1. Laurence Booth Sean Cleary

2. LEARNING OBJECTIVES Leasing 1616 16.1 Identify the characteristics of leases and differentiate between operating and financial (or capital) leases. 16.2 Describe the accounting treatment of both operating and financial leases. 16.3 Evaluate the lease decision using the discounted cash flow valuation methods. 16.4 Explain the various motives for leasing.

3. 16.1 LEASING ARRANGEMENTS In asset-based lending the decision to purchase an asset and the arrangement of its financing are combined into one decision. Leases are an example of secured financing, where the leased asset serves as collateral in the event of a default by the lessee. The Canadian Finance and Leasing Association (CFLA) is the professional body that acts as the umbrella group for asset-based lenders; it has about 160 members. – 60% are independent asset-based finance companies (e.g., CIT) which are mainly involved in machinery and equipment financing – 29% are captive finance companies which are subsidiaries of major manufacturing companies which give financing to their customers to buy their products (e.g., GM, Ford, Toyota) – 11% are chartered banks (on which the Bank Act imposes restrictions) 3© John Wiley & Sons Canada, Ltd.Booth Cleary – 3rd Edition

4. A lessor is the owner of the asset and the party in a lease agreement who conveys the right to use the asset in return for payment A lessee is the party in a lease agreement who pays the lessor to obtain the right to use the asset In operating leases some of the benefits of ownership do not transfer to the lessee but remain with the lessor In financial leases (or capital leases or full-payout leases) essentially all of the benefits of ownership transfer to the lessee 4© John Wiley & Sons Canada, Ltd.Booth Cleary – 3rd Edition 16.1 LEASING ARRANGEMENTS

5. In a sale and leaseback (SLB) agreement the owner of an asset sells it to another party and then leases the asset back from them Leveraged leases, which are popular in the United States, are a three-way agreement between a lessee, a lessor and a third- party lender where the lessor buys the asset with only a small down payment and the lender supplies the remaining financing. Differences between Canadian and American tax regulations on the restrictions on CCA deductions make leveraged leases less advantageous in Canada. 5© John Wiley & Sons Canada, Ltd.Booth Cleary – 3rd Edition 16.1 LEASING ARRANGEMENTS

6. 16.2 ACCOUNTING FOR LEASES Financing leases are included on the balance sheet of the lessee, while operating leases are not and so provide off-balance-sheet financing for the lessee A lease is classified as a financial if at least one of the four following criteria is met: – The lease transfers ownership of the property to the lessee by the end of the lease term. – The lessee has a bargain purchase option—that is, it can purchase the asset at a price below fair market value when the lease expires. – The lease term is 75 percent or more of the estimated economic life of the asset. – The present value of lease payments is 90 percent or more of the asset’s fair market value at the inception of the lease. Booth Cleary – 3rd Edition6© John Wiley & Sons Canada, Ltd.

7. The impact of operating and financial leases on the financial statements of the lessor and lessee is summarized in the table below Booth Cleary – 3rd Edition7© John Wiley & Sons Canada, Ltd. 16.2 ACCOUNTING FOR LEASES

8. Financial Statement Effects of Lease Classification Income Statement Effects – Net income will generally be higher for operating leases in the early years and lower in later years, because the interest expense charged for financial leases declines as the lease obligation is amortized. Cash Flow Statement Effects – The overall effect on total cash flow is the same for operating and financial leases; the difference depends on the classification not the amount of the cash flows. – Cash flow from operations will be lower for operating leases since the full lease payment is subtracted from cash from operations. For financial leases, only the interest portion of the lease payments is subtracted from cash from operations. – Cash flow from financing will be higher for operating leases because there is no principal repayment component for operating leases. Booth Cleary – 3rd Edition8© John Wiley & Sons Canada, Ltd. 16.2 ACCOUNTING FOR LEASES

9. Financial Statement Effects of Lease Classification Balance Sheet Effects – Financial leases cause a firm’s assets and liabilities to be larger than operating leases because operating leases provide off- balance-sheet financing. Financial Ratio Effects – If ratio analysis fails to take off-balance-sheet operating lease obligations into consideration, a company’s ratios will look better than they would if the lease were financial. – If a lease is classified as financial rather than operating, a firm will have: Lower current ratios Higher debt and leverage ratios Lower asset turnover ratios Lower profitability ratios Booth Cleary – 3rd Edition9© John Wiley & Sons Canada, Ltd. 16.2 ACCOUNTING FOR LEASES

10. 16.3 EVALUATING THE LEASE DECISION If a company needs an asset and has the opportunity to lease it, it must compare the cash flows from leasing with the cash flows from buying in order to determine which is better. There are four main differences in the cash flows for a company that leases an asset instead of buying it: 1.It does not have to pay for the asset up front. 2.If the lease is an operating lease, or it title is not transferred through a financial lease, the company does not get to sell the asset when it is finished with it. 3.It makes regular lease payments. If the lease is an operating lease, the full amount of these lease payments is tax deductible; if it is a financial lease, then only the interest portion of the payments is deductible. 4.It does not get to depreciate the asset for tax purposes if it is an operating lease. If it is a financial lease, it does get to charge depreciation. Booth Cleary – 3rd Edition10© John Wiley & Sons Canada, Ltd.

