Description
This corporate finance PPT explaining Types of leases, Tax treatment of leases, Effects on financial statements, Lessee’s analysis, Lessor’s analysis, Other issues in lease analysis
Lease Financing
? Types of leases ? Tax treatment of leases ? Effects on financial statements ? Lessee’s analysis ? Lessor’s analysis ? Other issues in lease analysis
Who are the two parties to a lease transaction?
? The lessee, who uses the asset and makes the
lease, or rental, payments.
? The lessor, who owns the asset and receives the
rental payments.
? Note that the lease decision is a financing decision
for the lessee and an investment decision for the lessor.
What are the four primary lease types?
? Operating lease
? Short-term and normally cancelable ? Maintenance usually included
? Financial lease
? Long-term and normally noncancelable ? Maintenance usually not included
? Sale and leaseback ? Combination lease
How are leases treated for tax purposes?
? Leases are classified by the IRS as either guideline
or nonguideline.
? For a guideline lease, the entire lease payment is
deductible to the lessee.
? For a nonguideline lease, only the imputed interest
payment is deductible.
? Why should the IRS be concerned about lease
provisions?
How does leasing affect a firm’s balance sheet?
? For accounting purposes, leases are classified as
either capital or operating. ? Capital leases must be shown directly on the lessee’s balance sheet. ? Operating leases, sometimes referred to as offbalance sheet financing, must be disclosed in the footnotes. ? Why are these rules in place?
What impact does leasing have on a firm’s capital structure?
? Leasing is a substitute for debt. ? As such, leasing uses up a firm’s debt capacity. ? Assume a firm has a 50/50 target capital structure.
Half of its assets are leased. How should the remaining assets be financed?
Assume that Lewis Securities plans to acquire some new equipment having a 4-year useful life.
? If the equipment is leased:
? Firm could obtain a 4-year lease which
includes maintenance. ? Lease meets IRS guidelines to expense lease payments. ? Rental payment would be $280,000 at the beginning of each year.
? Other information:
? Equipment cost: $1,000,000. ? Loan rate on equipment = 10%. ? Marginal tax rate = 40%.
? 3-year MACRS life.
? If company borrows and buys, 4 year
maintenance contract costs $20,000 at beginning of each year. ? Residual value at t = 4: $100,000.
Time Line: After-Tax Cost of Owning (In Thousands)
0 AT loan pmt Dep shld Maint -20 Tax sav 8 RV Tax NCF -12 1 -60 132 -20 8 2 -60 180 -20 8 3 -60 60 -20 8 4 -1,060 28
100 -40 60 108 -12 -972
? Note the depreciation shield in each year equals the
depreciation expense times the lessee’s tax rate. For Year 1, the depreciation shield is
$330,000(0.40) = $132,000.
? The present value of the cost of owning cash flows,
when discounted at 6%, is -$639,267.
Why use 6% as the discount rate?
? Leasing is similar to debt financing.
? The cash flows have relatively low risk; most are
fixed by contract. ? Therefore, the firm’s 10% cost of debt is a good candidate.
? The tax shield of interest payments must be
recognized, so the discount rate is 10%(1 - T) = 10%(1 - 0.4) = 6.0%.
Time Line: After-Tax Cost of Leasing (In Thousands)
0 Lease pmt -280 Tax sav 112 NCF -168 1 -280 112 -168 2 -280 112 -168 3 -280 112 -168 4
PV cost of leasing @ 6% = -$617,066.
What is the net advantage to leasing (NAL)?
? NAL
= PV cost of leasing - PV cost of
= - $617,066 - (-$639,267) = $22,201.
owning
? Should the firm lease or buy the equipment?
Why?
? Note that we have assumed the company will
not continue to use the asset after the lease expires; that is, project life is the same as the term of the lease.
? What changes to the analysis would be
required if the lessee planned to continue using the equipment after the lease expired?
Assume the RV could be $0 or $200,000, with an expected value of $100,000. How could this risk be reflected?
? The discount rate applied to the residual value
inflow (a positive CF) should be increased to account for the increased risk.
? All other cash flows should be discounted at the
original 6% rate.
(More...)
? If the residual value were included as an
outflow (a negative CF) in the cost of leasing cash flows, the increased risk would be reflected by applying a lower discount rate to the residual value cash flow.
? Again, all other cash flows have relatively low
risk, and hence would be discounted at the 6% rate.
What effect would increased uncertainty about the residual value have on the lessee’s decision?
? The lessor owns the equipment when the lease
expires.
? Therefore, residual value risk is passed from the
lessee to the lessor.
