CHAPTER 21: LEASING

Lessee (người thuê): has the right to use assets and in return make periodic payments to the
lessor.
Lessor (người cho thuê): is either the asset’s manufacturer or an independent leasing
company.
A lease: is a contractual agreement between a lessee and lessor. The agreement establishes
that the lessee has the right to use an asset and in return must make periodic payments to the
lessor, the owner of the asset.

Nhật wants to drive a Rolls Royce for 24 months. If he buys it immediately, the car will cost
$1,000,000. Otherwise, if he leases a car, he has to pay a periodic payment of $45,000 each
month. Interest rate is 10% annually, should Việt buy or lease this asset ?
Total payment = 45,000*24 = 1,080,000
45,000 45,000 45,000 45,000
Present value of the payment = (1+10%/12) + 2 + 3 ... + 24 =
(1+10%/12) (1+10%/12) (1+10%/12)
−24
1−(1+10%/12)
45,000* 10%/12
= $975,188,467.5
Net present value (NPV) when Viet lease = 1,000,000 - 975,188,467.5 = $24,811

1. TYPES OF LEASES
Opearing lease(thuê hoạt động) Financial lease(thuê tài chính)

length short-term long-term

Features + Operating leases are usually not fully + Do not provide maintenance or service by the lessor
amortized. + Financial lease are fully amortized
+ Operating leases usually require the lessor to + The lessee usually has a right to renew the lease on expiration
maintain and insure leased assets + Generally, financial leases cannot be canceled. In other words, the lessee must
+ Operating lease has the cancellation option. make all payments of face the risk of bankruptcy
(mosst interesting feature) + Ownership belong to lessee
+ Ownership belong to lessor + Have the right to buy the leased asset
+ Dont have the right to buy the leased asset + More risk
+ less risk

Sale and leaseback: occurs when a company sells an asset it owns to another
firm and immediately leases it back.
Leveraged leases: three-sided arrangement among the lessee, the lessor, and
the lenders.
● Lessors borrow money from lenders to purchase assets, then lease back
to lessees.
● Lessors receive periodic money from lessee and pay payment to lenders.

🧐
4. THE CASH FLOW OF LEASING
How to know whether we lease or buy ?
 👉We’ll based directly on the NPV and cash flows of leasing
Given: Company X makes a pipe-boring machine that can be purchased for $10,000. The
company has determined that it needs a new machine, and the machine will save company X
$6,000 dollar/year in reduced electricity for the next five year. Corporate tax = 34%. Lease
payment = $2,500/years. Interest rate = 7.575757%

Source: Ross, S. A., Westerfield, R. W., Jaffe, J., & Jordan, B. D. Corporate finance, McGraw-Hill Education.
After tax lease payment = -2500*(1-0.34) = -2500 + 2500*0.34 = -1650
$ Beginning After purchasing changes

Revenue 100,000 100,000

Salaries expsense 10,000 10,000

Electricity expense 16,000 10,000 -$6,000

EBT 74,000 80,000

Tax (34%) 25,160 27,200

Net income 48,840 52,800 $3,960

=80,000*(1 - 34%) =6,000*(1 - 34%)
=80,000-80,000*34%
🧐 👉Why does depreciation bring tax benefits ? And why does lease payment bring tax benefits ?
Because tax is account for net income. Depreciation and lease payment deduct net
income, which result in the company paying less tax.

🔹Net cash flow of lessee when buying rather than leasing

 Source: Ross, S. A., Westerfield, R. W., Jaffe, J., & Jordan, B. D. Corporate finance, McGraw-Hill Education.
If X can either borrow or lend at the interest rate of 7.5757%. And the corporate tax rate is 34%.
Correct discount rate = 7.5757% * (1 - 0.34) = 5%

NPV of lessee (when buying)

2,330 2,330 2,330 2,330 2,330

= -$10,000 + (1+5%) + 2 + 3 + 4 + 5
(1+5%) (1+5%) (1+5%) (1+5%)

1 1 1 1 1
= -$10,000 + 2,330*( (1+5%) + 2 + 3 + 4 + 5 )
(1+5%) (1+5%) (1+5%) (1+5%)
−5
1 − (1+5%)
= -$10,000 + 2,330*PVIFA(.05,5) = -$10,000 + 2, 330 * 5%
= $ 87.68
*

*NPV (when leasing) / value of the lease =

2,330 2,330 2,330 2,330 2,330
$10,000 - ( (1+5%) + 2 + 3 + 4 + 5 )
(1+5%) (1+5%) (1+5%) (1+5%)

