1. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-0 CHAPTER 21 Introduction to Corporate Finance (LEASING)

2. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-1 Chapter Outline 21.1 Types of Leases 21.2 Accounting and Leasing 21.3 The Cash Flows of Leasing 21.4 NPV Analysis of the Lease-versus-Buy Decision 21.5 Debt Displacement and Lease Valuation 21.6 Does Leasing Ever Pay: The Base Case 21.7 Reasons for Leasing 21.8 Some Unanswered Questions 21.9 Summary and Conclusions 21.1 Types of Leases 21.2 Accounting and Leasing 21.3 The Cash Flows of Leasing 21.4 NPV Analysis of the Lease-versus-Buy Decision 21.5 Debt Displacement and Lease Valuation 21.6 Does Leasing Ever Pay: The Base Case 21.7 Reasons for Leasing 21.8 Some Unanswered Questions 21.9 Summary and Conclusions

3. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 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. 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 Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-3 Buying versus Leasing BuyLease Firm U buys asset and uses asset; financed by debt and equity. Lessor buys asset, Firm U leases it. Manufacturer of asset Equity shareholders Firm U 1. Uses asset 2.Owns asset Creditors Manufacturer of asset Lessor 1. Owns asset 2. Does not use asset Equity shareholders Creditors Lessee (Firm U) 1. Uses asset 2. Does not own asset

5. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-4 Operating Leases Usually not fully amortized. Usually require the lessor to maintain and insure the asset. Lessee enjoys a cancellation option. Usually not fully amortized. Usually require the lessor to maintain and insure the asset. Lessee enjoys a cancellation option.

6. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-5 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. 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.

7. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-6 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. 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.

8. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-7 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. 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.

9. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-8 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. 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.

10. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-9 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 Truck Debt 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 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 Truck Debt 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 Consider a firm with two assets: a truck and some land.

11. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-10 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. 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.

12. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-11 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: 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

13. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-12 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. 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.

14. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-13 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. 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.

15. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-14 NPV Analysis of the Lease-vs.-Buy Decision 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 CF1 F1 CF0 5 –$5,825 –$219.20 $25,000 I NPV 5

16. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-15 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. CF1 F1 CF0 5 $5,825 $219.20 –$25,000 I NPV 5

17. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-16 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 (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. 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.

18. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-17 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 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. Suppose ClumZee agrees to a lease payment of $6,250 before tax. This payment would support a loan of $25,219.20 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. PMTNPV 5–$5,825$25,219.20 I/YrFV 50 Depreciation Tax Shield –5,000×(.34) = –$1,700 –$5,825 After-Tax Lease Payments –6,250×(1 –.34) = –$4,125

19. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-18 21.7 Debt Displacement and Lease Valuation Year 012345 Outstanding Loan Balance$25,219$20,655$15,862$10,831$5,547$0.00 Interest$1,910$1,565$1,202$821$420 Tax Deduction on interest$650$532$409$279$143 After-tax Interest Expense$1,261$1,033$793$542$277 Extra Cash that purchasing firm generates over leasing firm $5,825 Suppose ClumZee agrees to a lease payment of $6,250 before tax. This payment would support a loan of $25,219.20 05.020.219,25$96.260,1$   96.260,1$.825,5$20.219,25$16.655,20$  After-Tax Lease Payments–6,250×(1 –.34) = –$4,125 Forgone Depreciation Tax Shield –5,000×(.34) = –$1,700 –$5,825

20. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-19 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: 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: CF1F1 CF0 5$5,825$219.20 –$25,000 I NPV 5 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

21. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-20 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 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

22. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-21 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 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

23. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-22 Tiger Leasing’s Break even Payment 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 × (1 –.34) -$25,000 $1,700 + $L min × (1 –.34) 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 × (1 –.34) -$25,000 $1,700 + $L min × (1 –.34)     5 1 min )05.1( 700,1$66. 000,25$0 t t L NPV    5 1 5 1 min )05.1( 700,1$ )05.1( 1$ 66.000,25$ t t t t L        5 1 5 1 min )05.1( 1$ 66. )05.1( 700,1$ 000,25$ t t t t L

24. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-23 Tiger Leasing’s Break-even Payment Step one is to find the after-tax cost of the truck. Step two is to find the after-tax payment required. Step one is to find the after-tax cost of the truck. Step two is to find the after-tax payment required. CF1 F1 CF0 5 $1,700 −$17,639.89 −25,000 I NPV 5 Step OneStep Two I/Yr PV N 0 5 − $17,639.89 5 PMT FV $4,074.37 This is $6,173.29 on a pre-tax basis.

25. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-24 ClumZee Mover’s Break-even Payment 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 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     5 1 max )05.1( 250,1$75. 000,25$0 t t L NPV      5 1 5 1 max )05.1( 250,1$ )05.1( 75. 000,25$ t t t t L       5 1 5 1 max )05.1( 75. )05.1( 250,1$ 000,25$ t t t t L 49.032,6$ max  L No lease is possible: L min > L max

26. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-25 ClumZee Mover’s Break-even Payment Step one is to find the after-tax cost of the truck. Step two is to find the after-tax payment required. Step one is to find the after-tax cost of the truck. Step two is to find the after-tax payment required. CF1 F1 CF0 5 $1,250 −$19,588.15 −25,000 I NPV 5 Step OneStep Two I/Yr PV N 0 5 − $19,588.15 5 PMT FV $4,524.37 This is $6,032.49 on a pre-tax basis.

27. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-26 The most that ClumZee movers can afford to pay is $6,032.49 The least that Tiger Leasing can accept is $6,173.29 So there won’t be a lease in this case. The most that ClumZee movers can afford to pay is $6,032.49 The least that Tiger Leasing can accept is $6,173.29 So there won’t be a lease in this case.

28. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-27 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? 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?

29. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 21-28 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. 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.