17.2 Leasing

LG 2 17.2 Leasing

leasing Leasing enables the firm to obtain the use of certain fixed assets for which it must

The process by which a firm

make a series of contractual, periodic, tax-deductible payments. The lessee is the

can obtain the use of certain

receiver of the services of the assets under the lease contract; the lessor is the

fixed assets for which it must

owner of the assets. Leasing can take a number of forms.

make a series of contractual, periodic, tax-deductible payments.

TYPES OF LEASES

lessee The two basic types of leases that are available to a business are operating leases

The receiver of the services of

and financial leases (often called capital leases by accountants).

the assets under a lease contract.

Operating Leases

lessor The owner of assets that are

An operating lease is normally a contractual arrangement whereby the lessee

being leased.

agrees to make periodic payments to the lessor, often for 5 or fewer years, to obtain an asset’s services. Such leases are generally cancelable at the option of the

operating lease A cancelable contractual

lessee, who may be required to pay a penalty for cancellation. Assets that are

arrangement whereby the

leased under operating leases have a usable life that is longer than the term of the

lessee agrees to make periodic

lease. Usually, however, they would become less efficient and technologically

payments to the lessor, often

obsolete if leased for a longer period. Computer systems are prime examples of

for 5 or fewer years, to obtain

assets whose relative efficiency is expected to diminish as the technology changes.

an asset’s services; generally,

The operating lease is therefore a common arrangement for obtaining such sys-

the total payments over the

tems, as well as for other relatively short-lived assets such as automobiles.

term of the lease are less than the lessor’s initial cost of the

If an operating lease is held to maturity, the lessee at that time returns the

leased asset.

leased asset to the lessor, who may lease it again or sell the asset. Normally, the

CHAPTER 17

Hybrid and Derivative Securities

instances, the lease contract gives the lessee the opportunity to purchase the leased asset. Generally, the total payments made by the lessee to the lessor are less than the lessor’s initial cost of the leased asset.

Financial (or Capital) Leases

financial (or capital) lease

A financial (or capital) lease is a longer-term lease than an operating lease.

A longer-term lease than an

Financial leases are noncancelable and obligate the lessee to make payments for

operating lease that is

the use of an asset over a predefined period of time. Financial leases are com-

noncancelable and obligates

monly used for leasing land, buildings, and large pieces of equipment. The non-

the lessee to make payments for the use of an asset over a

cancelable feature of the financial lease makes it similar to certain types of

predefined period of time; the

long-term debt. The lease payment becomes a fixed, tax-deductible expenditure total payments over the term of that must be paid at predefined dates. As with debt, failure to make the contrac-

the lease are greater than the

tual lease payments can result in bankruptcy for the lessee.

lessor’s initial cost of the leased

With a financial lease, the total payments over the term of the lease are

asset.

greater than the lessor’s initial cost of the leased asset. In other words, the lessor must receive more than the asset’s purchase price to earn its required return on the investment. Technically, under FASB (Financial Accounting Standards Board) Statement No. 13, “Accounting for Leases,” a financial (or capital) lease is defined as one that has any of the following elements:

1. The lease transfers ownership of the property to the lessee by the end of the lease term.

2. The lease contains an option to purchase the property at a “bargain price.” Such an option must be exercisable at a “fair market value.”

3. The lease term is equal to 75 percent or more of the estimated economic life of the property (exceptions exist for property leased toward the end of its usable economic life).

4. At the beginning of the lease, the present value of the lease payments is equal to 90 percent or more of the fair market value of the leased property.

The emphasis in this chapter is on financial leases, because they result in inescapable long-term financial commitments by the firm.

The Focus on Practice box on page 680 discusses leasing by Disney that did not have a happy ending.

direct lease A lease under which a lessor owns or acquires the assets

LEASING ARRANGEMENTS

that are leased to a given lessee.

Lessors use three primary techniques for obtaining assets to be leased. The method depends largely on the desires of the prospective lessee.

sale-leaseback arrangement A lease under which the lessee

1. A direct lease results when a lessor owns or acquires the assets that are leased

sells an asset to a prospective

to a given lessee. In other words, the lessee did not previously own the assets

lessor and then leases back the

that it is leasing.

same asset, making fixed periodic payments for its use.