👉
= − $87. 68 *

👉
Lessee should buy rather than lease.
Lessor should lease rather than sell

🔹Cash flow of lessor when leasing rather than selling

Source: Ross, S. A., Westerfield, R. W., Jaffe, J., & Jordan, B. D. Corporate finance, McGraw-Hill Education.
**NPV of lessor (when leasing) =
2,330 2,330 2,330 2,330 2,330
-$10,000 + (1+5%) + 2 + 3 + 4 + 5 = $87. 68**
(1+5%) (1+5%) (1+5%) (1+5%)
−5
1 − (1+5%)
= − 10, 000 + 2, 330 * 5%
 🧐
9. REASONS FOR LEASING
We can see that the two circumstances * and ** The NPV are exactly the opposite. So it
seems that there seems to be no joint benefit to this lease. Because one would inevitably lose
money, one would definitely have money. So what are the reasons for leasing ?

1. Tax will be reduced by leasing (Tax advantages): The most important reason for
long-term leasing is tax reduction. The tax advantages of leasing exist because firms are in
different tax brackets. => Both lessor and lessee will find positive NPVs in leasing when finding
the appropriate lease payment.

Ex: in the previous case, if lessee don’t pay tax and the lease payments are reduced to
$2,475 from $2,500, both lessor and lessee will find positive NPV in leasing. Discount rate =
7.5757%, tax rate = 34%

Cash flow of lessee turn to (when leasing):

Lease - buy 0 1 2 3 4 5

Cost of machine 10,000

Depreciation tax benefit = =2,000*0=0 0 0 0 0

depreciation * tax

After tax lease payment -2,475*(1-0) -2,475 -2,475 -2,475 -2,475

(=lease*(1-tax))= lease - lease*tax) = -2,475

Cash flow when leasing rather 10,000 -2,475 -2,475 -2,475 -2,475 -2,475
than selling
Source: Ross, S. A., Westerfield, R. W., Jaffe, J., & Jordan, B. D. Corporate finance, McGraw-Hill Education.

Corrent discount rate = 7.57575(1-0%) (no tax)

=> Net present value when leasing (lessee) = Value of the lease = 10,000 -
−5
1 − (1+7.57575%)
2, 475 * 7.57575%%
=$6.55

Cash flow of lessor turn to(when leasing):

Lease - buy 0 1 2 3 4 5

Cost of machine -10,000

Depreciation tax benefit = =2,000*34%= 680 680 680 680

depreciation * tax 680
After tax lease payment 1633.5 1633.5 1633.5 1633.5 1633.5
(=lease*(1-tax))= lease - lease*tax)

Cash flow when leasing rather -10,000 2313.5 2313.5 2313.5 2313.5 2313.5
than selling
Correct discount rate = 7.57575%*(1-0.34) = 5%
−5
1 − (1+5%)
Net present value when leasing (lessor) = value of the lease = -10,000 + 2313.5* 5%
=
$16.2456

✅As a consequence of different tax rates, the lessee gains $6.55 and the lessor gains $16.24.
The lease payment is agreed upon through negotiation.

How to find the range of lease payment that both parties have benefited?

📍Reservation payment of the lessee (lessee don’t have to pay tax): the maximum money
the lessee willing to pay

Value of lease = $10,000 - Lmax x PVIFA(.0757575, 5) = 0

1 1 1 1 1
<=>$10,000 - Lmax x ( (1+7.57575%) + 2 + 3 + 4 + 5 )
(1+7.57575%) (1+7.57575%) (1+7.57575%) (1+7.57575%)
=0
−5
1−(1+7.57575%)
<=>$10,000 - Lmax x 7.57575%
=0 ⇔ 10,000 = Lmax x 4.038 => Lmax = 10,000/4.038 =

✅
$2,476.47
Meaning that the max payment that lessee could pay is $2,476.47

📍Reservation payment of the lessor (lessor pay 34% tax)

680+Lmin*0.66 680+Lmin*0.66 680+Lmin*0.66 680+Lmin*0.66 680+Lmin*0.66

Total -10,000

Value of lease
=> - $10,000 + PVIFA(.05, 5)(680 + Lmin x (.66)) = 0
 => PVIFA(.05, 5)(680 + Lmin x (.66)) = 10,000
=> 4.329*(680 + Lmin x (.66)) = 10,000
=> 2943.72+2.857*Lmin= 10,000
=> Lmin = (10,000 - 2943.72)/2.857 = $2,469.32
−5
1−(1+5%)
PVIFA(0.05,5) = 5%
= 4.329

✅Meaning that the min payment that lessor could accept is $2,469.32
👉🏻if the lease payment range from $2,469.32 to $2,476.62. Both parties have joint benefit (NPV
of both parties > 0)

2. A reduction of uncertainty: We have noted that the lessee does not own the property when the
lease expires. The value of the property at this time is called the residual value, and the lessor has a firm
claim to it. When the lease contract is signed, there may be substantial uncertainty about what the
residual value of the asset will be.

