Principles of corporate finance 6th brealey myers chapter 25

©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill Operating Lease Example Acme Limo has a client who will sign a lease for 7 years, with lease payments due at the start of each yea

 Leasing

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©The McGraw-Hill Companies, Inc., 2000

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Topics Covered

 What is a Lease?

 Why Lease?

 Operating Leases

 Valuing Financial Leases

 When Do Financial Leases Pay?

Lease Terms

 Operating Leases

 Financial Leases

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Why Lease?

 Sensible Reasons for Leasing

Why Lease?

 Dubious Reasons for Leasing

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Operating Lease

Example

Acme Limo has a client who will sign a lease for 7 years, with lease payments due at the start of each year The following table shows the NPV of the limo if Acme purchases the new limo for $75,000 and leases it our for 7 years

Operating Lease

Example - cont

Acme Limo has a client who will sign a lease for 7 years, with lease payments due at the start of each year The following table shows the NPV of the limo if Acme purchases the new limo for $75,000 and leases it our for 7 years

Year

Initial cost -75

Maintenance, insurance, selling, -12 -12 -12 -12 -12 -12 -12

and administrative costs Tax shield on costs 4.2 4.2 4.2 4.2 4.2 4.2 4.2

Depreciation tax shield 0 5.25 8.4 5.04 3.02 3.02 1.51

Total -82.8 -2.55 0.6 -2.76 -4.78 -4.78 -6.29

NPV @ 7% = - $98.15

Break even rent(level) 26.18 26.18 26.18 26.18 26.18 26.18 26.18

Tax -9.16 -9.16 -9.16 -9.16 -9.16 -9.16 -9.16

Break even rent after-tax 17.02 17.02 17.02 17.02 17.02 17.02 17.02

NPV @ 7% = - $98.15

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Financial Leases

Example

Greymore Bus Lines is considering a lease Your operating manager wants to buy a new bus for

$100,000 The bus has an 8 year life The bus saleswoman says she will lease Greymore the bus for 8 years at $16,900 per year, but Greymore

assumes all operating and maintenance costs

Should Greymore buy or lease the bus?

Financial Leases

Example - cont

Greymore Bus Lines is considering a lease Your operating manager wants

to buy a new bus for $100,000 The bus has an 8 year life The bus saleswoman says she will lease Greymore the bus for 8 years at $16,900 per year, but Greymore assumes all operating and maintenance costs

Should Greymore buy or lease the bus?

Year

Cost of new bus 100.00

Lost Depr tax shield (7.00) (11.20) (6.72) (4.03) (4.03) (2.02)

-Lease payment (16.90) (16.90) (16.90) (16.90) (16.90) (16.90) (16.90) (16.90)

Tax shield of lease 5.92 5.92 5.92 5.92 5.92 5.92 5.92 5.92

Cash flow of lease 89.02 (17.98) (22.18) (17.70) (15.01) (15.01) (13.00) (10.98)

Cash flow consequences of the lease contract to Greymore

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Financial Leases

Example - cont

Greymore Bus Lines is considering a lease Your operating manager wants

to buy a new bus for $100,000 The bus has an 8 year life The bus saleswoman says she will lease Greymore the bus for 8 years at $16,900 per year, but Greymore assumes all operating and maintenance costs

Should Greymore buy or lease the bus?

Cash flow consequences of the lease contract to Greymore:

•Greymore saves the $100,000 cost of the bus.

•Loss of depreciation benefit of owning the bus.

•$16,900 lease payment is due at the start of each year.

•Lease payments are tax deductible.

Financial Leases

Example - cont

Greymore Bus Lines Balance Sheet without lease

Equivalent lease balance sheet

Greymore Bus Lines (figures in $1,000s) Bus 10 100 Loan secured by bus All other assets 1000 450 Other loans

550 Equity Toital Assets 1100 1100 Total liabilities

Greymore Bus Lines (figures in $1,000s) Bus 10 100 Financial lease All other assets 1000 450 Other loans

550 Equity Toital Assets 1100 1100 Total liabilities

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Financial Leases

Example - cont

Greymore Bus Lines can borrow at 10%, thus the value of the lease should be discounted at

6.5% or 10 x (1-.35) The result will tell us if Greymore should lease or buy the bus

Financial Leases

Example - cont

Greymore Bus Lines can borrow at 10%, thus the value of the lease should be discounted

at 6.5% or 10 x (1-.35) The result will tell us if Greymore should lease or buy the bus

$700

-or 70

1.065

10.98

-1.065

13.00

-1.065

15.02

-

1.065

15.02

-1.065

17.71

-1.065

22.19

-1.065

17.99

-89.02 lease

NPV

7 6

5

4 3

2







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Financial Leases

Example - cont

Greymore Bus Lines lease cash flows can also be thought of as loan equivalent cash flows

Financial Leases

Example - cont

Greymore Bus Lines lease cash flows can also be thought of as loan equivalent cash flows.

Year

0 1 2 3 4 5 6 7 Amount borrowed

at year end 89.72 77.56 60.42 46.64 34.66 21.89 10.31 0.00

Interest paid @ 10% -8.97 -7.76 -6.04 -4.66 -3.47 -2.19 -1.03

Tax shield @ 35% 3.14 2.71 2.11 1.63 1.21 0.77 0.36

Interest paid after tax -5.83 -5.04 -3.93 -3.03 -2.25 -1.42 -0.67

Principal repaid -12.15 -17.14 -13.78 -11.99 -12.76 -11.58 -10.31

Net cash flow of

equivalent loan 89.72 -17.99 -22.19 -17.71 -15.02 -15.02 -13.00 -10.98

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Financial Leases

Example - cont

The Greymore Bus Lines lease cash flows can also be treated as a favorable financing alternative and valued using APV

$3,000 8,000

-5,000 APV

lease of

NPV project

of NPV

APV

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



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