Leasing & It’s

Different
Types.

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 Lease Financing
Lease -- A contract under which one party, the
lessor (owner) of an asset, agrees to grant the
use of that asset to another, the lessee, in
exchange for periodic rental payments.
Examples of familiar leases

Apartments Houses
Offices Automobiles

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 Lease Financing
Typically, a company first decides on the asset that
it needs. It then negotiates a lease contract with a
lessor for use of that asset. The lease agreement
establishes that the lessee has the right to use the
asset and, in return, must make periodic payments
to the lessor, the owner of the asset. The lessor is
usually either the asset’s manufacturer or an
independent leasing company. If the lessor is an
independent leasing company, it must buy the
asset from a manufacturer. The lessor then
delivers the asset to the lessee, and the lease
goes into effect.

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 Issues in Lease Financing
◆ Advantage:
Advantage Use of an asset without
purchasing the asset
◆ Obligation:
Obligation Make periodic lease payments
◆ Contract specifies who maintains the asset
◆ Full-service lease -- lessor pays maintenance
◆ Net lease -- lessee pays maintenance costs
◆ Cancelable or noncancelable lease?
◆ Operating lease (short-term, cancelable) vs.
financial lease (longer-term, noncancelable)
◆ Options at expiration to lessee
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 Operating lease
◆ Usually a shorter-term lease under which
the lessor is responsible for insurance,
taxes, and upkeep.
◆ May be cancelable by the lessee on short
notice.

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 Operating lease
With an operating lease, the payments received
by the lessor are usually not enough to allow
the lessor to fully recover the cost of the asset.
A primary reason is that operating leases are
often relatively short-term. Therefore, the life of
the lease may be much shorter than the
economic life of the asset. For example, if you
lease a car for two years, the car will have a
substantial residual value at the end of the
lease, and the lease payments you make will
pay off only a fraction of the original cost of the
car. The lessor in an operating lease expects to
either lease the asset again or sell it when the
lease terminates.
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 Operating lease
A second characteristic of an operating lease
is that it frequently requires that the lessor
maintain the asset. The lessor may also be
responsible for any taxes or insurance.
Of course, these costs will be passed on, at
least in part, to the lessee in the form of
higher lease payments.

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 Operating lease
The third, and perhaps most interesting, feature
of an operating lease is the cancellation option.
This option can give the lessee the right to cancel
the lease before the expiration date. If the option
to cancel is exercised, the lessee returns the
equipment to the lessor and ceases to make
payments. The value of a cancellation clause
depends on whether technological and/or
economic conditions are likely to make the value
of the asset to the lessee less than the present
value of the future lease payments under the
lease.
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 Financial lease
Typically a longer-term, fully amortized
lease under which the lessee is
responsible for maintenance, taxes, and
insurance. Usually not cancelable by
the lessee without penalty.

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 Financial lease
A financial lease is the other major type of lease. In
contrast to the situation with an operating lease, the
payments made under a financial lease (plus the
anticipated residual, or salvage, value) are usually
sufficient to fully cover the lessor’s cost of purchasing
the asset and pay the lessor a return on the
investment. For this reason, a financial lease is
sometimes said to be a fully amortized or full-payout
lease, whereas an operating lease is said to be partially
amortized. Financial leases are often called capital
leases by the accountants.
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 Financial lease
With a financial lease, the lessee (not
the lessor) is usually responsible for
insurance, maintenance, and taxes. It
is also important to note that a
financial lease generally cannot be
canceled, at least not without a
significant penalty. In other words, the
lessee must make the lease payments
or face possible legal action.