2. In a sale-leaseback arrangement, lessors acquire leased assets by purchasing assets already owned by the lessee and leasing them back. This technique is

leveraged lease normally initiated by a firm that needs funds for operations. By selling an

A lease under which the lessor

existing asset to a lessor and then leasing it back, the lessee receives cash for

acts as an equity participant, supplying only about 20

the asset immediately, while obligating itself to make fixed periodic payments

percent of the cost of the asset,

for use of the leased asset.

while a lender supplies the

3. Leasing arrangements that include one or more third-party lenders are

PART 8

Special Topics in Managerial Finance

focus on PRACTICE Leases to Airlines End on a Sour Note

in practice The Walt Disney

leases. Disney had to write off entirely Company is in the

equipment. Under a typical leveraged

lease, Disney put up 20 percent of the the $114 million book value assigned business of providing entertainment

purchase price. The rest was borrowed to its investment in two Boeing 747s experiences based on its rich legacy of under a loan using the plane as collat-

and two 767s leased to United. creative content and exceptional story-

Pursuing the matter in the courts, Disney telling. From theme parks and resorts to were put at risk.

eral. None of Disney’s other assets

was able to recoup $50 million from motion pictures and cartoons, the Walt

United for its lost tax benefits. Disney Company presents tales in

During the 1990s, leveraged

With additional aircraft leased out which many Disney characters live hap- boosted a company’s return on invest-

leases were attractive investments that

to Delta Air Lines (five aircraft, $119 pily ever after. However, one Disney

million), the Disney tale of leveraged tale that did not have a happy ending

ment. However, the destruction of the

World Trade Center on September 11, leases had not reached its final reel. was Disney’s investment in leveraged

Delta Air Lines announced 7,000 jobs aircraft leases.

2001, and the ensuing reaction to

cut in September 2004 as part of a Using a structure known as a

potential terrorist threats crippled air

$5 billion cost-saving program and leveraged lease, cash-rich Disney pur-

travel and put U.S. air carriers under

entered bankruptcy in late 2005. At chased airplanes in the early 1990s

tremendous financial pressure. The

that time Disney was forced to declare and leased them out to air carriers. The ruptcy. Under bankruptcy protection,

result for United Airlines was bank-

a write-off of $68 million for its Delta deals, with ironclad terms, were seen

leases, and the company eventually left as safe and offered tax advantages.

United was able to break any lease it

didn’t want, giving the airline powerful the aircraft-leasing business entirely. Since the 1980s, large corporations

leverage to renegotiate lower lease

have been leasing out planes to take payments, at lower market rates. When 3 Were the Disney leases of air- advantage of tax rules that allow for

craft to United Airlines operating accelerated depreciation of large

no deal was reached, United Airlines

was able to walk away from the

leases or financial leases?

supplying only about 20 percent of the cost of the asset, and a lender supplies the balance. Leveraged leases are especially popular in structuring leases of very expensive assets.

maintenance clauses

A lease agreement typically specifies whether the lessee is responsible for

Provisions normally included in

maintenance of the leased assets. Operating leases normally include maintenance

an operating lease that require

clauses requiring the lessor to maintain the assets and to make insurance and tax

the lessor to maintain the

payments. Financial leases nearly always require the lessee to pay maintenance

assets and to make insurance

and other costs.

and tax payments.

The lessee is usually given the option to renew a lease at its expiration. renewal options

Renewal options, which grant lessees the right to re-lease assets at expiration, are

Provisions especially common

especially common in operating leases because their term is generally shorter than

in operating leases that grant

the usable life of the leased assets. Purchase options allowing the lessee to pur-

the lessee the right to re-lease

chase the leased asset at maturity, typically for a prespecified price, are frequently

assets at the expiration of the lease.

included in both operating and financial leases.

The lessor can be one of a number of parties. In operating leases, the lessor is purchase options

likely to be the manufacturer’s leasing subsidiary or an independent leasing com-

Provisions frequently included

pany. Financial leases are frequently handled by independent leasing companies

in both operating and financial leases that allow the lessee to

or by the leasing subsidiaries of large financial institutions such as commercial

purchase the leased asset at

banks and life insurance companies. Life insurance companies are especially

maturity, typically for a

active in real estate leasing. Pension funds, like commercial banks, have also been

CHAPTER 17

Hybrid and Derivative Securities

LEASE-VERSUS-PURCHASE DECISION Firms that are contemplating the acquisition of new fixed assets commonly con-

lease-versus-purchase (or front the lease-versus-purchase (or lease-versus-buy) decision. The alternatives lease-versus-buy) decision

available are (1) lease the assets, (2) borrow funds to purchase the assets, or

The decision facing firms

(3) purchase the assets using available liquid resources. Alternatives 2 and 3,

needing to acquire new fixed

although they differ, are analyzed in a similar fashion; even if the firm has the

assets: whether to lease the assets or to purchase them,

liquid resources with which to purchase the assets, the use of these funds is

using borrowed funds or

viewed as equivalent to borrowing. Therefore, we need to compare only the

available liquid resources.

leasing and purchasing alternatives.

