On Leasing Adapted from Fundamentals of Corporate Finance

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On Leasing Adapted from Fundamentals of Corporate Finance RWJR, Fourth Canadian Edition

Definition A lease is a contractual agreement between two parties: Lesee: the user of an asset, makes payments to the lessor Lessor: the owner of the asset, receives payments from lessee

Operating vs. Financial lease

Sale and Leaseback Agreements When a company sells an asset it owns to another firm and immediately leases it back: • The lessee receives cash from the sale of the asset • The lessee continues to use the asset. Ex: In January 1989 Air Canada arranged a sale and leaseback of four Boeing 767 airplanes with a Canadian financial institution.

Leveraged leases Tax oriented lease involving a lessee, a lessor, and a lender. When the lessee cannot fully take advantage of its CCA deductions associated with owning the asset, the lessee will find someone willing to buy The lessee selects the asset, uses the asset, and makes the periodic lease payments. The lessor (owner of the asset) makes a down payment (20 -30%) towards the purchase of the asset, borrows from a lender the balance, has the title of the asset, and receives the lease payments. The lender supplies the financing and receives interest payments.

Accounting and Leasing The Canadian Institute for Chartered Accountants requires that all financial leases must be capitalized:

Exemplification: Bearskin Airlines contemplates adding another airplane to its fleet. The candidate it's a Swedish made Saab, which cost $350, 000. The company has to decide whether to buy or lease the airplane:

Borrow and buy the airplane

Operating lease

Financial lease

Clarification For accounting purposes, a lease is declared to be a financial lease, and must be disclosed, if at least one of the following criteria is met: • the lease transfers ownership of the property to the lessee by the end of the lease term • The lessee has an option to purchase the asset at a price below fair market value (bargain purchase price option) when the lease expires. • The lease term is 75% or more the estimated economic life of the asset • The present value of the lease payments is at least 90% of the fair market value of the asset at the start of the lease.

Why do managers want to disguise financial leases as operating leases? • Under an operating lease, the lessee can deduct lease payments for income tax purposes. • Under a financial lease, the lessee is allowed to amortize the asset over a period that might be longer than the lease, and only the interest portion of the lease is deductible for tax purposes. • Not showing a financial lease can disguise a firm’s long-term financial commitments

Leasing: A NPV analysis Trans. Canada Distributors runs a fleet of company cars for its sales staff. Business has been expanding and the firm needs an 50 additional cars to provide basic transportation. Each car can be purchased wholesale for $10, 000 and will generate an additional $6, 000/year in added sales for the next five years. Trans. Canada has a corporate tax rate of 40%. The CCA rate is also 40%, over an estimated life span of five years. After that the residual value of each car would be zero. Financial Lease Co. has offered to lease for $2, 500/year for each car, over a five-year period. Lease payments are made at the beginning of the year. Trans Canada would be responsible for maintenance, insurance, and operating expense.

Trans. Canada: Tax shield if buying (assuming the asset pool is closed after 5 years)

Trans. Canada: Annual tax shield if leasing $2, 500(0. 4) = $1, 000

Trans. Canada: Incremental cash flow analysis

Trans. Canada: Analysis If Trans. Canada can borrow at 11% from the bank, then its after-tax cost of borrowing is 11(1 -0. 4) = 6. 6%. NPV of the lease = Investment - PV(after-tax lease payments) - PV(CCA tax shield) NPV = $7, 700 - $2, 780/(1. 066) - $2, 268/(1. 066)2 - $1, 961/(1. 066)3 $1776/(1. 066)4 - $415/(1. 066)5 = -$199 Here, buying is preferred over leasing.

Trans. Canada: Analysis (2) If the asset pool is not closed after five years, PV (CCA) = Investment(T)(d)(1+k/2)/(k+d)(1+k) PV (CCA) = 10, 000 (0. 4)(1. 033) /(0. 466)(1. 066) = $3, 327 NPV = $10, 000 - $6, 627 -$3, 327 = $46 In this case, leasing is better than buying.

The Lessor: Financial Lease Co. (decision: buy and lease versus do nothing) Assumptions: • Asset pool is closed after five years • CCA rate = 40% • Corporate tax rate = 40%

Cash flow to the lessor: Financial Lease Co.

Financial Lease Co. : Analysis If the after-tax cost of borrowing is also 6%, NPV = $199 Note: NPV to Trans. Canada =$-199 NPV to the lessor = $199. Obviously Trans. Canada will not agree to the lease contract.

Special Case Assume Trans. Canada pays no taxes, and is able to negotiate an annual lease payment of $2, 437

Cash flow to the lessee (Trans. Canada) NPV = $7, 563 - $2, 437 PVA*(r = 11%, t = 5) = $2. 34 In this case, leasing is better than buying.

Cash flow to the lessor NPV to the lessor = $32

IMPLICATION LEASE CONTRACTS ARE USUALLY BENEFICIAL FOR BOTH PARTIES WHEN THE LESSE IS IN A LOWER TAX BRACKET THAN THE LESSOR CAN PASS ON SOME OF THE TAX SAVINGS TO THE LESSEE IN THE FORM OF LOWER LEASE PAYMENTS.