
purposes, in which the lessee reports the entire
lease payment as an operating expense
• The lessee does not deduct a depreciation
expense for the asset and does not report the
asset or the lease payment liability on its balance
sheet.
• Operating leases are disclosed in the footnotes
of the lessee’s financial statements.
 34

25.2 Accounting, Tax, and Legal

Consequences of Leasing (3 of 5)
• Lease Accounting
• Capital Lease
• Long-term lease contract that obligates a firm to make regular
lease payments in exchange for the use of an asset
• Viewed as an acquisition for accounting purposes; the
lessee lists the asset on its balance sheet and incurs
depreciation expenses.
• The lessee also lists the present value of the future lease
payments as a liability and deducts the interest portion of
the lease payments as an interest expense.
 35

Textbook Example 25.4 (1 of 3)

Leasing and the Balance Sheet
Problem
Harbord Cruise Lines currently has the following balance sheet (in millions of dollars):

Assets Liabilities
Cash 100 Debt 900
Property, Plant, and Equipment 1500 Equity 700
Total Assets 1600 Total Debt plus Equity 1600

Harbord is about to add a new fleet of cruise ships. The price of the fleet is
$400 million. What will Harbord’s balance sheet look like if (a) it purchases the
fleet by borrowing the $400 million, (b) it acquires the fleet through a $400
million capital lease, or (c) it acquires the fleet through an operating lease?
 36

Textbook Example 25.4 (2 of 3)

Solution
For parts (a) and (b), the balance sheet consequences are the same: The fleet
becomes a new asset of the firm, and the $400 million becomes an additional
liability.

Assets Liabilities
Cash 100 Debt 1300
Property, Plant, and Equipment 1900 Equity 700
Total Assets 2000 Total Debt plus Equity 2000

Note that the firm’s debt-equity ratio increases in this case

 900 1300 
 from = 1.29 to = 1.86  .
 700 700 
 37

Textbook Example 25.4 (3 of 3)

• If the fleet is acquired through an operating lease, as described
in part (c), there is no change in the original balance sheet: The
fleet is not listed as an asset, and the lease is not viewed as a
liability. Thus, the apparent leverage ratio is unchanged.
 25.2 Accounting, Tax, and Legal
Consequences of Leasing (4 of 5)
• Lease Accounting
• A lease is treated as a capital lease for the lessee and must
be listed on the firm’s balance sheet if it satisfies any of the
following four conditions:

1. Title to the property transfers to the lessee at the end of the

lease term.
2. The lease contains an option to purchase the asset
at a bargain price that is substantially less than its fair market
value.

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 25.2 Accounting, Tax, and Legal
Consequences of Leasing (5 of 5)
• Lease Accounting

3. The lease term is 75% or more of the estimated economic life

of the asset.
4. The present value of the minimum lease payments at the
start of the lease is 90% or more of the asset’s fair market
value.

39
 40

Textbook Example 25.5 (1 of 3)

Operating Versus Capital Leases
Problem
Consider a seven-year fair market value lease for a $12.5 million
Gulfstream Jet with a remaining useful life of 10 years.
Suppose the monthly lease payments are $175,000 and the
appropriate discount rate is a 6% APR with monthly compounding.
Would this lease be classified as an operating lease or a capital
lease for the lessee?
What if the lease contract gave the lessee the option to cancel the
contract after five years?
 41

Textbook Example 25.5 (2 of 3)

Solution
We compute the present value of the monthly lease payments at the
beginning of the lease using the annuity formula with a monthly interest rate
of 6%
= 0.5% and 7  12 − 1 = 83 monthly payments after the initial
12
payment. Thus,
 1  1 
PV (Lease Payments) = 175,000  1 +  1.00583   = $12.04 million
1 −
 0.005  
12.4
Because the present value of the lease payments is = 96.3%
12.50
of the value of the jet, the lease satisfies condition 4 and so it is a capital
lease.
Textbook Example 25.5 (3 of 3)
If the lessee can cancel the contract after five years, then the minimum number of
lease payments is 60 under the contract. In this case,
 1  1 
PV (Lease Payments) = 175,000  1 +  1 − 59  
= $9.10million
 0.005  1.005  

This, is only 9.10 = 73 % of the value of the jet. As no other conditions

12.5
for a capital lease are satisfied, the lease would be classified as an
operating lease.

42
Changes to accounting standards

• For those accounting under International Accounting Standards, IFRS16 will now bring
operating leases on balance sheet.

