Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-

Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-

chase the same asset, this decision will have an impact on the firm’s cash flow. The cash flow consequences, which are stated relative to the pur- chase of the asset, can be summarized as follows:

1. There will be a cash inflow equivalent to the cost of the asset.

2. The lessee may or may not forgo some tax credit. For example, prior to the elimination of the investment tax credit, the lessor could pass this credit through to the lessee.

3. The lessee must make periodic lease payments over the life of the lease. These payments need not be the same in each period. The lease payments are fully deductible for tax purposes if the lease is a true

5 The adjusted discount rate technique presented in this chapter is fundamentally equivalent to and results in the same answer as is obtained by comparing financing

provided by a loan that gives the same cash flow as the lease in every future period. This will be illustrated below.

Although the adjusted discount rate technique is fundamentally equivalent to cal- culating the adjusted present value of a lease, it is less accurate. The adjusted present value technique takes into consideration the present value of the side effects of ac- cepting a project financed with a lease. (The adjusted present value technique was first developed by Stewart C. Myers, “Interactions of Corporate Financing and In- vestment Decisions: Implications for Capital Budgeting,” Journal of Finance (March 1974), pp. 1–26.) The reason for a possible discrepancy between the solutions to the lease versus borrow-to-buy decision using the adjusted discount rate technique and adjusted present value technique is that different discount rates are applied where necessary in discounting the cash flow when the latter technique is used.

6 Stewart C. Myers, David A. Dill, and Alberto J. Bautista, “Valuation of Financial Lease Contracts,” Journal of Finance (June 1976), p. 799.

SELECTED TOPICS IN FINANCIAL MANAGEMENT

lease. The tax shield is equal to the lease payment times the lessee’s marginal tax rate.

4. The lessee forgoes the tax shield provided by the depreciation allow- ance since it does not own the asset. The tax shield resulting from depreciation is the product of the lessee’s marginal tax rate times the depreciation allowance.

5. There will be a cash outlay representing the lost after-tax proceeds from the residual value of the asset.

For example, consider the capital budgeting problem faced by the Hieber Machine Shop Company. The company is considering the acqui- sition of a machine that requires an initial net cash outlay of $59,400 and will generate a future cash flow for the next five years of $16,962, $19,774, $20,663, $21,895, and $26,825. Assuming a discount rate of 14%, the net present value (NPV) for this machine was found to be $11,540.

Let’s assume that the following information was used to determine the initial net cash outlay and the cash flow for the machine:

Cost of the machine = $66,000 Tax credit 7 = $6,600 Estimated pre-tax residual = $6,000 value after disposal costs Estimated after-tax proceeds from residual value = $3,600 Economic life of the machine = 5 years

Depreciation is assumed to be as follows: 8

Year Depreciation Deductions

7 We use a tax credit in this illustration to show how the model can be applied should Congress decide to introduce some form of tax credit for capital investments in fu-

ture tax legislation. 8 The depreciation schedule used in this illustration is not consistent with the tax law

at the time of this writing and is used for illustrative purposes only. The depreciation in this example is based on a depreciable basis comprised of the cost of the asset, less one-half of the tax credit, or $66,000 − 3,300 = $62,700. The rates of depreciation for the five years, in order, are 15%, 22%, 21%, 21%, and 21%.

Equipment Leasing

The same machine may be leased by the Hieber Machine Shop Com- pany. The lease would require five annual payments of $13,500, with the first payment due immediately. The lessor would retain the assumed tax credit. The tax shield resulting from the lease payments would be realized at the time that Hieber Machine Shop Company made the pay- ment. No additional annual expenses will be incurred by Hieber Machine Shop Company by owning rather than leasing (that is, the lease is a net lease). The lessor will not require Hieber Machine Shop Company to guarantee a minimum residual value.

Exhibit 27.2 presents the worksheet for the computation of the direct cash flow from leasing rather than borrowing to purchase. The marginal tax rate of Hieber Machine Shop Company is assumed to be 40%. The direct cash flow is summarized below:

Year

$51,300 ($11,862) ($13,618) ($13,367) ($13,367) ($8,867) The direct cash flow from leasing was constructed assuming that (1)

the lease is a net lease and (2) the tax benefit associated with an expense is realized in the tax year the expense is incurred. These two assump- tions require further discussion.

First, if the lease is a gross lease instead of a net lease, the lease pay- ments must be reduced by the cost of maintenance, insurance, and property taxes. These costs are assumed to be the same regardless of whether the asset is leased or purchased with borrowed funds. Where have these costs been incorporated into the analysis? The cash flow from owning an asset is constructed by subtracting the additional operating expenses from the addi- tional revenue. Maintenance, insurance, and property taxes are included in the additional operating expenses. There may be instances when the cost of maintenance differs depending on the financing alternative selected. In such cases, an adjustment to the value of the lease must be made.

Second, many firms considering leasing may be currently in a nontaxpay- ing position but anticipate being in a taxpaying position in the future. The derivation of the lease valuation model presented in the next section does not consider this situation. It assumes that the tax shield associated with an expense can be fully absorbed by the firm in the tax year in which the expense arises. There is a lease valuation model that, under certain conditions, will handle the situation of a firm currently in a nontaxpaying position. 9

9 The generalized model is explained and illustrated in Julian R. Franks and Stewart D. Hodges, “Valuation of Finance Contracts: A Note,” Journal of Finance (May

1978), pp. 657–669.

EXHIBIT 27.2 Worksheet for Direct Cash Flow from Leasing: Hieber Machine Shop Company*

End of Year

Cost of machine

Lost tax credit

Lease payment

($13,500) ($13,500) ($13,500) ($13,500) Tax shield from lease payment**

5,400 5,400 Lost depreciation tax shields***

(5,267) (5,267) ($5,267) Lost residual value

($11,862) ($13,618) ($13,367) ($13,367) ($8,867) * Parentheses denote cash outflow.

** Lease payment multiplied by the marginal tax rate (40%). *** Depreciation for year multiplied by the marginal tax rate (40%).

Equipment Leasing