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 Types of Leasing
Sale and Leaseback -- The sale of an asset with
the agreement to immediately lease it back for
an extended period of time.
◆ The lessor realizes any residual value.
◆ There may be a tax advantage as land is not
depreciable, but the entire lease payment is a
deductible expense.
◆ Lessors:
Lessors insurance companies, institutional
investors, finance companies, and independent
companies.
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 Types of Leasing
Direct Leasing -- Under direct leasing a firm
acquires the use of an asset it did not
previously own.
◆ The firm often leases an asset directly from a
manufacturer (e.g., IBM leases computers and
Xerox leases copiers).
◆ Lessors:
Lessors manufacturers, finance companies,
banks, independent leasing companies, special-
purpose leasing companies, and partnerships.
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 Types of Leasing
Leverage Leasing -- A lease arrangement in which the
lessor provides an equity portion (usually 20 to 40
percent) of the leased asset’s cost and third-party
lenders provide the balance of the financing.
◆ Popular for big-ticket assets such as aircraft, oil rigs, and railway
equipment.
◆ Normally, there are three parties involved i.e. Lessee, Lessor & the
Lender.
◆ The role of the lessor changes as the lessor is borrowing funds
itself to finance the lease for the lessee (hence, leveraged lease).
lease
◆ Loan is secured against the mortgage of the Asset & Lease
Installments.
◆ Any residual value belongs to the lessor as well as any net cash
inflows during the lease.

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 Accounting and Tax
Treatment of Leases
◆ In the past, leases were “off-balance-sheet” items
and hid the true obligations of some firms.
◆ The lessee can deduct the full lease payment in a
properly structured lease. To be a “true lease” the
requirements are:
◆ Lessor must have a minimum “at-risk”
(inception and throughout lease) of 20% or
more of the acquisition cost.
◆ The remaining life of the asset at the end of the
lease period must be the longer of 1 year or
20% of original estimated asset life.
◆ An expected profit to the lessor from the lease
contract apart from any tax benefits.
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 Accounting Treatment of
Leases
◆ In November 1976, the Financial Accounting
Standards Board (FASB) issued its Statement
of Financial Accounting Standards No. 13
(FASB 13), “Accounting for Leases.” The
basic idea of FASB 13 is that certain financial
leases must be “capitalized.” Essentially, this
requirement means that the present value of
the lease payments must be calculated and
reported along with debt and other liabilities
on the right-hand side of the lessee’s balance
sheet. The same amount must be shown as
the capitalized value of leased assets on the
left-hand side of the balance sheet.
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 Reporting of a Lease on
the Balance Sheet.
◆ It is difficult, if not impossible, to
give a precise definition of what
constitutes a financial lease or an
operating lease. For accounting
purposes, a lease is declared to be a
capital lease, and must therefore be
disclosed on the balance sheet, if at
least one of the following criteria is
met:
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 Reporting of a Lease on
the Balance Sheet.
1. The lease transfers ownership of the property to
the lessee by the end of the term of the lease.
2. The lessee can purchase the asset at a price
below fair market value (bargain purchase price
option) when the lease expires.
3. The lease term is 75 percent or more of the
estimated economic life of the asset.
4. 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.
If one or more of the four criteria are met, the lease
is a capital lease; otherwise, it is an operating
lease for accounting purposes.

