CHAPTER 22 Leasing Topics 22

CHAPTER 22: Leasing Topics: • • • 22. 1 Types of Leases 22. 2 Accounting and leasing 22. 4 The Cash Flows of Operating Leasing 22. 6 NPV Analysis of the Lease-versus-Buy Decision 22. 8 Does Leasing Ever Pay: The Base Case 22. 9 Reasons for Leasing (This illustration contains a minor correction of your text. Section 22. 4 should be operating lease rather than financial lease. ) 1

22. 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. • Two types: – Operating lease – Financial lease • Sale and lease-back • Leverage lease 2

Buying versus Leasing Buy Lease Firm U buys asset and uses asset; financed by debt and equity. Lessor buys asset, Firm U leases it. Manufacturer of asset Firm U Lessor 1. Uses asset 1. 2. Owns asset 2. Does not use asset Equity shareholders Creditors Owns asset Equity shareholders Lessee (Firm U) 1. Uses asset 2. Does not own asset Creditors 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 usually enjoys a cancellation option. This option gives the lessee the right to cancel the lease contract before the expiration date. 4

Financial Leases • • Most commonly referred to as “Capital lease” The opposite of an operating lease. 1. 2. 3. 4. Do not provide for maintenance or service by the lessor. Generally 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. 5

Sale and Lease-Back (Read by your own) • 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. • Example: Sell you IT assets to HP Financial Services and lease them back. – You can easily adapt to future needs down the road. 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. 7

Leveraged Leases Lessor buys asset, Firm U leases it. Manufacturer of asset Lessor 1. Owns asset 2. Does not use asset Equity shareholders Lessee (Firm U) 1. Uses asset 2. Does not own asset Creditors 8

22. 2 Accounting: Financial (Capital) Lease • The accounting treatment of leasing follows CICA 3065 • A lease must be capitalized (balance sheet disclosure) if any one of the following four criteria is met (CICA or GAAP): – 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. • Both CRA and IRS will treat a capitalized lease as sales for tax purposes. – Lessor records leasing as installment sales; – Lessee records leasing on balance sheet and take depreciation on assets. – Please refer to the attached CRA or IRS regulations for further illustration. 9

22. 4 The Cash Flows of (Operating) Leasing • Capital leasing is (generally) no different from sales. – Same budgeting process as sales – Lessor: asset sale – Lessee: asset on balance sheet, dep. tax shield • Operating leasing – Lessor: asset on balance-sheet • takes depreciation and enjoys tax-deduction of depreciation – Lessee: Off-balance-sheet • lease payment tax-deductible 10

Incremental cashflow approach to lease: An example Zee Movers needs to acquire 50 more cars. Each car will generate $12, 000 per year in added sales for the next five years. The firm has a corporate tax rate of 40%. The car would qualify for a CCA (cost of capital allowance) rate of 40% (rental car). There is no residual value of the car after five years. Assume that this is an operating lease. Two options: (1) Each car can be purchased at a wholesale price of 20, 000. (2) Each car can be leased through an operating leasing with Tiger Leasing at a payment of $5, 000 each year for five years (payable at the beginning of each year). Suppose that all the conditions for operating lease are met. Buy or lease? 11

Example cont’d: Tax shield on CCA for car Year UCC CCA 1 Tax Shield 4 0 1 $1, 600 2 2, 560 3 9, 600 3, 840 1, 536 4 5, 760 2, 304 922 5 3, 456 1, 382 553 Residual at yr 5 2, 074 829. 6 12

Cont’d: Incremental cashflows of leasing compared with buying • If the cars are leased, then: 1. • Lease payment of 5, 000 each year. Tax-deductible expenses. • Lease payment shield = lease payment * tax rate If buy, then: 1. 2. 3. Ownership—Depreciate for tax purposes. Cash outlay of 20, 000 at time 0. Tax deduction due to residual value loss. Note: The added sales of 12, 000 each car apply to both leasing and buying, so the incremental cashflow of added sales for leasing is zero. • Timing of cashflow: (a bit different from the text) – – Lease rental payment happens in advance Depreciation happens in arrears 13

Cont’d: Incremental Cashflows: Lease minus buy Year 0 1 2 3 4 -3000 2560 1536 921. 6 5 After-tax cash flows from leasing (1) AT lease payment -3000 After-tax cashflows from buying the asset Asset cost -20, 000 Dep. tax shield 1600 Residual tax shield (2) Net cash from buying 552. 8 829. 6 -20, 000 1600 2560 1536 921. 6 1, 382 -4600 -5560 -4536 -3922 -1382 Differential cashflow (3) Lease minus buy 17, 000 Note: (3) = (1) – (2) 14

Cont’d: Incremental cashflows—Textbook method • Same cashflow, but view things from the aggregate of (leasebuy): – Lease: Lease payment (outflow) + lease payment tax shield (inflow) – Effects of “Minus Buy”: Save on initial purchase price (inflow), but bypass depreciation tax shields (outflow). 15

22. 6 NPV Analysis of the Lease-vs. -Buy Decision • • • Lease payment is like interest payment!—Cashflows are deterministic once the lease contract is entered into. A lease payment is like the debt service on a secured bond issued by the lessee. A lessee incurs a liability equal to the present value of all future lease payments. (Lease displaces debt—“Debt displacement”) In practice, 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. 16

Example cont’d: NPV of leasing Assume that Zee can either borrow or lend at 11% interest rate. What is the NPV of the lease? AT discount rate = NPV = 17, 000– 4, 600/1. 066 – 5, 560 /1. 0662 – 4, 536 /1. 0663 3, 922/1. 0664 -1382/1. 0665 = 6. 21 • Lease or buy? 17