• IFRS 16 is a new International Financial Reporting • The Financial Accounting Standards Board (FASB) introduced a
Standard for lease accounting which came into force on new accounting standard (ASU 2016-02) that requires
1 January 2019. It replaced the existing IAS 17 companies to recognize operating lease assets and liabilities
accounting standard and was introduced by the on the balance sheet.
International Accounting Standards Board (IASB).

• Accounting standards are always under review and depending on the industry/sector or
country your are operating you might be subject to different accounting rules that will
determine if at certain point in time you can treat your lease on or off balance sheet.
• This is a Corporate Finance course: the important thing to remember is that the inclusion of a
Lease in your balance sheet affects the financial situation of the Lessee (balance sheets will
grow, leverage ratios will increase, and capital ratios will decrease. This will affect credit ratings
and cost of capital).

43
 44

The Tax Treatment of Leases

• For the rest of this chapter we will consider all
leases either “True Tax Lease” or “Non-tax Lease”
• This will be “given”, we will not learn in this course
the accounting/tax rules used to classify a lease in
each type.
• You can read further in the book about the IRS
standards applied in the USA, but consider that
these accounting standards might change from
country to country.
 45

The Tax Treatment of Leases

• True Tax Lease
• A type of lease in which the lessor receives the
depreciation deduction associated with the
ownership of the asset.
• The lessee can deduct the full amount of the
lease payments as an operating expense and the
lease payments are treated as revenue for the
lessor.
• A Non-Tax Lease
• A type of lease where there are no tax
deductions.
 46

End of Leasing part I

• Stay tuned for Leasing part II: the leasing decision!

 47

Leasing part II: The leasing

decision

• Don’t forget to watch Part I for an overview of

Lease contracts!
 48

25.3 The Leasing Decision (1 of 3)

• Cash Flows for a True Tax Lease
• Assume Emory Printing needs a printing press.
• It can purchase one for $50,000 in cash.
• The machine will last five years, and it will be
depreciated for tax purposes using straight-line
depreciation over that period.
• Emory can deduct $10,000 per year for
depreciation.
• Emory’s tax rate is 35%.
• Thus, Emory will save $3500 per year in taxes
from the depreciation deduction.
 49

25.3 The Leasing Decision (2 of 3)

• Cash Flows for a True Tax Lease
• As an alternative, Emory can lease the machine instead of
purchasing it.
• A five-year lease contract will cost $12,500 per year (this is
given).
• Emory must make these payments at the beginning of
each year.
• Because the lease is a true tax lease, Emory deducts the
lease payments as an operating expense when they are paid.
• The after-tax cost of each lease payment is
(1 − 35%) × $12,500 = $8125.
 50

25.3 The Leasing Decision (3 of 3)

• Cash Flows for a True Tax Lease
• As shown on the following slide, the cash flows of
leasing differ from buying.
• A purchase requires a large initial outlay followed by
a series of depreciation tax credits.
• The cost of a leased machine is more evenly spread
over time.
• Note: It is also assumed that the machine has no
residual value after five years if it is purchased.
 51

Table 25.1 Spreadsheet Cash Flow ($)

Consequences from Leasing Versus Buying

2) Depreciation is straight line during 5 years: $10000 per year, taxed at 35% create a tax
shield of $3500 per year.
4) Lease Payments per year are given at $12500.
5) Income Tax savings are calculated as 35% x 12500
 52

To Lease, to buy or to borrow

• We are going to compare Leasing to two
alternatives:

• Lease vs. Buy (compare the lease with buying with

our own cash). Note that this is what the textbook
calls an “unfair” comparison. I’d argue this is an
“incorrect” comparison (more on this later).

• Lease vs. Borrow to buy (we compare leasing with

buying the asset with money we borrow).
 53

Lease Versus Buy (An Unfair

Comparison) (1 of 6)
• To decide if it is better to lease or buy, we must
compute the present value of the cash flows in
each transaction.
• The risk of the lease payments is no greater than the
risk of secured debt, so it is reasonable to discount the
lease payments at the firm’s secured borrowing rate.
 54

Lease Versus Buy (An Unfair

Comparison) (2 of 6)
• Assuming Emory’s borrowing rate is 8%, the cost of
buying the machine has a present value of

3500 3500 3500 3500 3500

PV (Buy) = − 50,000 + + 2
+ 3
+ 4
+ 5
= − $36,026
1.08 1.08 1.08 1.08 1.08
 Lease Versus Buy (An Unfair
Comparison) (3 of 6)
• The cost of leasing the machine has a present value of

8125 8125 8125 8125

PV (Lease) = − 8125 − − 2
− 3
− 4
= − $35,036
1.08 1.08 1.08 1.08

• Leasing is cheaper than buying, with a net savings of $990.