The lease-versus-purchase decision involves application of the capital budg- eting methods presented in Chapters 10 through 12. First, we determine the rele- vant cash flows and then apply present value techniques. The following steps are involved in the analysis:

Step 1 Find the after-tax cash outflows for each year under the lease alternative. This step generally involves a fairly simple tax adjustment of the annual lease payments. In addition, the cost of exercising a purchase option in the final year of the lease term must frequently be included. 1

Step 2 Find the after-tax cash outflows for each year under the purchase alter- native. This step involves adjusting the sum of the scheduled loan pay- ment and maintenance cost outlay for the tax shields resulting from the tax deductions attributable to maintenance, depreciation, and interest.

Step 3 Calculate the present value of the cash outflows associated with the lease (from Step 1) and purchase (from Step 2) alternatives using the after-tax cost of debt as the discount rate. The after-tax cost of debt is used to evaluate the lease-versus-purchase decision because the decision itself involves the choice between two financing techniques—leasing and borrowing—that have very low risk.

Step 4 Choose the alternative with the lower present value of cash outflows from Step 3. It will be the least-cost financing alternative.

The application of each of these steps is demonstrated in the following example.

Example 17.1 3 Roberts Company, a small machine shop, is contemplating acquiring a new machine that costs $24,000. Arrangements can be made to lease or purchase the

machine. The firm is in the 40% tax bracket. Lease The firm would obtain a 5-year lease requiring annual end-of-year lease

payments of $6,000. All maintenance costs would be paid by the lessor, and insurance and other costs would be borne by the lessee. The lessee would exercise its option to purchase the machine for $1,200 at termination of the lease. 2

1. Including the cost of exercising a purchase option in the cash flows for the lease alternative ensures that under both lease and purchase alternatives the firm owns the asset at the end of the relevant time horizon. The other approach would be to include the cash flows from sale of the asset in the cash flows for the purchase alternative at the end of the lease term. These strategies guarantee avoidance of unequal lives, which were discussed in Chapter 12. In addition, they make any subsequent cash flows irrelevant because these would be either identical or nonexistent, respectively, under each alternative.

2. Lease payments are generally made at the beginning of the year. To simplify the following discussions, end-of-year lease payments are assumed. We are assuming that the machine’s market value and book value are both $1,200 at

PART 8

Special Topics in Managerial Finance

Purchase The firm would finance the purchase of the machine with a 9%, 5-year loan requiring end-of-year installment payments of $6,170. 3 The machine would

be depreciated under MACRS using a 5-year recovery period. The firm would pay $1,500 per year for a service contract that covers all maintenance costs; insurance and other costs would be borne by the firm. The firm plans to keep the machine and use it beyond its 5-year recovery period.

Using these data, we can apply the steps presented earlier: Step 1 The after-tax cash outflow from the lease payments can be found by multi-

plying the before-tax payment of $6,000 by 1 minus the tax rate, T, of 40%. After-tax cash outflow from lease = $6,000 * (1 - T)

= $6,000 * (1 - 0.40) = $3,600 Therefore, the lease alternative results in annual cash outflows over the

5-year lease of $3,600. In the final year, the $1,200 cost of the purchase option would be added to the $3,600 lease outflow to get a total cash outflow in year 5 of $4,800 ($3,600 + $1,200).

Step 2 The after-tax cash outflow from the purchase alternative is a bit more dif- ficult to find. First, the interest component of each annual loan payment must be determined because the Internal Revenue Service allows the deduction of interest only—not principal—from income for tax purposes. 4 Table 17.1 presents the calculations necessary to split the loan payments

Determining the Interest and Principal Components of the Roberts Company Loan Payments

Principal principal

End of

payments

year principal

a The values in this table have been rounded to the nearest dollar, which results in a slight difference ($2) between the beginning-of-year-5 principal (in column 2) and the year-5 principal payment (in column 4).

3. The annual loan payment on the 9 percent, 5-year loan of $24,000 is calculated by using the loan amortization technique described in Chapter 5. To calculate the loan payment in Excel, you would use the “pmt” function, entering into any blank cell, pmt(0.09,5,24000,0,0). In the terms inside the parenthesis, 0.09 is the interest rate, =

5 is the term of the lease in years, and 24,000 is the amount being borrowed (or equivalently, the cost of the new machine). The final two zeros inside the parenthesis tell Excel that after 5 years the loan is totally paid off (zero remaining balance) and that payments are made at the end of each year. The exact loan payment is $6,170.22, but in the example we round down to the nearest dollar.

