1. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-0 Corporate Finance Ross  Westerfield  Jaffe Sixth Edition 21 Chapter Twenty One Leasing

2. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-1 Chapter Outline 21.1 Types of Leases 21.2 Accounting and Leasing 21.3 Taxes, the IRS, and Leases 21.4 The Cash Flows of Leasing 21.5 A Detour on Discounting and Debt Capacity with Corporate Taxes 21.6 NPV Analysis of the Lease-versus-Buy Decision 21.7 Debt Displacement and Lease Valuation 21.8 Does Leasing Ever Pay: The Base Case 21.9 Reasons for Leasing 21.10 Some Unanswered Questions

3. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-2 21.1 Types of Leases The Basics –A 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.

4. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-3 Operating Leases Usually not fully amortized. Usually require the lessor to maintain and insure the asset. Lessee enjoys a cancellation option.

5. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-4 Financial Leases The exact opposite of an operating lease. 1.Do not provide for maintenance or service by 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.

6. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-5 Sale and Lease-Back 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.

7. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-6 Leveraged Leases A leveraged lease is another type of financial 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 the lender in case of a default by the lessee.

8. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-7 21.2 Accounting and Leasing In the old days, leases led to off-balance-sheet financing. Today, leases are either classified as capital leases or operating leases. Operating leases do not appear on the balance sheet. Capital leases appear on the balance sheet—the present value of the lease payments appears on both sides.

9. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-8 Accounting and Leasing Balance Sheet Truck is purchased with debt Truck$100,000Debt$100,000 Land$100,000Equity$100,000 Total Assets$200,000Total Debt & Equity $200,000 Operating Lease TruckDebt Land$100,000Equity$100,000 Total Assets$100,000Total Debt & Equity $100,000 Capital Lease Assets leased$100,000Obligations under capital lease$100,000 Land$100,000Equity$100,000 Total Assets$200,000Total Debt & Equity$200,000

10. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-9 Capital Lease A lease must be capitalized if any one of the following is met: –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.

11. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-10 21.3 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.

12. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-11 21.3 Taxes, the IRS, and Leases The lessee can deduct lease payments if the lease is qualified by 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 payments that is very high at the start of the lease and low thereafter. 4.The lease payments must provide the lessor with a fair market rate of return. 5.The lease should not limit the lessee’s right to issue debt or pay dividends. 6.Renewal options must be reasonable and reflect fair market value of the asset.

13. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-12 21.4 The Cash Flows of Leasing Consider a firm, ClumZee Movers, that wishes to acquire a delivery truck. The truck is expected to reduce costs by $4,500 per year. The truck costs $25,000 and has a useful life of 5 years. If the firm buys the truck, they will depreciate it straight-line to zero. They can lease it for 5 years from Tiger Leasing with an annual lease payment of $6,250.

14. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-13 21.4 The Cash Flows of Leasing Cash Flows: Buy Year 0Years 1-5 Cost of truck – $25,000 After-tax savings4,500×(1-.34) = $2,970 Depreciation Tax Shield5,000×(.34) = $1,700 – $25,000$4,670 Cash Flows: Lease Year 0Years 1-5 Lease Payments–6,250×(1-.34) = –$4,125 After-tax savings4,500×(1-.34) = $2,970 –$1,155 Cash Flows: Leasing Instead of Buying Year 0Years 1-5 $25,000 – $1,155 – $4,670 = – $5,825

15. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-14 21.4 The Cash Flows of Leasing Cash Flows: Leasing Instead of Buying Year 0Years 1-5 $25,000 –$1,155 – $4,670 = –$5,825 Cash Flows: Buying Instead of Leasing Year 0Years 1-5 –$25,000 $4,670 –$1,155 = $5,825 However we wish to conceptualize this, we need to have an interest rate at which to discount the future cash flows. That rate is the after-tax rate on the firm’s secured debt.

16. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-15 21.5 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 firm’s optimal debt level by discounting a future guaranteed after-tax inflow at the after-tax riskless interest rate.

17. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-16 21.6 NPV Analysis of the Lease-vs.-Buy Decision A lease payment is like the debt service on a secured bond issued by the lessee. In the real world, 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.

18. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-17 NPV Analysis of the Lease-vs.-Buy Decision NPV Buying Instead of Leasing Year 0Years 1-5 -$25,000 $4,670 – $1,155 = $5,825 There is a simple method for evaluating leases: discount all cash flows at the after-tax interest rate on secured debt issued by the lessee. Suppose that rate is 5 percent. NPV Leasing Instead of Buying Year 0Years 1-5 $25,000 –$1,155 – $4,670 = -$5,825

19. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-18 21.7 Debt Displacement and Lease Valuation Considering the issues of debt displacement allows for a more intuitive understanding of the lease versus buy decision. Leases displace debt—this is a hidden cost of leasing. If a firm leases, it will not use as much regular debt as it would otherwise. –The interest tax shield will be lost.

20. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-19 21.7 Debt Displacement and Lease Valuation The debt displaced by leasing results in forgone interest tax shields on the debt that ClumZee movers didn’t go into when they leased instead of bought the truck. Suppose ClumZee agrees to a lease payment of $6,250 before tax. This payment would support a loan of $25,219.20 (see the next slide) In exchange for this, they get the use of a truck worth $25,000. Clearly the NPV is a negative $219.20, which agrees with our earlier calculations.

21. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-20 21.7 Debt Displacement and Lease Valuation Suppose ClumZee agrees to a lease payment of $6,250 before tax. This payment would support a loan of $25,219.20 After-Tax Lease Payments–6,250×(1-.34) = –$4,125 Forgone Depreciation Tax Shield – 5,000×(.34) = –$1,700 -$5,825 Calculate the increase in debt capacity by discounting the difference between the cash flows of the purchase and the cash flows of the lease by the after-tax interest rate.

22. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-21 21.8 Does Leasing Ever Pay: The Base Case In the above example, ClumZee Movers chose to buy, because the NPV of leasing was a negative $219.20 Note that this is the opposite of the NPV that Tiger Leasing would have: Cash Flows: Tiger Leasing Year 0Years 1-5 Cost of truck – $25,000 Depreciation Tax Shield5,000×(.34) = $1,700 Lease Payments6,250×(1-.34) = $4,125 – $25,000 $5,825

23. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-22 21.9 Reasons for Leasing Good Reasons –Taxes may be reduced by leasing. –The lease contract may reduce certain types of uncertainty. –Transactions costs can be higher for buying an asset and financing it with debt or equity than for leasing the asset. Bad Reasons –Accounting

24. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-23 A Tax Arbitrage Suppose ClumZee movers is actually in the 25% tax bracket and Tiger Leasing is in the 34% tax bracket. If Tiger reduces the lease payment to $6,200, can both firms have a positive NPV? Cash Flows: Tiger Leasing Year 0Years 1-5 Cost of truck–$25,000 Depreciation Tax Shield5,000×(.34) = $1,700 Lease Payments6,200×(1 –.34) = $4,092 –$25,000 $5,792 NPV = 76.33 Cash Flows ClumZee Movers: Leasing Instead of Buying Year 0Years 1-5 Cost of truck we didn’t buy$25,000 Lost Depreciation Tax Shield5,000×(.25) = –$1,250 After-Tax Lease Payments6,200×(1 –.25) = –$4,650 $25,000 –$5,900 NPV = -$543.91

25. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-24 Reservations and Negotiations What is the smallest lease payment that Tiger Leasing will accept? Set their NPV to zero and solve for $L min : Cash Flows: Tiger Leasing Year 0Years 1-5 Cost of truck-$25,000 Depreciation Tax Shield5,000×(.34) = $1,700 Lease Payments$L min ×(1 –.34) = $L min ×.66 -$25,000 $1,700 + $L min ×.66

26. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-25 Reservations and Negotiations What is the highest lease payment that ClumZee Movers can pay? Set their NPV to zero and solve for $L max : Cash Flows ClumZee Movers: Leasing Instead of Buying Year 0Years 1-5 Cost of truck we didn’t buy$25,000 Lost Depreciation Tax Shield5,000×(.25) = – $1,250 After-Tax Lease Payments – $L max ×( 1 –.25) =.75× L max $25,000 – 1,250 –.75× L max No lease is possible: L min > L max

27. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-26 21.10 Some Unanswered Questions Are the Uses of Leases and of Debt Complementary? Why are Leases offered by Both Manufacturers and Third Party Lessors? Why are Some Assets Leased More than Others?

28. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-27 21.11 Summary and Conclusions There are three ways to value a lease. 1.Use the real-world convention of discounting the incremental after-tax cash flows at the lessors after-tax rate on secured debt. 2.Calculate the increase in debt capacity by discounting the difference between the cash flows of the purchase and the cash flows of the lease by the after-tax interest rate. The increase in debt capacity from a purchase is compared to the extra outflow at year 0 from a purchase. 3.Use APV (presented in the appendix to this chapter). They all yield the same answer. The easiest way is the least intuitive.

29. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-28 Appendix 21A: APV Approach to Leasing APV = All-Equity Value + Financing NPV Calculations shown on the following slides will show that for the latest Clumzee Movers example (tax rate is 25%) APV = $591.38 – $1,135.30 APV = –$543.91 Which is the same value as the easier NPV analysis.

30. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-29 Appendix 21A: APV Approach to Leasing APV = All-Equity Value + Financing NPV To find the all-equity value, discount the cash flows at the pre-tax interest rate. The after tax rate was 5% which implies a pretax rate of 6.66% = 5%/(1-.25). Cash Flows ClumZee Movers: Leasing Instead of Buying Year 0Years 1-5 Cost of truck we didn’t buy$25,000 Lost Depreciation Tax Shield5,000×(.25) = –$1,250 After-Tax Lease Payments6,200×(1 –.25) = –$4,650 $25,000 –$5,900

31. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-30 Appendix 21A: APV Approach to Leasing APV = All-Equity Value + Financing NPV The NPV of the financing is the forgone interest tax shields on the debt that ClumZee movers didn’t go into when they leased instead of bought the truck. ClumZee agreed to a lease payment of $5,900. This payment would support a loan of $25,543.91

32. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-31 Appendix 21A: APV Approach to Leasing The lost interest tax shield associated with this additional debt capacity of $25,543.91 has a present value of $1,135.30

33. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-32 21.7 Debt Displacement and Lease Valuation The lost interest tax shield associated with this additional debt capacity of $25,219.20 has a present value of $