11. Leasing versus Buying Example 16-4: – A firm wishes to obtain a limousine for its executives. The limousine would cost $1 million to buy (it is very luxurious and also bulletproof). The limousine would be depreciated at a rate of $100,000 per year for tax purposes. Assume the limousine could be sold in five years for $500,000. The firm could also sign a five-year operating lease for the limousine, with lease payments of $140,000 per year. Each payment would be due at the beginning of the year. The firm’s effective tax rate is 40 percent. Determine whether or not the firm should lease the limousine, assuming its before-tax cost of borrowing is 7 percent. Booth Cleary – 3rd Edition11© John Wiley & Sons Canada, Ltd. 16.3 EVALUATING THE LEASE DECISION

12. Leasing versus Buying The company’s before-tax cost of borrowing is 7%. We should use the after-tax cost of borrowing to discount: 7% (1 – 0.4) = 4.2% The purchase price savings is the cost of the limousine, or $1,000,000. Depreciation tax savings = 0.4 × $100,000 = $40,000 per year. The present value of the depreciation tax savings is: The present value of the $500,000 salvage value is: The after-tax lease payments are: $140,000(1 - 0.4) = $84,000 per year The present value of the after-tax lease payments is: Booth Cleary – 3rd Edition12© John Wiley & Sons Canada, Ltd. 16.3 EVALUATING THE LEASE DECISION

13. Leasing versus Buying NPV (leasing versus buying) = The NPV of leasing versus buying, $28,409.05, is positive, and therefore leasing is better than buying in this case. Booth Cleary – 3rd Edition13© John Wiley & Sons Canada, Ltd. purchase price savings$1,000,000.00 ― PV(foregone depreciation tax savings)177,076.81 ― PV(foregone salvage value)407,034.68 ― PV(after-tax lease payments)387,479.47 $28,409.05 16.3 EVALUATING THE LEASE DECISION

14. Financial Leases versus Borrowing Example 16-7: – A company is given the option of entering into a five-year, $10,000 financial lease arrangement that calls for monthly payments based on a 6 percent lease rate, or borrowing $10,000 through a five-year loan that calls for monthly payments based on a 6.12 percent lending rate. Which option should the firm choose? Note: Don’t just compare the 6% lease rate to the 6.12% lending rate. This isn’t valid because the lease payments occur at the beginning of the month while the loan payments occur at the end of the month. Instead, calculate and compare the present value of the payments under each option. Booth Cleary – 3rd Edition14© John Wiley & Sons Canada, Ltd. 16.3 EVALUATING THE LEASE DECISION

15. Financial Leases versus Borrowing Step 1: Calculate monthly payments for each option. Lease The monthly lease rate is 6% / 12 = 0.5%, and over five years we make 60 payments on the $10,000 financial lease. Loan The monthly loan rate is 6.12% / 12 = 0.51%, and over five years we make 60 payments on the $10,000 loan. Booth Cleary – 3rd Edition15© John Wiley & Sons Canada, Ltd. 16.3 EVALUATING THE LEASE DECISION

16. Financial Leases versus Borrowing Step 2: Calculate the present value of payments for each option using the loan rate. (We can use either rate, but if we use the loan rate we automatically know the PV of the loan payments is the amount borrowed. PV(lease payments) PV(loan payments) = Amount of loan = $10,000.00 Conclusion: The lease arrangement costs marginally less than the loan arrangement, therefore the firm should lease. Booth Cleary – 3rd Edition16© John Wiley & Sons Canada, Ltd. 16.3 EVALUATING THE LEASE DECISION

17. 16.4 MOTIVATION FOR LEASING 1.Cheaper financing – The entire payment on an operating lease is tax deductible – If the lessor is better able than the lessee to take advantage of CCA tax savings associated with asset ownership, the lessee may benefit from lower lease costs if these savings are passed on by the lessor 2.Reduce the risks of asset ownership – Equipment can be acquired and used without assuming resale and obsolescence risks 3.Implicitly fixed interest rates – If firms, such as small firms, are only able to obtain variable-rate prime-based lending from banks, leases can offer the benefit of fixed-rate financing over the term of the lease. 4.Maintenance – Efficiencies can be realized if the lessor specializes in maintaining the leased equipment and offers a full-serve lease arrangement Booth Cleary – 3rd Edition17© John Wiley & Sons Canada, Ltd.

18. 5.Convenience – Assets that are needed only for a short period of time, which are very specialized or relatively hard to sell in the future are more easily leased than purchased 6.Flexibility – Leases can include options to cancel the lease, or other customizations that benefit the lessee 7.Capital budget restrictions – Although potentially dubious, leasing assets is an option if the capital required to purchase them is not available since leasing requires a limited initial capital outlay (just the first lease payment plus any arrangement fees) 8.Financial statement effects – Operating leases provide off-balance-sheet financing which allows firms to report higher net income, lower debt ratios and higher liquidity ratios. Booth Cleary – 3rd Edition18© John Wiley & Sons Canada, Ltd. 16.4 MOTIVATION FOR LEASING

19. WEB LINKS Wiley Weekly Finance Updates site (weekly news updates): http://wileyfinanceupdates.ca/ http://wileyfinanceupdates.ca/ Textbook Companion Website (resources for students and instructors): www.wiley.com/go/boothcanadawww.wiley.com/go/boothcanada Booth Cleary – 3rd Edition© John Wiley & Sons Canada, Ltd.19

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