Chapter Outline21.1 Types of Leases 21.2 Accounting and Leasing 21.3 Taxes, the IRS, and Leases 21.4 The Cash Flows of Leasing 21.5 A Detour on Discounting and Debt Capacity with Corpora
Trang 121
Introduction to Corporate Finance
Trang 2Chapter Outline
21.1 Types of Leases
21.2 Accounting and Leasing
21.3 Taxes, the IRS, and Leases
21.4 The Cash Flows of Leasing
21.5 A Detour on Discounting and Debt Capacity with Corporate
Taxes21.6 NPV Analysis of the Lease-versus-Buy Decision
21.7 Debt Displacement and Lease Valuation
21.8 Does Leasing Ever Pay: The Base Case
21.9 Reasons for Leasing
21.10 Some Unanswered Questions
21.11 Summary and Conclusions
21.1 Types of Leases
21.2 Accounting and Leasing
21.3 Taxes, the IRS, and Leases
21.4 The Cash Flows of Leasing
21.5 A Detour on Discounting and Debt Capacity with Corporate
Taxes21.6 NPV Analysis of the Lease-versus-Buy Decision
21.7 Debt Displacement and Lease Valuation
21.8 Does Leasing Ever Pay: The Base Case
21.9 Reasons for Leasing
21.10 Some Unanswered Questions
21.11 Summary and Conclusions
Trang 4Buying versus Leasing
Firm U buys asset and uses asset;
financed by debt and equity.
Lessor buys asset, Firm U leases it.
Trang 5Operating Leases
Usually not fully amortized.
Usually require the lessor to maintain and insure the asset.
Lessee enjoys a cancellation option.
Usually not fully amortized.
Usually require the lessor to maintain and
insure the asset.
Lessee enjoys a cancellation option.
Trang 6Financial Leases
The exact 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.
The exact 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.
Trang 7Sale 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.
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.
Trang 8Leveraged 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
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
Trang 92 Does not own 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
Lessor borrows from lender to partially finance purchase
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.
Trang 1021.2 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.
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.
Trang 11Accounting and Leasing
Total Assets $200,000 Total Debt & Equity
Consider a firm with two assets: a truck and some land
Trang 12Capital 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
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
Trang 1321.3 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
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.
Trang 1421.3 Taxes, the IRS, and Leases
The lessee can deduct lease payments if the lease
is qualified by the IRS.
1 The term 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
The lessee can deduct lease payments if the lease
is qualified by the IRS.
1 The term 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
Trang 1521.4 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 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
They can lease it for 5 years from Tiger Leasing
with an annual lease payment of $6,250.
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 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
They can lease it for 5 years from Tiger Leasing
with an annual lease payment of $6,250.
Trang 1621.4 The Cash Flows of Leasing
Cash Flows: Buy
Trang 1721.4 The Cash Flows of Leasing
Cash Flows: Leasing Instead of Buying
However we wish to conceptualize this, we need
to have an interest rate at which to discount the
future cash flows.
That rate is the after-tax rate on the firm’s secured debt.
Cash Flows: Leasing Instead of Buying
However we wish to conceptualize this, we need
to have an interest rate at which to discount the
future cash flows.
That rate is the after-tax rate on the firm’s secured debt.
Trang 1821.5 A Detour on 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 after-tax riskless rate of
a future guaranteed after-tax inflow at the after-tax
Present Value of Riskless Cash Flows
In a world with corporate taxes, firms should discount riskless cash flows at the after-tax riskless rate of
Trang 1921.6 NPV Analysis of the Lease-vs.-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 shields and the
lease payments at the after-tax interest rate
on secured debt issued by the lessee.
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 shields and the
lease payments at the after-tax interest rate
on secured debt issued by the lessee.
Trang 20NPV Analysis of the Lease-vs.-Buy Decision
There is a simple method for evaluating leases: discount all cash flows at the after-tax interest rate on secured debt issued
by the lessee Suppose that rate is 5 percent
NPV Leasing Instead of Buying
5
Trang 21NPV Analysis of the Lease-vs.-Buy Decision
NPV Buying Instead of Leasing
Trang 2221.7 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.
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.
Trang 2321.7 Debt Displacement and Lease Valuation
The debt displaced by leasing results in forgone interest tax shields on the debt that ClumZee movers didn’t go into when they leased instead of bought the truck
Suppose ClumZee agrees to a lease payment of $6,250 before tax This payment would support a loan of
$25,219.20 (see the next slide)
In exchange for this, they get the use of a truck worth
$25,000
Clearly the NPV is a negative $219.20, which agrees
with our earlier calculations.
The debt displaced by leasing results in forgone interest tax shields on the debt that ClumZee movers didn’t go into when they leased instead of bought the truck
Suppose ClumZee agrees to a lease payment of $6,250 before tax This payment would support a loan of
$25,219.20 (see the next slide)
In exchange for this, they get the use of a truck worth
$25,000
Clearly the NPV is a negative $219.20, which agrees
with our earlier calculations.