$36,026 − $35,036 = $990

55
 56

Lease Versus Buy (An Unfair

Comparison) (4 of 6)
• Why is the previous comparison “Unfair”?
• Because is it too simple. So far we have compared
Leasing with buying in Cash (as if the firm already has
the cash ready to be spent in t=0 to purchase the
machine). However, the preceding analysis ignores an
important point:
• When a firm enters into a lease, it is committing to lease
payments that are a fixed future obligation of the firm
that effectively adds leverage to its capital structure.
• Because leasing is a form of financing, it should be
compared to other financing options.
 57

Lease Versus Buy (An Unfair

Comparison) (5 of 6)
• For example, rather than buy the asset outright, Emory
could borrow funds to finance the purchase of the
machine, thus matching the leverage of the lease.
• If Emory does borrow, it will also benefit from the
interest tax shield provided by the additional
leverage (additional benefit on top of the tax shield
calculated before).
 58

Lease Versus Buy (An Unfair

Comparison) (6 of 6)
• To correctly evaluate a lease, it should be compared
to purchasing the asset using an equivalent amount
of leverage.
• The appropriate comparison is not lease versus buy
(with cash), but rather lease versus borrow (to buy).
 59

Lease Versus Borrow (The Right

Comparison) (1 of 10)
• The Lease-Equivalent Loan
• Lease-Equivalent Loan
• A loan that is required for the purchase of an asset
that leaves the purchaser with the same net future
obligations as a lease would entail
 60

Lease Versus Borrow (The Right

Comparison) (2 of 10)
• The Lease-Equivalent Loan
• In the Emory example, to compute the lease-equivalent
loan, the difference between the cash flows from leasing
versus buying must first be computed (as shown on the
following slide).
• Relative to buying, leasing saves cash upfront but
results in lower future cash flows.
 61

Table 25.2 Spreadsheet Incremental Free Cash

Flows of Leasing Versus Buying

Note the change in the sign!

3) is like the net benefit of Leasing instead of buying.

In t=0, we save $41875, but in period t=1 we not only pay the net cost of the leasing but
also foregoing the 3500 in depreciation tax shield.

If we borrowed a loan that would make us repay these L-B cash flows, we would be able to
borrow more than what we are saving in t=0
 62

Lease Versus Borrow (The Right

Comparison) (3 of 10)
• The Lease-Equivalent Loan
• The initial balance on the lease-equivalent loan is the
present value of the incremental cash flows discounted at
the after-tax cost of debt.

Loan Balance = PV [Future FCF of Lease Versus Buy at rD (1 −  c )]

 63

Lease Versus Borrow (The Right

Comparison) (4 of 10)
• The Lease-Equivalent Loan
• In the Emory example, the after-tax cost of debt is
• 8% (1 − 35%) = 5.2%
• So the initial lease-equivalent loan balance should be

11,625 11,625 11,625 11,625 3500

Loan Balance = + 2
+ 3
+ 4
+ 5
= $43,747
1.052 1.052 1.052 1.052 1.052
 64

Lease Versus Borrow (The Right

Comparison) (5 of 10)
• The Lease-Equivalent Loan
• Instead of leasing, Emory could instead buy the printing
press by borrowing $43,747.
• By buying and borrowing using the lease-equivalent
loan, Emory saves an additional $1872 at time
period 0. Leasing the machine is unattractive relative
to this alternative.
$43,747 − $41,875 = $1872
 65

Lease Versus Borrow (The Right

Comparison) (6 of 10)
• The Lease-Equivalent Loan
• As shown on the following slide, the same result can be
obtained by computing the cash flows that result from
buying the machine and borrowing using the lease-
equivalent loan.
 66

Lease Versus Borrow (The Right

Comparison) (7 of 10)
• The Lease-Equivalent Loan
• Comparing the cash flows from buying the printing press
and financing it with the lease-equivalent loan with the
cash flows of the lease, Emory has a net future
obligation of $8125 per year for four years in both cases.
 67

Lease Versus Borrow (The Right

Comparison) (8 of 10)
• The Lease-Equivalent Loan
• While the leverage is the same for the two strategies,
the initial cash flow is not.
• With the lease, Emory will pay $8125 initially.
• With the loan, Emory will pay $6253.
• The purchase price of the printing press minus the
amount borrowed
• $50,000 − $43,747 = $6253
• Again, borrowing to buy the machine is cheaper than
the lease with a savings of $1872.
• $8125 − $6253 = $1872
 68

Lease Versus Borrow (The Right

Comparison) (9 of 10)
• A Direct Method
• Leasing can be compared to buying the asset using
equivalent leverage by discounting the incremental cash
flows of leasing versus buying using the after-tax
borrowing rate.