3. Transaction costs: The costs of changing an asset’s ownership are generally

greater than the costs of writing a lease agreement. Consider the choice that confronts
a person who lives in Los Angeles but must do business in New York for two days. It
would clearly be cheaper to rent a hotel room for two nights than it would be to buy an
apartment condominium for two days and then to sell it.

⏰PRACTICE⏰
Use the following information to work Problems 1–5. You work for a nuclear research laboratory
that is contemplating leasing a diagnostic scanner (leasing is a common practice with
expensive, high-tech equipment). The scanner costs $5,800,000, and it would be depreciated
straight-line to zero over four years. Because of radiation contamination, it will actually be
completely valueless in four years. You can lease it for $1,690,000 per year for four years.

1. Lease or Buy Assume that the tax rate is 35 percent. You can borrow at 8 percent before
taxes. Should you lease or buy?

Lease 0 1 2 3 4

After tax lease payment = (lease -1,098,500 -1,098,500 -1,098,500 -1,098,500

payment*(1-tax)

Total cash flow (lease) 0 -1,098,500 -1,098,500 -1,098,500 -1,098,500

Buy

Cost of machine -5,800,000

Depreciation tax shield 507,500 507,500 507,500 507,500

 Total cash flow (buy) -5,800,000 507,500 507,500 507,500 507,500

Cash flow (Lease - Buy) 5,800,000 -1,606,000 -1,606,000 -1,606,000 -1,606,000

(unit: $)
2. Leasing Cash Flows What are the cash flows from the lease from the lessor’s viewpoint?
Assume a 35 percent tax bracket.
NPV of lessor (lease - buy) = -$131,561.25

3. Finding the Break-Even Payment What would the lease payment have to be for both the
lessor and the lessee to be indifferent about the lease?

Lease 0 1 2 3 4

After tax lease payment = (lease -L*0.65 -L*0.65 -L*0.65 -L*0.65

payment*(1-tax)

Total cash flow (lease) 0 -L*0.65 -L*0.65 -L*0.65 -L*0.65

Buy

Cost of machine -5,800,000

Depreciation tax shield 507,500 507,500 507,500 507,500

Total cash flow (buy) -5,800,000 507,500 507,500 507,500 507,500

Cash flow (Lease - Buy) 5,800,000 -L*0.65 - -L*0.65 - -L*0.65 - -L*0.65 -

507,500 507,500 507,500 507,500
(unit: $)
4. Taxes and Leasing Cash Flows Assume that your company does not contemplate paying
taxes for the next several years. What are the cash flows from leasing in this case and its net
present value ?

Lease 0 1 2 3 4

After tax lease payment = (lease -1,690,000 -1,690,000 -1,690,000 -1,690,000

payment*

Total cash flow (lease) 0 -1,690,000 -1,690,000 -1,690,000 -1,690,000

Buy

Cost of machine -5,800,000

Total cash flow (buy) -5,800,000

Cash flow (Lease - Buy) 5,800,000 -1,690,000 -1,690,000 -1,690,000 -1,690,000

 −4
1 − (1+8%)
NPV of lessee (lease - buy) = 5,800,000 - CF* 8%
=$202,505.64
=> lessee should lease

5. Setting the lease payment In the previous question, over what range of lease payments will
the lease be profitable for both parties?
−4
1 − (1+8%)
5,800,000 - CF* 8%
=0
(CF = Lmax in this case) => CF = Lmax = $1,751,140.67

Lmin = $1,747,345.15

Rage of lease payment between $1,747,345.15 and $1,751,140.67.

6. Setting the Lease Price An asset costs $720,000 and will be depreciated in a straight line
manner over its three-year life. It will have no salvage value. The corporate tax rate is 34
percent, and the appropriate interest rate is 10 percent.
a. What set of lease payments will make the lessee and the lessor equally well off?
b. Assume that the lessee pays no taxes and the lessor is in the 34 percent tax bracket. For
what range of lease payments does the lease have a positive NPV for both parties?