leasing acf present

7/28/2019 Leasing ACF Present

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Leasing

Marini 807899Wang Fei 808652


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Key Concepts and Skills

Understand the different types of leases.

Understand how to apply NPV to the lease

vs. buy decision.

Understand the importance of tax rates in

determining the benefit of leasing.


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Types of Leases

The BasicsA lease is a contractual agreement between a

lessee and lessor.

The lessor owns the asset and for a fee

allows the lessee to use the asset.


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Buying versus LeasingBuy Lease

Firm U buys asset and uses asset;financed by debt and equity. Lessor buys asset, FirmUleases 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

Usually require the lessor to maintain and

insure the asset

Lessee enjoys a cancellation option


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Financial Leases

The exact opposite of an operating

lease.1.

Do not provide for maintenance or serviceby the lessor.

2. Financial leases are fully amortized.

3. The lessee usually has a right to renew the

lease at expiry.

4. Generally, financial leases cannot be

cancelled.


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Sale and Lease-Back

A particular type of financial lease

Occurs when a company sells an

asset it already owns to another firmand 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 leasepayments, thereby retaining the use of theasset.


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Leveraged Leases

A leveraged lease is another type offinancial 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 thelender in case of a default by the lessee.


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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

The lenders typically use a

nonrecourse loan. This

means that the lessor is notobligated to the lender in

case of a default by the

lessee.

Lessor borrows from lender to

partially finance purchase

In the event of a default by

the lessor, the lender has afirst lien on the asset. Also,

the lease payments are

made directly to the lender

after a default.


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Leveraged Leases

In the old days, leases led to off-balance-sheet financing.

Today, leases are either classified ascapital leases or operating leases.

Operating leases do not appear on thebalance sheet.

Capital leases appear on the balancesheetthe present value of the leasepayments appears on both sides.


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Taxes, the IRS, 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.

Naturally, the IRS seeks to limit this,

especially if the lease appears to be set up

solely to avoid taxes.


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Taxes, the IRS, and Leases

The lessee can deduct lease payments if thelease is qualifiedby the IRS.

1. The term must be less than 30 years.

2. There can be no bargain purchase option.

3. The lease should not have a schedule of paymentsthat is very high at the start of the lease and lowthereafter.

4. The lease payments must provide the lessor with a

fair market rate of return.5. The lease should not limit the lessees right to issue

debt or pay dividends.

6. Renewal options must be reasonable and reflect fair

market value of the asset.


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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 firms optimal debt level by

discounting a future guaranteed after tax inflow at

the after tax riskless interest rate.


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Operating and Capital Leases

Firms often choose to lease long-term assets rather

than buy them for a variety of reasons - the tax

benefits are greater to the lessor than the lessees,

leases offer more flexibility in terms of adjusting tochanges in technology and capacity needs.

If a firm is allowed to lease a significant portion of its

assets and keep it off its financial statements, a

perusal of the statements will give a very misleadingview of the company's financial strength


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Two ways of accounting for leases:

In an operating lease, the lessor (or owner) transfers

only the right to use the property to the lessee. At the

end of the lease period, the lessee returns the property

to the lessor.

Since the lessee does not assume the risk of

ownership, the lease expense is treated as anoperating expense in the income


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Financial Accounting Standards Board has ruled that a

lease should be treated as an capital lease if it meets

any one of the following four conditions:

(a) if the lease life exceeds 75% of the life of the asset

(b) if there is a transfer of ownership to the lessee at

the end of the lease term


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CONT

(c) if there is an option to purchase the asset at a

"bargain price" at the end of the lease term.

(d) if the present value of the lease payments,

discounted at an appropriate discount rate, exceeds

90% of the fair market value of the asset.


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Operating versus Capital Leases

The lessor uses the same criteria for determining

whether the lease is a capital or operating lease and

accounts for it accordingly:

If it is a capital lease, the lessor records thepresent value of future cash flows as revenue

and recognizes expenses. The lease receivable

is also shown as an asset on the balance sheet,

and the interest revenue is recognized over theterm of the lease,


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CONT.

In practical terms, however, reclassifying operating

leases as capital leases can increase the debt shown

on the balance sheet substantially especially for firms

in sectors which have significant operating leases;airlines and retailing come to mind

The fact that the lessee may not take ownership of the

asset at the end of the lease period, which seems to be

the crux on which the operating/capital lease choice ismade, should not be a significant factor in whether

the commitments are treated as the equivalent of debt.


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Conclusion

As an approximation, using the firms current pre-tax

cost of debt as the discount rate yields a good

estimate of the value of operating leases. Note that

capital leases are accounted for similarly in financialstatements, but the significant difference is that the

present value of capital lease payments is computed

using the cost of debt at the time of the capital lease

commitment, and is not adjusted as market rateschange.


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