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Unit 9 Leasing

The document discusses key concepts around leasing, including different types of leases and how to apply net present value analysis to the lease vs buy decision. It covers operating leases, financial leases, sale-leaseback, and leveraged leases. It also discusses accounting treatment of leases and provides an example calculation comparing the net present value of leasing versus purchasing a machine.

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Anuska Jayswal
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74 views21 pages

Unit 9 Leasing

The document discusses key concepts around leasing, including different types of leases and how to apply net present value analysis to the lease vs buy decision. It covers operating leases, financial leases, sale-leaseback, and leveraged leases. It also discusses accounting treatment of leases and provides an example calculation comparing the net present value of leasing versus purchasing a machine.

Uploaded by

Anuska Jayswal
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Leasing

CHAPTER 21
Key Concepts and Skills
Understand the different types of leases.

Understand how to apply NPV to the lease vs. buy decision.

Understand the importance of tax rates in determining the


benefit of leasing.
Leases
The Basics
◦ A rental agreement that extends for a year or more and involves a series of fixed
payments

◦ 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.

◦ The lessor is either the asset’s manufacturer or an independent company

◦ If the lessor is a independent company, it must buy the assets from manufacturer and
then it lease to third parties
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
Manufacturer
asset
of asset

Firm U Lessor Lessee (Firm U)


1. Uses asset 1. Owns asset 1. Uses asset
2. Owns asset 2. Does not use asset 2. Does not own asset

Equity Equity
Creditors Creditors
shareholders shareholders
Operating Leases
Usually not fully amortized
◦ Payment required under the term of lease are not enough to recover
the full cost of the asset for the lessor.
◦ The life of operating lease is less than the economic life of the assets

Usually require the lessor to maintain and insure the asset

Lessee enjoys a cancellation option


Financial Leases
Source of financing: like borrowing a money
Lessee assumes a binding agreement to make a full payment
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.
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.
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.
Leveraged Leases
Lessor borrows from lender to
Lessor buys asset, Firm U leases it. partially finance purchase
Manufacturer The lenders typically use
of asset a nonrecourse loan. This
means that the lessor is
not obligated to the lender
Lessor Lessee (Firm U) in case of a default by the
1. Owns asset 1. Uses asset lessee.
2. Does not use asset 2. Does not own asset
In the event of a default
by the lessor, the lender
has a first lien on the
asset. Also, the lease
Equity payments are made
shareholders Creditors directly to the lender after
a default.
Why Lease?

Sensible Reasons for Leasing


◦ Short-term leases are convenient
◦ Cancellation options are valuable
◦ Maintenance is provided
◦ Standardization leads to low costs
◦ Tax shields can be used
◦ Leasing and financial distress
◦ Avoiding the alternative minimum tax
Why Lease?

Dubious Reasons for Leasing


◦Leasing avoids capital expenditure controls
◦Leasing preserves capital
◦Leases may be off balance sheet financing
◦Leasing effects book income
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.
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.
NPV of leasing
Wadia Co, pipe manufacturing wants to buy a pipe boring machine @ 10,000.
The new machine will save Rs. 6000 per year in electricity bill.
Corporate tax rate is 34%
Straight line depreciation
Lease option:
Falguni Co offered same machine @ 2500 per year for five years
What should Wadia Co. do? Buy or Lease?
Example
Buy Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Cost of Machine -10000
After tax operating 3960 3960 3960 3960 3960
savings=6000X(1-
0.34)
Tax benefit from 680 680 680 680 680
Depreciation
Total -10,000 4640 4640 4640 4640 4640

Depreciation= 10,000/5= 2,000


Tax rate: 0.34*2,000=680
Example
Lease Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Lease payment -2500 -2500 -2500 -2500 -2500
Tax benefit from 850 850 850 850 850
Leasing
(2500*0.34)
After tax operating 3960 3960 3960 3960 3960
savings
Total 2310 2310 2310 2310 2310
Incremental cash Flow from Leasing instead
of buying
Lease Minus Buy Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Lease payment -2500 -2500 -2500 -2500 -2500
Tax benefit from Leasing 850 850 850 850 850
(2500*0.34)
Total= lease payment -1650 -1650 -1650 -1650 -1650
after tax
Buy (Minus)
Cost of machine 10,000
Lost Deprecation tax -680 -680 -680 -680 -680
benefit
Total (Net Cash Flow) 10,000 -2330 = -2330 -2330 -2330 -2330
OCF

These numbers represents the cash flows from leasing relative to the cash flow from the purchase
What next?
Discount the cash flow
What is the discount rate?
Difficult question
The answer is: Discount all cash flows at the after-tax interest rate
Discount Rate
After tax riskless rate of return??
A lease payment is like debt service on a secured bond issued by the lessee
A discount rate should be approximately the same as the interest rate of such debt
◦ Slightly higher due to changes in corporate tax rate
NPV
Lest assume that Wadia can borrow or lend @ 7.57%
Corporate Tax rate is 34%
Aftear tax discount rate is {7.57575%*(1-0.34)}= 5%
NPV=10,000-2330 X PVIA (0.05,5)=-87.68
Since the NPV of incremental cash flows from leasing relative to purchasing is negative, Wadia
prefers to purchase
Calculation of NPV for lease against
purchase
NPV = Purchase Price – OCF * PVIFA kdt%,n
Where,
OCF= lease payment after tax+ Depreciation tax shield
OCF = lease payment (1-tax%) + Depreciation * tax%
OR
NPV = Purchase price – lease payment (1-tax%) * PVIFA kdt%,n – Depreciation * tax% * PVIFA
kdt%, n

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