Trang 2421.7 Debt Displacement and Lease Valuation
Suppose ClumZee agrees to a lease payment of $6,250 before tax
This payment would support a loan of $25,219.20
Calculate the increase in debt capacity by discounting the difference between the cash flows of the purchase and the cash flows of the lease by the after-tax interest rate
Suppose ClumZee agrees to a lease payment of $6,250 before tax
This payment would support a loan of $25,219.20
Calculate the increase in debt capacity by discounting the difference between the cash flows of the purchase and the cash flows of the lease by the after-tax interest rate
PMT
Forgone Depreciation Tax Shield –5,000×(.34) = –$1,700
–$5,825After-Tax Lease Payments –6,250×(1 –.34) = –$4,125
Trang 2521.7 Debt Displacement and Lease Valuation
Outstanding Loan Balance $25,219 $20,655 $15,862 $10,831 $5,547 $0.00 Interest $1,910 $1,565 $1,202 $821 $420 Tax Deduction on interest $650 $532 $409 $279 $143 After-tax Interest Expense $1,261 $1,033 $793 $542 $277 Extra Cash that purchasing
firm generates over leasing
firm $5,825 $5,825 $5,825 $5,825 $5,825
Suppose ClumZee agrees to a lease payment of $6,250 before tax This payment would support a loan of $25,219.20
05 0 20 219 , 25
$ 96 260 , 1
$5,825. $1,260.96
20 219 , 25
$ 16 655 , 20
After-Tax Lease Payments –6,250×(1 –.34) = –$4,125
Forgone Depreciation Tax Shield –5,000×(.34) = –$1,700
–$5,825
Trang 2621.8 Does Leasing Ever Pay: The Base Case
In the above example, ClumZee Movers chose to buy, because the NPV of leasing was a negative $219.20
Note that this is the opposite of the NPV that Tiger Leasing would have:
In the above example, ClumZee Movers chose to buy, because the NPV of leasing was a negative $219.20
Note that this is the opposite of the NPV that Tiger Leasing would have:
Cash Flows: Tiger Leasing
Cost of truck – $25,000 Depreciation Tax Shield 5,000×(.34) = $1,700
Trang 2721.9 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
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
Trang 28A Tax Arbitrage
Suppose ClumZee movers is actually in the 25% tax bracket and Tiger Leasing
is in the 34% tax bracket If Tiger reduces the lease payment to $6,200, can
both firms have a positive NPV?
Cash Flows: Tiger Leasing
Cost of truck we didn’t buy $25,000
Lost Depreciation Tax Shield 5,000×(.25) = –$1,250
After-Tax Lease Payments 6,200×(1 –.25) = –$4,650
$25,000 –$5,900
Suppose ClumZee movers is actually in the 25% tax bracket and Tiger Leasing
is in the 34% tax bracket If Tiger reduces the lease payment to $6,200, can
both firms have a positive NPV?
Cash Flows: Tiger Leasing
Cost of truck we didn’t buy $25,000
Lost Depreciation Tax Shield 5,000×(.25) = –$1,250
After-Tax Lease Payments 6,200×(1 –.25) = –$4,650
$25,000 –$5,900
Trang 29Tiger Leasing’s Break-even Payment
What is the smallest lease payment that Tiger Leasing will
accept? Set their NPV to zero and solve for $L min:
Cash Flows: Tiger Leasing
What is the smallest lease payment that Tiger Leasing will
accept? Set their NPV to zero and solve for $L min:
Cash Flows: Tiger Leasing
Year 0 Years 1-5 Cost of truck -$25,000
Depreciation Tax Shield 5,000×(.34) = $1,700
Lease Payments $L min × (1 –.34) = $L min × (1 –.34)
min ) 05 1 (
700 , 1
$ 66
000
, 25
$
0
L NPV
5 1
min
) 05 1 (
700 , 1
$ )
05 1 (
1
$ 66
000 , 25
) 05 1 (
1
$ 66
.
) 05 1 (
700 , 1
$ 000
, 25
$
L
Trang 30Tiger Leasing’s Break-even Payment
Step one is to find the after-tax cost of the truck
Step two is to find the after-tax payment required
Step one is to find the after-tax cost of the truck
Step two is to find the after-tax payment required
CF1F1
Trang 31ClumZee Mover’s Break-even Payment
What is the highest lease payment that ClumZee Movers
can pay? Set their NPV to zero and solve for $Lmax:
Cash Flows ClumZee Movers: Leasing Instead of Buying
Cost of truck we didn’t buy $25,000
What is the highest lease payment that ClumZee Movers
can pay? Set their NPV to zero and solve for $Lmax:
Cash Flows ClumZee Movers: Leasing Instead of Buying
Cost of truck we didn’t buy $25,000
After-Tax Lease Payments – $L max ×( 1 –.25) = 75× L max
max ) 05 1 (
250 , 1
$ 75
000
, 25
$
0
L NPV
5 1
max
) 05 1 (
250 , 1
$ )
05 1 (
75 000
, 25
) 05 1 (
75
) 05 1 (
250 , 1
$ 000
, 25
$ max
L
No lease is possible: L > L