21 -0 Leasing Chapter Twenty One Corporate Finance

21 -0 Leasing Chapter Twenty One Corporate Finance Ross Westerfield Jaffe 21 Sixth Edition Prepared by Gady Jacoby University of Manitoba and Sebouh Aintablian American University of Beirut Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -1 Chapter Outline 21. 1 Types of Leases 21. 2 Accounting and Leasing 21. 3 Taxes and Leases 21. 4 The Cash Flows of Leasing 21. 5 A Detour on Discounting and Debt Capacity with Corporate Taxes 21. 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 Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -2 21. 1 Types of Leases • The Basics – 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 lessor is either the asset’s manufacturer or an independent leasing company. Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -3 Operating Leases • Usually not fully amortized. This means that the payments required under the terms of the lease are not enough to recover the full cost of the asset for the lessor. • Usually require the lessor to maintain and insure the asset. • Lessee enjoys a cancellation option. This option gives the lessee the right to cancel the lease contract before the expiration date. Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -4 Financial Leases The exact opposite of an operating lease. 1. 2. 3. 4. Do not provide for maintenance or service by the lessor. Financial leases are fully amortized. The lessee usually has a right to renew the lease at expiry. Generally, financial leases cannot be cancelled, i. e. , the lessee must make all payments or face the risk of bankruptcy. Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -5 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. Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -6 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. Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -7 21. 2 Accounting and Leasing • In the old days, leases led to off-balance-sheet financing. • In 1979, the Canadian Institute of Chartered Accountants implemented new rules for lease accounting according to which financial leases must be “capitalized. ” • Capital leases appear on the balance sheet—the present value of the lease payments appears on both sides. Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -8 Accounting and Leasing Balance Sheet Truck is purchased with debt Truck $100, 000 Land $100, 000 Total Assets $200, 000 Debt $100, 000 Equity $100, 000 Total Debt & Equity $200, 000 Operating Lease Truck Land Total Assets $100, 000 Debt Equity $100, 000 Total Debt & Equity $100, 000 Capital Lease Assets leased Land Total Assets $100, 000 $200, 000 Obligations under capital lease Equity Total Debt & Equity Mc. Graw-Hill Ryerson $100, 000 $200, 000 © 2003 Mc. Graw–Hill Ryerson Limited

21 -9 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. Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -10 21. 3 Taxes 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. • If the CCRA (Canada Customs and Revenue Agency) detects one or more of the following, the lease will be disallowed. 1. The lessee automatically acquires title to the property after payment of a specified amount in the form of rentals. 2. The lessee is required to buy the property from the lessor. 3. The lessee has the right during the lease to acquire the property at a price less than fair market value. Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -11 21. 4 The Cash Flows of Leasing Consider a firm, Clum. Zee 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 five years. If the firm buys the truck, they will depreciate it straight -line to zero. They can lease it for five years from Tiger Leasing with an annual lease payment of $6, 250. Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -12 21. 4 The Cash Flows of Leasing • Cash Flows: Buy Cost of truck After-tax savings Depreciation Tax Shield Year 0 –$25, 000 Years 1 -5 4, 500×(1 -. 34) = 5, 000×(. 34) = –$25, 000 $2, 970 $1, 700 $4, 670 • Cash Flows: Lease Year 0 Lease Payments After-tax savings Years 1 -5 – 6, 250×(1 -. 34) = 4, 500×(1 -. 34) = –$4, 125 $2, 970 –$1, 155 • Cash Flows: Leasing Instead of Buying Year 0 $25, 000 Mc. Graw-Hill Ryerson Years 1 -5 –$1, 155 – $4, 670 = –$5, 825 © 2003 Mc. Graw–Hill Ryerson Limited

21 -13 21. 4 The Cash Flows of Leasing • Cash Flows: Leasing Instead of Buying Year 0 $25, 000 Years 1 -5 –$1, 155 – $4, 670 = –$5, 825 • Cash Flows: Buying Instead of Leasing Year 0 –$25, 000 Years 1 -5 $4, 670 –$1, 155 = $5, 825 • 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. Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -14 21. 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 interest. • Optimal Debt Level and Riskless Cash Flows – In a world with corporate taxes, one determines the increase in the firm’s optimal debt level by discounting a future guaranteed after-tax inflow at the after-tax riskless interest rate. Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -15 21. 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 aftertax interest rate on secured debt issued by the lessee. • The various tax shields could be riskier than lease payments for two reasons: 1. The value of the CCA tax benefits depends on the firm’s ability to generate enough taxable income. 2. The corporate tax rate may change. Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -16 NPV 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 Year 0 $25, 000 Years 1 -5 –$1, 155 – $4, 670 = -$5, 825 NPV Buying Instead of Leasing Year 0 Years 1 -5 -$25, 000 $4, 670 – $1, 155 = $5, 825 Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -17 21. 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. Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -18 21. 7 Debt Displacement and Lease Valuation • The debt displaced by leasing results in forgone interest tax shields on the debt that Clum. Zee movers didn’t go into when they leased instead of bought the truck. • Suppose Clum. Zee 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. Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -19 21. 7 Debt Displacement and Lease Valuation Suppose Clum. Zee agrees to a lease payment of $6, 250 before tax. This payment would support a loan of $25, 219. 20 After-Tax Lease Payments Forgone Depreciation Tax Shield – 6, 250×(1 -. 34) = – 5, 000×(. 34) = –$4, 125 –$1, 700 -$5, 825 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. Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -20 21. 8 Does Leasing Ever Pay: The Base Case • In the above example, Clum. Zee 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 Year 0 Cost of truck Years 1 -5 –$25, 000 Depreciation Tax Shield 5, 000×(. 34) = Lease Payments 6, 250×(1 -. 34) = $4, 125 –$25, 000 Mc. Graw-Hill Ryerson $1, 700 $5, 825 © 2003 Mc. Graw–Hill Ryerson Limited

