Corporate Finance

Chapter 21

Slide 8
2 specific types of financial lease (capital lease)
+ Sale and Lease-back
 Occurs when company sells an asset it already owns to another firm and immediately
leases it from them
 2 sets of CFs occur

+ Leveraged lease
 A three-sided arrangement btw the lessee, the lessor and lenders:
- The lenders typically use a nonrecourse loan

Slide 14
2 tax benefits of the lessor (owner of an asset)
+ Depreciation of tax shield = D x TC

D: Depreciation
TC: Corporate tax rate
+ Interest tax shield if borrowing debt to buy the asset

Notes:
Lessor often has high tax rate
Lessee often has low tax rate  only need equipment but cannot take full advantage of tax
benefits of ownership (due to low rate)
Slide 16: 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 cost savings of $4,500/ year (exist from either buying/leasing)
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.
$ 25,000
 Depreciation = D = = $5,000
5

They can lease it for 5 years from Tiger Leasing with an annual lease payment of $6,250.
Tax rate is 34%.
• Cash Flows: Buy
Year 0 Each year from Year 1 to 5
Cost of truck –$25,000
After-tax savings 4,500×(1-0.34) = $2,970
Depreciation Tax Shield 5,000×(0.34) = $1,700
–$25,000 $4,670
• Cash Flows: Lease
Year 0 Each year from Year 1 to 5
Lease Payments – 6,250×(1-0.34) = –$4,125
After-tax savings 4,500×(1-0.34) = $2,970
–$1,155

NPV Leasing instead of Buying = NPV of (Leasing CFs – Buying CFs)

Discount rate = After-tax interest rate on secured debt issues by the lessee
Let assume discount rate = 5%
 𝑁𝑃𝑉 = 25,000−5,825[ 0.05 − ]=−219.20 < 0
1 1
5
0.05 ×(1+0.05)

What’s the NPV of Buying-instead of-Leasing decision? What’s your

decision: Lease or Buy?

 NPV is negative  we should buy and should not lease

Note that since the after-tax savings are equivalent whether the asset is bought or leased, they
could be excluded as a cash flow for this analysis.
Assume lease payment is qualified for tax deductible.
Note use WACC for this case

Slide 20:

NPV Leasing instead of Buying: NPV of (Leasing CFs – Buying CFs)

𝑁𝑃𝑉 = 25,000−5,825[ 0.05 −

1 1
5
]=−219.20
0.05 ×(1+0.05)
PVAF
Slide 21:

NPV Buying instead of Leasing: NPV of (Buying CFs – Leasing CFs)

𝑁𝑃𝑉 = 25,000+5,825 [ 0.05 −

1 1
5
]=219.20
0.05 ×(1+ 0.05)

Slide 29: Break-even analysis for Tiger Leasing

*For lessor: Lmin lease payment that make NPVLess =0

𝑁𝑃𝑉 = 0 = −25,000 + (0.66𝑥𝐿𝑚𝑖𝑛 + 1,700) 0.05 – [ ]

1 1
5
0.05 × ( 1+0.05 )

[ 0.05 0.05 × ( 1+0.05 )5 = PVAF  need to calculate 1 time incase to use it

]
1 1
–

$ 25,000
→ 0.66 x Lmin + 1,700 = 5,774.37 ( = )
PVAF
→ Lmin = $6,173.29
Slide 30: Break-even analysis for ClumZee Movers
* For lessee: Lmax lease payment that make NPVLessee = 0

𝑁𝑃𝑉 = 0 = 25,000 - (0.75𝑥𝐿𝑚𝑎𝑥 + 1,250) 0.05 – [ ]

1 1
5
0.05 × ( 1+0.05 )

[ 0.05 0.05 × ( 1+0.05 )5 = PVAF

]
1 1
–

$ 25,000
5,774.37 =
PVAF

$ 25,000
→ 0.75 x Lmax + 1,250 =
PVAF

→ Lmax = $6,032.49

Chapter 21:

Concept questions (page 676 textbook): 2, 5, 6, 7

2. Leasing and Taxes Taxes are an important consideration in the leasing decision. Which
is more likely to lease: A profitable corporation in a high tax bracket or a less profitable one
in a low tax bracket? Why?

The less profitable one because leasing provides a mechanism for transferring tax benefits
from entities that value them less to entities that value them more

5. Accounting for Leases Discuss the accounting criteria for determining whether a lease
must be reported on the balance sheet. In each case give a rationale for the criterion.
A capital lease is recorded on the balance sheet because the lease transfers substantially all
of the benefits and risks incident to the ownership of property to the lessee.

6. IRS Criteria Discuss the IRS criteria for determining whether a lease is tax deductible. In
each case give a rationale for the criterion.
To be considered a capital lease, a lease must meet one or more of these four criteria:
(1) title of the asset passes automatically from the lessor to the lessee at end of the lease
term
(2) lease contains a bargain purchase option under which the lessee may acquire the
leased-asset at less than its fair market value ...

7. Off–Balance Sheet Financing What is meant by the term off–balance sheet financing?
When do leases provide such financing, and what are the accounting and economic
consequences of such activity?

Off Balance Sheet financing can be used when the business is close to its borrowing limit
and still wants to try and purchase something, it is also used as a method to lower borrowing
rates and managing risk. Off Balance Sheets are also used to fund projects. Typically I would
say leases provide such finance when they are being rented and not purchased, the off
balance sheet then only has to record the rental price and not the price of the machine
which would be much lower and prove a cleaner balance sheet

Questions and Problems (page 677 textbook): 1, 2, 3, 7

Use the following information to work Problems 1–3.

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 $5,200,000, 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 $1,525,000 per year for four years.
Depreciation expense = $5,200,000 / 4 = 1,300,000

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?
PV of leasing = - $1,525,000 x (1-35%)

2. Leasing Cash Flows What are the cash flows from the lease from the lessor’s
viewpoint? Assume a 35 percent tax bracket.
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?

7. Lease or Buy Super Sonics Entertainment is considering buying a machine that costs
$540,000. The machine will be depreciated over five years by the straight-line method and
will be worthless at that time. The company can lease the machine with year-end payments
of $145,000. The company can issue bonds at a 9 percent interest rate. If the corporate tax
rate is 35 percent, should the company buy or lease?
Machine cost = $540,000
Interest rate = 9%
Tax rate = TC = 0.35
Cost of buying
Annual depreciation expense = $540,000/5 =$108,000
Interest expense = $540,000 x 9%= $48,600
Tax shield = (Depreciation + Interest) x TC = ($108,000 + $48,600) x 0.35 = $54,810
After-tax cost of buying = Total cost before tax – tax shield
= (Depreciation + Interest) – Tax shield = ($108,000 + $48,600) - $54,810 = $101,790

Cost of leasing
Lease payment = $145,000
Tax shield on lease payment = $145,000 x 0.35 = $50750
After-tax cost of leasing = Lease payment – Tax shield = $145,000 - $50750 = $94250