What if there is economic residual value left? • To make it compatible with laws, the lease needs to be an operating lease. One way is to specify sufficiently high residual value. Let’s suppose 5 years later, the cars are returned to Tiger Leasing with a residual guarantee value of 15%, which is also the residual economic value. Everything else remains the same. What’s your answer now? – CF to lease won’t change. – Changes in CF to buy: • If you buy, 5 years later you dispose of (sell) the asset for 15% of purchase price. • You realize some proceeds; • You pay (deduct) taxes if there is capital gains (loss) in asset disposal. (Depreciation Recapture when terminating the pool. ) 18

Cont’d: Add residual guarantee to valuation Year 0 2 3 4 5 4000 Depreciation schedule 1 6400 3840 2304 1382 Residual book 2074 Residual guarantee (1) After-tax cashflows from buying the asset Asset cost -20, 000 Depreciation tax shield 1600 2560 1536 921. 6 552. 8 1, 600 2, 560 1, 536 922 3, 182 AT Residual cashflow (2) Net cash from buying -20, 000 Notes: (1) Residual guarantee = (2) AT Residual cashflow = 19

Cont’d: Solution After-tax rental payment -3000 -3000 Net cash from buying -20000 1600 2560 1536 922 3182 Lease minus buy 17000 -4600 -5560 -4536 -3922 -3182 NPV -1301 IRR 9. 60% Decision? Please refer to the spreadsheet in the course webpage. 20

22. 8 Does Leasing Ever Pay: The Base Case • Cashflow to Tiger Leasing (the lessor) is just the opposite of that to Zee Movers (the lessee) in the leasing: • Lease minus sell (for the case of no residual value) Year Negative of Asset sale AT lease income 0 1 2 3 4 3000 1600 2560 1536 921. 6 -20, 000 3000 Dep. tax shield Residual tax shield Net CF 5 552. 8 829. 6 -17, 000 4600 5560 4536 3922 1382 NPV: Same tax rate and same discount rate: -6. 21! 21

A zero-sum game for lessee and lessor if • Both are at the same corporate tax bracket • Both borrow and lend at the same rate • No transaction costs No leasing would ever occur! 22

22. 9 Reasons for Leasing • Taxes may be reduced by leasing in operating leasing. – The principal benefit of long-term leasing is tax reduction. – Leasing allows the transfer of tax benefits from those (lessee) who need equipment but cannot take full advantage of the tax benefits of ownership to a party (lessor) who can. • The lease contract may reduce certain types of uncertainty (the residual value risk at the end of the contract is borne by the lessor, and it may be in a better position to bear this risk) • Transactions costs can be higher for buying an asset and financing it with debt or equity than for leasing the asset. 23

An Illustration of Benefit of Tax Reduction: Tax Arbitrage Back to the example where there’s no economic residual. Suppose Zee (the LESSEE) is still in the 40% tax bracket, but Tiger Leasing (the LESSOR) is in the 30% tax bracket instead. Can leasing happen in this case? (i. e. , Can both firms have a positive NPV? ) • What’s changed? – For Lessee, nothing is changed: same tax rate, same interest rate, same payment Same incremental cashflow in Lease vs. buy decision. + NPV. – For Lessor’s Lease vs. sell decision, after-tax cashflow is now changed • AT lease income • Depreciation and residual tax shield • AT discount rate as well! 24

Tax arb. cont’d: Lease vs. sell (no residual guarantee) Year 0 1 3 4 5 4000 Depreciation 2 6400 3840 2304 1, 382 Residual 2, 074 After-tax cash flows from leasing After-tax rental income 3500 Residual tax shield 3500 1200 Depreciation tax shield 3500 1920 1152 691 Net cash from leasing 3, 500 Selling Asset proceeds -16, 500 622 20, 000 Diff: Lease minus sell 415 NPV 4, 700 5, 420 4, 652 4, 191 1, 037 $91. 16 Notes: 1. Depreciation tax shield and lease payment is now calculated at tax rate of 30%. 2. Discount rate for NPV is: 25

Tax arb. cont’d: Reservations and Negotiations • What is the smallest lease payment that Lessor (Tiger Leasing) will accept? Set their NPV to zero (break-even) and solve for the payment. • What is the highest lease payment that Lessee (Zee Movers) can pay? Set their NPV to zero (break-even) and solve for the payment. • As long as the highest payment from the lessee is larger than the smallest payment for the lessor, it is feasible to lease. – Feasible lease payment: [lessor’s smallest lease payment, lessee’s largest lease payment] 26

Derivation of reservation payment: Lessee Three components: • PV of Depreciation (and residual loss) Tax Shield • PV of AT lease payment—Annuity (in advance) • Equipment cost at time 0 Set 3 – 2 – 1 = 0. (Answer: $5002) For Zee Movers: 27

Cont’d 28

Derivation of reservation payment: Lessor Three components: 1. PV of Depreciation (and, if any, residual loss) Tax Shield 2. PV of AT lease payment—Annuity (in advance) 3. Equipment proceeds at time 0 Set 1+2 -3 = 0. • Repeat the same exercise for Tiger Leasing. – Note that tax rate, and hence AT discount rate, are different. – Answer: $4970. – Lease will happen with a lease payment in [4970, 5002]. 29

Review Questions • How would you evaluate a capital lease through incremental cashflow approach? Give the incremental cashflow from the perspective of lease vs. buy. • Assigned problems: #22. 1, 2 -6, 8, 11 (Assume operating leasing for incremental cashflow analysis. ) 30