? Increased residual value risk makes the lease more
attractive to the lessee.
How should the lessor analyze the lease transaction?
? To the lessor, writing the lease is an investment. ? Therefore, the lessor must compare the return on
the lease investment with the return available on alternative investments of similar risk.
Assume the following data for Consolidated Leasing, the lessor:
? $300,000 rental payment instead of $280,000. ? All other data are the same as for the lessee.
Time Line: Lessor’s Analysis (In Thousands)
0 Cost -1,000 Dep shld Maint -20 Tax sav 8 Lse pmt 300 Tax -120 RV RV tax NCF -832 1 2 3 60 -20 8 300 -120 228 4 28
132 180 -20 -20 8 8 300 300 -120 -120 300 348
100 -40 88
? The NPV of the net cash flows, when discounted
at 6%, is $21,875.
? The IRR is 7.35%. ? Should the lessor write the lease? Why?
Find the lessor’s NPV if the lease payment were $280,000.
? With lease payments of $280,000, the lessor’s
cash flows would be equal, but opposite in sign, to the lessee’s NAL. ? Thus, lessor’s NPV = -$22,201. ? If all inputs are symmetrical, leasing is a zero-sum game. ? What are the implications?
What impact would a cancellation clause have on the lease’s riskiness from the lessee’s standpoint? From the lessor’s standpoint?
? A cancellation clause would lower the risk of the
lease to the lessee but raise the lessor’s risk.
? To account for this, the lessor would increase the
annual lease payment or else impose a penalty for early cancellation.
Other Issues in Lease Analysis
? Do higher residual values make leasing less
attractive to the lessee?
? Is lease financing more available or “better” than
debt financing?
? Is the lease analysis presented here applicable to
real estate leases? To auto leases?
(More...)
? Would spreadsheet models be useful in lease
analyses?
? What impact do tax laws have on the
attractiveness of leasing? Consider the following provisions:
? Investment tax credit (when available) ? Tax rate differentials between the lessee and the
lessor ? Alternative minimum tax (AMT)
Numerical analyses often indicate that owning is less costly than leasing. Why, then, is leasing so popular?
? Provision of maintenance services. ? Risk reduction for the lessee.
? Project life
? Residual value ? Operating risk
? Portfolio risk reduction enables lessor to better
bear these risks.
doc_554385901.ppt
This corporate finance PPT explaining Types of leases, Tax treatment of leases, Effects on financial statements, Lessee’s analysis, Lessor’s analysis, Other issues in lease analysis
Lease Financing
? Types of leases ? Tax treatment of leases ? Effects on financial statements ? Lessee’s analysis ? Lessor’s analysis ? Other issues in lease analysis
Who are the two parties to a lease transaction?
? The lessee, who uses the asset and makes the
lease, or rental, payments.
? The lessor, who owns the asset and receives the
rental payments.
? Note that the lease decision is a financing decision
for the lessee and an investment decision for the lessor.
What are the four primary lease types?
? Operating lease
? Short-term and normally cancelable ? Maintenance usually included
? Financial lease
? Long-term and normally noncancelable ? Maintenance usually not included
? Sale and leaseback ? Combination lease
How are leases treated for tax purposes?
? Leases are classified by the IRS as either guideline
or nonguideline.
? For a guideline lease, the entire lease payment is
deductible to the lessee.
? For a nonguideline lease, only the imputed interest
payment is deductible.
? Why should the IRS be concerned about lease
provisions?
How does leasing affect a firm’s balance sheet?
? For accounting purposes, leases are classified as
either capital or operating. ? Capital leases must be shown directly on the lessee’s balance sheet. ? Operating leases, sometimes referred to as offbalance sheet financing, must be disclosed in the footnotes. ? Why are these rules in place?
What impact does leasing have on a firm’s capital structure?
? Leasing is a substitute for debt. ? As such, leasing uses up a firm’s debt capacity. ? Assume a firm has a 50/50 target capital structure.
Half of its assets are leased. How should the remaining assets be financed?
Assume that Lewis Securities plans to acquire some new equipment having a 4-year useful life.
? If the equipment is leased:
? Firm could obtain a 4-year lease which
includes maintenance. ? Lease meets IRS guidelines to expense lease payments. ? Rental payment would be $280,000 at the beginning of each year.
? Other information:
? Equipment cost: $1,000,000. ? Loan rate on equipment = 10%. ? Marginal tax rate = 40%.
? 3-year MACRS life.
? If company borrows and buys, 4 year
maintenance contract costs $20,000 at beginning of each year. ? Residual value at t = 4: $100,000.