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 Should Lease be Hidden?
◆ There are several alleged benefits from “hiding”
financial leases. One of the advantages of
keeping leases off the balance sheet has to do
with fooling financial analysts, creditors, and
investors. The idea is that if leases are not on the
balance sheet, they will not be noticed.
◆ Financial managers who devote substantial effort
to keeping leases off the balance sheet are
probably wasting time. Of course, if leases are
not on the balance sheet, traditional measures of
financial leverage, such as the ratio of total debt
to total assets, will understate the true degree of
financial leverage. As a consequence, the balance
sheet will appear “stronger” than it really is. But it
seems unlikely that this type of manipulation
would mislead many people.
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 TAXES, THE IRS, AND
LEASES
◆ The lessee can deduct lease payments for
income tax purposes if the lease is
deemed to be a true lease by the Internal
Revenue Service. The tax shields
associated with lease payments are
critical to the economic viability of a lease,
so IRS guidelines are an important
consideration. Essentially, the IRS
requires that a lease be primarily for
business purposes and not merely for
purposes of tax avoidance. In broad terms,
a lease that is valid from the IRS’s
perspective will meet the following
standards:
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 TAXES, THE IRS, AND
LEASES
1. The term of the lease must be less than 80 percent of the economic
life of the asset. If the term is greater than this, the transaction will
be regarded as a conditional sale.
2. The lease should not include an option to acquire the asset at the
end of the lease term at a price below the asset’s then–fair market
value. This type of bargain option would give the lessee the
asset’s residual scrap value, implying an equity interest.
3. The lease should not have a schedule of payments that are very
high at the start of the lease term and thereafter very low. If the
lease requires early “balloon” payments, this will be considered
evidence that the lease is being used to avoid taxes and not for a
legitimate business purpose. The IRS may require an adjustment
in the payments for tax purposes in such cases.
4. The lease must survive a profits test, meaning that the lessor must
have the reasonable expectation of making a profit without
considering income taxes.
5. Renewal options must be reasonable and reflect the fair market
value of the asset at the time of renewal. This requirement can be
met by, for example, granting the lessee the first option to meet a
competing outside offer.
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 Economic Rationale
for Leasing
◆ Leasing allows higher-income taxable companies to
own equipment (lessor) and take accelerated
depreciation, while a marginally profitable company
(lessee) would prefer the advantages afforded by
leases.
◆ Thus, leases provide a means of shifting tax
benefits to companies that can fully utilize those
benefits.
◆ Other non-tax issues:
issues economies of scale in the
purchase of assets; different estimates of asset life,
salvage value, or the opportunity cost of funds; and
the lessor’s expertise in equipment selection and
maintenance.
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 “Should I Lease
or Should I Buy?”
Analyze cash flows and determine which
alternative has the lowest (present value) cost
to the firm.
Example:
◆ Basket Wonders (BW) is deciding between leasing
a new machine or purchasing the machine outright.
◆ The equipment, which manufactures Easter
baskets, costs $74,000 and can be leased over
seven years with payments being made at the
beginning of each year.
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 “Should I Lease
or Should I Buy?”
◆ The lessor calculates the lease payments
based on an expected return of 11% over the
seven years. (Ignore possible residual value
of equipment to lessor.)
◆ The lease is a net lease.
lease
◆ The firm is in the 40% marginal tax bracket.
◆ If bought, the equipment is expected to have
a final salvage value of $7,500.
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 “Should I Lease
or Should I Buy?”
◆ The purchase of the equipment will result in
a depreciation schedule of 20%, 32%,
19.2%, 11.52%, 11.52%, and 5.76% for the
first six years (5-year property class) based
on a $74,000 depreciable base.
◆ Loan payments are based on a 12% loan
with payments occurring at the beginning
of each period.

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 Determining the PV of Cash
Outflows for the Lease
0 1 2 3 4 5 6
11%

L L L L L L L
This is an annuity due that equals $74,000 today.
$74,000.00 = L (PVIFA 11%,
11% 7) (1.11)
11
$66,666.67 = L (4.712)
$14,148.27 = L
◆ The lessor will charge BW $14,148.27,
$14,148.27
beginning today, for seven years until
expiration of the lease contract.
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 Determining the PV of Cash
Outflows for the Lease
0 1 2 3 4 5 6 7