4. When the rate of interest on the loan used to finance the purchase just equals the cost of debt, the present value of the after-tax loan payments (annual loan payments - interest tax shields) discounted at the after-tax cost of debt just equals the initial loan principal. In such a case, it is unnecessary to amortize the loan to determine the payment amount and the amounts of interest when finding after-tax cash outflows. The loan payments and interest payments (columns 1 and 4 in Table 17.2) can be ignored, and, in their place, the initial loan principal ($24,000) is shown as an outflow occurring at

CHAPTER 17

Hybrid and Derivative Securities

TA B L E 1 7 . 2 After-Tax Cash Outflows Associated with Purchasing for Roberts Company

After-tax Loan

Total

Tax shields cash outflows payments

Maintenance

deductions

Interest a [(2) ⴙ (3) ⴙ (4)] [(0.40 : (5)] [(1) ⴙ (2) ⴚ (6)] End of year

1,956 5,714 a From Table 17.1, column 3.

into their interest and principal components. Columns 3 and 4 show the annual interest and principal paid.

In Table 17.2, the annual loan payment is shown in column 1, and the annual maintenance cost, which is a tax-deductible expense, is shown in column 2. Next, we find the annual depreciation write-off resulting from the $24,000 machine. Using the applicable MACRS 5-year recovery period depreciation percentages— 20% in year 1, 32% in year 2, 19% in year 3, and 12% in years 4 and 5—given in Table 4.2 on page 117 results in the annual depreciation for years 1 through 5 given in column 3 of Table 17.2. 5

Table 17.2 presents the calculations required to determine the cash outflows 6 associated with borrowing to purchase the new machine. Column 7 of the table presents the after-tax cash outflows associated with the purchase alternative. A few points should be clarified with respect to the calculations in Table 17.2. The major cash outflows are the total loan payment for each year given in column 1 and the annual maintenance cost in column 2. The sum of these two outflows is reduced by the tax savings from writing off the maintenance, depreciation, and interest expenses associated with the new machine and its financing. The resulting cash outflows are the after-tax cash outflows associated with the pur- chase alternative.

Step 3 The present values of the cash outflows associated with the lease (from Step 1) and purchase (from Step 2) alternatives are calculated in Table 17.3 using the firm’s 6% after-tax cost of debt. 7 The sum of the present values of the cash outflows for the leasing alternative is given in column 2 of Table 17.3, and the sum of those for the purchasing alternative is given in column 4.

5. We are ignoring depreciation in year 6 because regardless of which option the company selects there will be $1,200 worth of depreciation remaining.

6. Although other cash outflows such as insurance and operating expenses may be relevant here, they would be the same under the lease and purchase alternatives and therefore would cancel out in the final analysis.

7. If we ignore any flotation costs, the firm’s after-tax cost of debt would be 5.4% [9% debt cost * (1 - 0.40 tax rate)]. To reflect both the flotation costs associated with selling new debt and the possible need to sell the debt at a

PART 8

Special Topics in Managerial Finance

Comparison of Cash Outflows Associated with Leasing versus

TA B L E 1 7 . 3

Purchasing for Roberts Company

Present value

After-tax Present value

cash outflows

of outflows

cash outflows a of outflows

End of year

PV of cash outflows $16,062

PV of cash outflows $19,541

a From column 7 of Table 17.2.

b After-tax lease payment outflow of $3,600 plus the $1,200 cost of exercising the purchase option.

Step 4 Because the present value of cash outflows for leasing ($16,062) is lower than that for purchasing ($19,541), the leasing alternative is preferred. Leasing results in an incremental savings of $3,479 ($19,541 - $16,062) and is therefore the less costly alternative.

The techniques described here for comparing lease and purchase alterna- tives may be applied in different ways. The approach illustrated by the Roberts Company data is one of the most straightforward. It is important to recognize that the lower cost of one alternative over the other results from factors such as the differing tax brackets of the lessor and lessee, different tax treatments of leases versus purchases, and differing risks and borrowing costs for lessor and lessee. Therefore, when making a lease-versus-purchase decision, the firm will find that inexpensive borrowing opportunities, high required lessor returns, and a low risk of obsolescence increase the attractiveness of purchasing. Subjective factors must also be included in the decision-making process. Like most financial decisions, the lease-versus-purchase decision requires some judg- ment or intuition.

Personal Finance Example 17.2 3 Jake Jiminez is considering either leasing or purchasing a new Honda Fit that will cost $15,000. The 3-year lease requires an

initial payment of $1,800 and monthly payments of $300. Purchasing requires a $2,500 down payment, sales tax of 5% ($750), and 36 monthly payments of $392. He estimates the trade-in value of the new car will be $8,000 at the end of

3 years. Assuming Jake can earn 4% annual interest on his savings and is subject to a 5% sales tax on purchases, we can make a reasonable recommendation to Jake using the following analysis (for simplicity, ignoring the time value of

CHAPTER 17

Hybrid and Derivative Securities