Time Line: After-Tax Cost of Owning (In Thousands)
0 AT loan pmt Dep shld Maint -20 Tax sav 8 RV Tax NCF -12 1 -60 132 -20 8 2 -60 180 -20 8 3 -60 60 -20 8 4 -1,060 28
100 -40 60 108 -12 -972
? Note the depreciation shield in each year equals the
depreciation expense times the lessee’s tax rate. For Year 1, the depreciation shield is
$330,000(0.40) = $132,000.
? The present value of the cost of owning cash flows,
when discounted at 6%, is -$639,267.
Why use 6% as the discount rate?
? Leasing is similar to debt financing.
? The cash flows have relatively low risk; most are
fixed by contract. ? Therefore, the firm’s 10% cost of debt is a good candidate.
? The tax shield of interest payments must be
recognized, so the discount rate is 10%(1 - T) = 10%(1 - 0.4) = 6.0%.
Time Line: After-Tax Cost of Leasing (In Thousands)
0 Lease pmt -280 Tax sav 112 NCF -168 1 -280 112 -168 2 -280 112 -168 3 -280 112 -168 4
PV cost of leasing @ 6% = -$617,066.
What is the net advantage to leasing (NAL)?
? NAL
= PV cost of leasing - PV cost of
= - $617,066 - (-$639,267) = $22,201.
owning
? Should the firm lease or buy the equipment?
Why?
? Note that we have assumed the company will
not continue to use the asset after the lease expires; that is, project life is the same as the term of the lease.
? What changes to the analysis would be
required if the lessee planned to continue using the equipment after the lease expired?
Assume the RV could be $0 or $200,000, with an expected value of $100,000. How could this risk be reflected?
? The discount rate applied to the residual value
inflow (a positive CF) should be increased to account for the increased risk.
? All other cash flows should be discounted at the
original 6% rate.
(More...)
? If the residual value were included as an
outflow (a negative CF) in the cost of leasing cash flows, the increased risk would be reflected by applying a lower discount rate to the residual value cash flow.
? Again, all other cash flows have relatively low
risk, and hence would be discounted at the 6% rate.
What effect would increased uncertainty about the residual value have on the lessee’s decision?
? The lessor owns the equipment when the lease
expires.
? Therefore, residual value risk is passed from the
lessee to the lessor.
? Increased residual value risk makes the lease more
attractive to the lessee.
How should the lessor analyze the lease transaction?
? To the lessor, writing the lease is an investment. ? Therefore, the lessor must compare the return on
the lease investment with the return available on alternative investments of similar risk.
Assume the following data for Consolidated Leasing, the lessor:
? $300,000 rental payment instead of $280,000. ? All other data are the same as for the lessee.
Time Line: Lessor’s Analysis (In Thousands)
0 Cost -1,000 Dep shld Maint -20 Tax sav 8 Lse pmt 300 Tax -120 RV RV tax NCF -832 1 2 3 60 -20 8 300 -120 228 4 28
132 180 -20 -20 8 8 300 300 -120 -120 300 348
100 -40 88
? The NPV of the net cash flows, when discounted
at 6%, is $21,875.
? The IRR is 7.35%. ? Should the lessor write the lease? Why?
Find the lessor’s NPV if the lease payment were $280,000.
? With lease payments of $280,000, the lessor’s
cash flows would be equal, but opposite in sign, to the lessee’s NAL. ? Thus, lessor’s NPV = -$22,201. ? If all inputs are symmetrical, leasing is a zero-sum game. ? What are the implications?
What impact would a cancellation clause have on the lease’s riskiness from the lessee’s standpoint? From the lessor’s standpoint?
? A cancellation clause would lower the risk of the
lease to the lessee but raise the lessor’s risk.
? To account for this, the lessor would increase the
annual lease payment or else impose a penalty for early cancellation.
Other Issues in Lease Analysis
? Do higher residual values make leasing less
attractive to the lessee?
? Is lease financing more available or “better” than
debt financing?
? Is the lease analysis presented here applicable to
real estate leases? To auto leases?
(More...)
? Would spreadsheet models be useful in lease
analyses?
? What impact do tax laws have on the
attractiveness of leasing? Consider the following provisions:
? Investment tax credit (when available) ? Tax rate differentials between the lessee and the
lessor ? Alternative minimum tax (AMT)
Numerical analyses often indicate that owning is less costly than leasing. Why, then, is leasing so popular?
? Provision of maintenance services. ? Risk reduction for the lessee.
? Project life
? Residual value ? Operating risk
? Portfolio risk reduction enables lessor to better
bear these risks.
doc_554385901.ppt