L L L L L L L
B B B B B B B

B = Tax-shield benefit (Inflow) = $ 5,659.31

L = Lease payment (Outflow) = $ 14,148.27
Net cash outflows at t = 0: $ 14,148.27
Net cash outflows at t = 1 to 6: $ 8,488.96
Net cash outflows at t = 7: $ -5,659.31
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 Determining the PV of Cash
Outflows for the Lease
Comments for the previous slide:
slide
◆ Since the lease payments are prepaid, the company is
not able to deduct the expenses until the end of each
year.
◆ The lessee, BW,
BW can deduct the entire $14,148.27 as
an expense each year. Thus, the net cash outflows
are given as the difference between lease payments
(outflow) and tax-shield benefits (inflow).
◆ The difference in risk between the lease and the
purchase (using debt) is negligible and the
appropriate before-tax cost is the same as debt, 12%.
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 Determining the PV of Cash
Outflows for the Lease
Calculating the Present Value of
Cash Outflows for the Lease
◆ The after-tax cost of financing the lease should be
equivalent to the after-tax cost of debt financing.
◆ After-tax cost = 12% ( 1 - .4 ) = 7.2%.
7.2%
◆ The discounted present value of cash outflows:
$14,148.27 x (PVIF 7.2%, 1) = $13,198.01
$ 8,488.96 x (PVIFA 7.2%, 6) = 40,214.34
$ -5,659.31 x (PVIF 7.2%, 7) = -3,478.56
Present Value $ 49,933.79
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 Determining the PV of Cash
Outflows for the Term Loan
0 1 2 3 4 5 6
12%

TL TL TL TL TL TL TL
This is an annuity due that equals $74,000 today.
$74,000.00 = TL (PVIFA 12%,
12% 7) (1.12)
12
$66,071.43 = TL (4.564)
$14,477.42 = TL
◆ BW will make loan payments of
$14,477.42,
$14,477.42 beginning today, for seven
years until full payment of the loan.
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 Determining the PV of Cash
Outflows for the Term Loan
End of Loan Loan Annual
Year Payment Balance*
Balance Interest
0 $14,477.42 $59,522.58 ---
1 14,477.42 52,187.87 $7,142.71
2 14,477.42 43,972.99 6,262.54
3 14,477.42 34,772.33 5,276.76
4 14,477.42 24,467.59 4,172.68
5 14,477.42 12,926.28 2,936.11
6 14,477.43 0 1,551.15

Loan balance is the principal amount

owed at the end of each year.
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 Determining the PV of Cash
Outflows for the Term Loan
End of Annual Annual Tax-Shield
Year Interest Depreciation*
Depreciation Benefits**
Benefits
0 --- $ 0 ---
1 $7,142.71 14,800.00 $ 8,777.08
2 6,262.54 23,680.00 11,977.02
3 5,276.76 14,208.00 7,793.90
4 4,172.68 8,524.80 5,078.99
5 2,936.11 8,524.80 4,584.36
6 1,551.15 4,262.40 2,325.42
7 0 0 -3,000.00***
* Based on schedule given on Slide 21-26.
** .4 x (annual interest + annual depreciation).
1-32 *** Tax due to recover salvage value, $7,500 x .4.
 Determining the PV of Cash
Outflows for the Term Loan
End of Loan Tax-Shield Cash Present
Year Payment Benefit Outflow*
Outflow Value**
Value
0 $14,477.42 --- $14,477.42 $14,477.42
1 14,477.42 $ 8,777.08 5,700.34 5,317.48
2 14,477.42 11,977.02 2,500.40 2,175.80
3 14,477.42 7,793.90 6,683.52 5,425.26
4 14,477.42 5,078.99 9,398.43 7,116.66
5 14,477.42 4,584.36 9,893.06 6,988.06
6 14,477.43 2,325.42 12,152.01 8,007.18
7 - 7,500.00*** -3,000.00 - 4,500.00 - 2,765.98
* Loan payment - tax-shield benefit.
** Present value of the cash outflow discounted at 7.2%.
1-33 *** Salvage value that is recovered when owned.
 Determining the PV of Cash
Outflows for the Term Loan
◆ The present value of costs for the term loan is
$46,741.88.
$46,741.88 The present value of the lease
program is $49,933.79.
$49,933.79
◆ The least costly alternative is the term loan.
loan
Basket Wonders should proceed with the term
loan rather than the lease.
◆ Other considerations:
considerations The tax rate of the
potential lessee, timing and magnitude of the
cash flows, discount rate employed, and
uncertainty of the salvage value and their
impacts on the analysis.
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