11,625 11,625 11,625 11,625 3500

PV (Lease Versus Borrow) = 41,875 − − − − −
1.052 1.0522 1.0523 1.0524 1.0525
= − $1872
 69

Lease Versus Borrow (The Right

Comparison) (10 of 10)
• The Effective After-Tax Lease Borrowing Rate
• Leasing and buying can be compared in terms of an
effective after-tax borrowing rate associated with the lease.
This is given by the IRR of the incremental lease cash flows
• In Emory’s case, the IRR is 7.0%. This option is not
attractive compared to the after-tax rate of 5.2% that
Emory pays on its debt.

11,625 11,625 11,625 11,625 3500

41,875 − − 2
− 3
− 4
− 5
=0
1.07 1.07 1.07 1.07 1.07
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Evaluating a True Tax Lease (1 of 2)

• In summary, when evaluating a true-tax lease,
compare the leasing to a purchase that is financed
with equivalent leverage.
• First, compute the incremental cash flows for leasing
versus buying, including the depreciation tax shield (if
buying) and the tax deductibility of the lease payments
if leasing.
• Then compute the NPV of leasing versus buying using
equivalent leverage by discounting the incremental cash
flows at the after-tax borrowing rate.
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Evaluating a True Tax Lease (2 of 2)

• If the NPV is negative, then leasing is unattractive

compared to traditional debt financing.

• If the NPV is positive, then leasing does provide an

advantage over traditional debt financing and
should be considered.
 72

Textbook Example 25.6 (1 of 3)

Evaluating New Lease Terms
Problem
Suppose Emory rejects the lease we analyzed, and
the lessor agrees to lower the lease rate to $11,800
per year. Does this change make the lease attractive?
 Textbook Example 25.6 (2 of 3)
Solution
The incremental cash flows are shown in the following table:

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 Textbook Example 25.6 (3 of 3)
Using Emory’s after-tax borrowing cost of 5.2%, the gain from
leasing versus an equivalently leveraged purchase is

11,170 11,170 11,170 11,170 3500

NPV (Lease Versus Borrow) = 42,330 - - - - -
1.052 1.0522 1.0523 1.0524 1.0525
= 42,330 - 42,141
= $189

Therefore, the lease is attractive at the new terms.

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 75

Evaluating a Non-tax Lease (1 of 3)

• Evaluating a non-tax lease is much more
straightforward than evaluating a true tax lease.
• The lessee still receives the depreciation deductions;
however, only the interest portion of the lease payment
is deductible.
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Evaluating a Non-tax Lease (2 of 3)

• In terms of cash flows, a non-tax lease is directly
comparable to a traditional loan and is attractive
only if it offers a better interest rate than would be
available with a loan.
• To determine whether it offers a better rate, discount
the lease payments at the firm’s pretax borrowing rate
and compare it to the purchase price of the asset.
 77

Evaluating a Non-tax Lease (3 of 3)

• If there is a residual value, differences in the
maintenance arrangements with a lease versus a
purchase, or any cancellation or other lease
options, they should also be included when
comparing leasing versus a debt-financed purchase.
 Textbook Example 25.7 (2 of 2)
Instead of purchasing the machine for $50,000, Emory will pay lease
payments of $11,800 per year. That is, Emory is effectively borrowing
$50,000 by making payments of $11,800 per year. Given Emory’s 8%
borrowing rate, payments of $11,800 per year on a standard loan
would allow Emory to borrow

11,800 11,800 11,800 11,800

PV (Lease Payments) = 11,800 + + + + = $50,883
1.08 1.082 1.083 1.084

That is, by making the same payments on a loan, Emory could raise
more than $50,000. Thus, the lease is not attractive at these terms if it
is a non-tax lease.

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End of Leasing lecture
• Next steps:
• Revise Chapter 25 from the textbook:
• I highly encourage you to revise all the exercises and examples in the book.
They are really good practice.
• Try to create your own excel spreadsheet to replicate the cash-flows of
the examples discussed in the lecture and Chapter 25.
• Give it a try to the exercises we will work during next week’s workshop.
• Checkout Moodle for additional (optional) reading material about how
accounting rules have changed for leases.

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