ch22 leasing
TRANSCRIPT
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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. Section22.4 should be operating lease rather than financial lease.)
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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 assets manufacturer or an independent
leasing company.
Two types:
Operating lease Financial lease
Sale and lease-back
Leverage lease
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Buying versus Leasing
Buy LeaseFirm Ubuys asset and uses asset;financed by debt and equity.
Lessor buys asset, Firm Uleases it.
Manufacturer
of asset
Equity
shareholders
Firm U1. Uses asset
2. Owns asset
Creditors
Manufacturer
of asset
Lessor1. Owns asset
2. Does not use asset
Equity
shareholders Creditors
Lessee (Firm U)1. Uses asset
2. Does not own asset
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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 theasset.
Lessee usually enjoys a cancellation option. This
option gives the lessee the right to cancel the leasecontract before the expiration date.
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Financial Leases
Most commonly referred to as Capital lease
The opposite of an operating lease.
1. Do not provide for maintenance or service by the lessor.
2. Generally fully amortized
3. The lessee usually has a right to renew the lease atexpiry.
4. Generally, financial leases cannot be cancelled, i.e., the
lessee must make all payments or face the risk of
bankruptcy.
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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.
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Leveraged Leases
Lessor buys asset, Firm Uleases it.
Manufacturer
of asset
Lessor1. Owns asset
2. Does not use asset
Equity
shareholders Creditors
Lessee (Firm U)1. Uses asset
2. Does not own asset
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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.
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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 fiveyears. 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 withTiger 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?
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Example contd: Tax shield on CCA for car
Year UCC CCA1 Tax Shield4
01 $1,600
2 2,560
3 9,600 3,840 1,536
4 5,760 2,304 9225 3,456 1,382 553
Residual at yr 5 2,074 829.6
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Contd: 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. OwnershipDepreciate for tax purposes.2. Cash outlay of 20,000 at time 0.
3. 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
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Contd: Incremental cashflowsTextbook method
Same cashflow, but view things from the aggregate of
(lease-buy):
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).
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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
debtDebt 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.
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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. Lets 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.
Whats your answer now?
CF to lease wont 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 Recapturewhen terminating the pool.)
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Contd: Add residual guarantee to valuation
Year 0 1 2 3 4 5
Depreciation schedule 4000 6400 3840 2304 1382Residual book 2074
Residual guarantee (1)
After-tax cashflows from buying the assetAsset cost -20,000
Depreciation tax shield 1600 2560 1536 921.6 552.8
AT Residual cashflow (2)
Net cash from buying -20,000 1,600 2,560 1,536 922 3,182
Notes: (1) Residual guarantee =
(2) AT Residual cashflow =
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Contd: Solution
After-tax rental payment -3000 -3000 -3000 -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.
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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 0 1 2 3 4 5
Negative of Asset sale -20,000
AT lease income 3000 3000 3000 3000 3000
Dep. tax shield 1600 2560 1536 921.6 552.8
Residual tax shield 829.6Net CF -17,000 4600 5560 4536 3922 1382
NPV: Same tax rate and same discount rate: -6.21!
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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!
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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.
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An Illustration of Benefit of Tax Reduction: Tax Arbitrage
Back to the example where theres no economic residual.
Suppose Zee (the LESSEE) is still in the 40% tax bracket, but TigerLeasing (the LESSOR) is in the 30% tax bracket instead. Canleasing happen in this case? (i.e., Can both firms have a positive
NPV?)
Whats changed? For Lessee, nothing is changed: same tax rate, same interest rate,
same paymentSame incremental cashflow in Lease vs. buydecision. + NPV.
For Lessors Lease vs. selldecision, after-tax cashflow is nowchanged
AT lease income
Depreciation and residual tax shield
AT discount rate as well!
T b td L ll ( id l t )
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Tax arb. contd: Lease vs. sell (no residual guarantee)
Year 0 1 2 3 4 5
Depreciation 4000 6400 3840 2304 1,382
Residual 2,074After-tax cash flows from leasing
After-tax rental income 3500 3500 3500 3500 3500
Depreciation tax shield 1200 1920 1152 691 415
Residual tax shield 622Net cash from leasing 3,500 4,700 5,420 4,652 4,191 1,037
Selling Asset proceeds 20,000
Diff: Lease minus sell -16,500 4,700 5,420 4,652 4,191 1,037
NPV $91.16
Notes: 1. Depreciation tax shield and lease payment is now
calculated at tax rate of 30%.
2. Discount rate for NPV is:
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Tax arb. contd: Reservations and Negotiations
What is the smallest lease paymentthat Lessor (Tiger Leasing)
will accept? Set their NPV to zero (break-even) and solve for thepayment.
What is the highest lease paymentthat Lessee (Zee Movers) can
pay? Set their NPV to zero (break-even) and solve for thepayment.
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: [lessors smallest lease payment, lessees
largest lease payment]
D i ti f ti t L
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Derivation of reservation payment: Lessee
Three components:
PV of Depreciation (and residual loss) Tax Shield
PV of AT lease paymentAnnuity (in advance) Equipment cost at time 0
Set 321 = 0. (Answer: $5002)
For Zee Movers:
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Contd
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Derivation of reservation payment: Lessor
Three components:
1. PV of Depreciation (and, if any, residual loss) Tax Shield
2. PV of AT lease paymentAnnuity (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].
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Review Questions
How would you evaluate a capital lease through incremental
cashflow approach? Give the incremental cashflow from theperspective of lease vs. buy.
Assigned problems: #22. 1, 2-6, 8, 11 (Assume operating
leasing for incremental cashflow analysis )