21 -21 21. 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 – Leasing and accounting income – 100% financing Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -22 A Tax Arbitrage • Suppose Clum. Zee 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 Depreciation Tax Shield Lease Payments Year 0 –$25, 000 Years 1 -5 5, 000×(. 34) = 6, 200×(1 –. 34) = –$25, 000 $1, 700 $4, 092 $5, 792 NPV = 76. 33 • Cash Flows Clum. Zee Movers: Leasing Instead of Buying Cost of truck we didn’t buy Lost Depreciation Tax Shield After-Tax Lease Payments Year 0 $25, 000 Years 1 -5 5, 000×(. 25) = 6, 200×(1 –. 25) = $25, 000 –$1, 250 –$4, 650 –$5, 900 NPV = -$543. 91 Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -23 Reservations and Negotiations • What is the smallest lease payment that Tiger Leasing will accept? Set their NPV to zero and solve for $Lmin: • Cash Flows: Tiger Leasing Cost of truck Depreciation Tax Shield Lease Payments Year 0 -$25, 000 Mc. Graw-Hill Ryerson Years 1 -5 5, 000×(. 34) = $1, 700 $Lmin ×(1 –. 34) = $Lmin ×. 66 $1, 700 + $Lmin ×. 66 © 2003 Mc. Graw–Hill Ryerson Limited

21 -24 Reservations and Negotiations • What is the highest lease payment that Clum. Zee Movers can pay? Set their NPV to zero and solve for $Lmax: • Cash Flows Clum. Zee Movers: Leasing Instead of Buying Cost of truck we didn’t buy Lost Depreciation Tax Shield After-Tax Lease Payments Year 0 $25, 000 Years 1 -5 5, 000×(. 25) = – $1, 250 – $Lmax×( 1 –. 25) =. 75× Lmax – 1, 250 –. 75× Lmax No lease is possible: Lmin > Lmax Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -25 21. 10 Some Unanswered Questions • Are the Uses of Leases and of Debt Complementary? • Why are Leases offered by Both Manufacturers and Third Party Lessors? – For manufacturer lessors, the basis for determining capital cost allowance is the manufacturer’s cost. – For third party lessors, the basis is the sale price that the lessor paid to the manufacturer. • Why are Some Assets Leased More than Others? – The more sensitive is the value of an asset to use and maintenance decisions, the more likely it is that the asset will be purchased instead of leased. Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -26 21. 11 Summary and Conclusions • There are three ways to value a lease. 1. Use the real-world convention of discounting the incremental after-tax cash flows at the lessor’s after-tax rate on secured debt. 2. 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. The increase in debt capacity from a purchase is compared to the extra outflow at year 0 from a purchase. 3. Use APV (presented in the appendix to this chapter). • They all yield the same answer. • The easiest way is the least intuitive. Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -27 Appendix 21 A: APV Approach to Leasing APV = All-Equity Value + Financing NPV Calculations shown on the following slides will show that for the latest Clumzee Movers example (tax rate is 25%) APV = $591. 38 – $1, 135. 30 APV = –$543. 91 Which is the same value as the easier NPV analysis. Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -28 Appendix 21 A: APV Approach to Leasing APV = All-Equity Value + Financing NPV • To find the all-equity value, discount the cash flows at the pre-tax interest rate. The after-tax rate was 5% which implies a pretax rate of 6. 66% = 5%/(1 -. 25). Cash Flows Clum. Zee Movers: Leasing Instead of Buying Year 0 Years 1 -5 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 Mc. Graw-Hill Ryerson –$5, 900 © 2003 Mc. Graw–Hill Ryerson Limited

21 -29 Appendix 21 A: APV Approach to Leasing APV = All-Equity Value + Financing NPV • The NPV of the financing is the forgone interest tax shields on the debt that Clum. Zee movers didn’t go into when they leased instead of bought the truck. • Clum. Zee agreed to a lease payment of $5, 900. • This payment would support a loan of $25, 543. 91 Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -30 Appendix 21 A: APV Approach to Leasing The lost interest tax shield associated with this additional debt capacity of $25, 543. 91 has a present value of $1, 135. 30 Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited

21 -31 21. 7 Debt Displacement and Lease Valuation The lost interest tax shield associated with this additional debt capacity of $25, 219. 20 has a present value of $ Mc. Graw-Hill Ryerson © 2003 Mc. Graw–Hill Ryerson Limited