1. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–1 Chapter 16 Leasing and Other Equipment Finance

2. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–2 Learning Objectives Explain the main features of finance leases and operating leases. Understand the reasons for leveraged leases and cross-border leases. Outline the accounting and tax treatment of leases in Australia. Calculate rentals for a finance lease. Evaluate a finance lease from the lessee’s viewpoint.

3. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–3 Learning Objectives (cont.) Evaluate an operating lease from the lessee’s viewpoint. Critically evaluate the suggested advantages of leasing. Explain the factors that can influence leasing policy. Outline the main features of chattel mortgages and hire-purchase agreements.

4. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–4 Introduction Leasing is distinguished from most other forms of finance by the fact that the financier (the lessor) is the legal owner of the leased asset. The asset user (the lessee) obtains the right to use the asset in return for periodic payments (lease rentals) to the lessor. Equipment finance: a general term that encompasses leasing hire-purchase and chattel mortgages. Recent figures from the Australian Equipment Lessors Association (2004) estimate around 20% of all new capital equipment acquired by Australian businesses is leased.

5. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–5 Operating Leases Essentially a rental agreement. Cancellable by the lessee, at little or no cost. Normally only for a short period, which is considerably less than the useful life of the leased asset. Risks of ownership borne by the lessor. Maintenance lease: operating lease where the lessor is responsible for all maintenance and service of the leased asset.

6. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–6 Finance Leases A long-term agreement that generally covers most of the economic life of the asset. Non-cancellable, or cancellable only if the lessee pays a substantial penalty to the lessor. The obligation is essentially the same as a borrower’s obligation to repay a loan. From the lessor's viewpoint it is, in effect, a secured loan. The risks and benefits of ownership of the asset are effectively transferred from the lessor to the lessee.

7. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–7 Sale and Lease-back Agreements The owner of an asset sells the asset to a financial institution for an amount usually equal to its current market value and immediately leases it back from the institution. An alternative to raising cash by borrowing, using the asset as security. Lessor is typically an insurance company, super fund, bank or specialist lease company. Typical assets include commercial real estate, railway rolling stock and vehicle fleets.

8. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–8 Leveraged Leasing Form of finance lease. A lease in which most of the funds needed to purchase the leased asset are borrowed by the lessor. Involves at least three parties instead of the normal two. The additional party is a lender, normally referred to as a ‘debt participant’. Typically involves a non-recourse loan, whereby the lessor is not responsible for its repayment.

9. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–9 Cross-Border Leasing A lease in which the lessee and lessor are located in different countries. Usually leveraged, and motivated by differences between the tax regulations of different countries. Generally structured so that the lessor and lessee can both claim depreciation deductions on the same asset. Complex tax issues in Australia: – Difficult for Australian lessor to participate in a CBL involving an offshore asset. – Australian lessee can be involved in CBL provided there is a purchase option.

10. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–10 Accounting for Leases In Australia, AASB 117 ‘Leases’, provides that the accounting treatment of a lease depends on whether it is classified as an operating or a finance lease. Operating leases are treated in the traditional way (lease rentals expensed and no recognition of any assets or liabilities).

11. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–11 Accounting for Leases (cont.) AASB 117 provides that a lease would normally be classified as a finance lease if: – Substantially all of the risks and rewards associated with ownership of the leased asset are effectively transferred to the lessee. Where lease is a finance lease, lease asset and liability equal to fair value of leased property or PV of lease payments must be recognised on balance sheet.

12. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–12 Accounting for Leases (cont.) The previous criteria are, however, only guidelines. The classification of a lease should depend on the economic substance of the transaction. However, lessors have made efforts to structure finance leases such that they are recognised as operating leases to avoid the need to recognise finance leases as assets or liabilities.

13. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–13 Taxation Treatment of Leases If a leased asset is used to generate taxable income, the lease rentals paid by the lessee are an allowable tax deduction, provided that the lease is classified as a ‘genuine lease’ rather than an ‘instalment purchase arrangement’. While lease rentals are deductible, the lessee cannot deduct, for tax purposes, depreciation on the leased asset.

14. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–14 Setting Lease Rentals Four steps: – Calculate the present value of the cash flows from ownership of the asset. – Calculate the required present value of the lease payments. – Calculate the minimum after-tax lease payment. – Calculate the minimum before-tax payment, given the tax rate t c.

15. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–15 Evaluation of Finance Leases Should we compare: – Leasing with borrowing, or – Leasing with buying? Myers, Dill and Bautista (MDB) (1976) suggested analysing a finance lease in the context of its effect on the lessee’s capital structure.

16. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–16 Evaluation of Finance Leases (cont.) MDB emphasised that entering into a finance lease uses some of the lessee’s debt capacity. – Therefore, it follows that a finance lease should be analysed by comparing it with debt. MDB method: – Leasing will be economically advantageous to a lessee if the finance provided by leasing is greater than the liability incurred by leasing.

17. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–17 Leasing Decisions and Investment Decisions In practice, the investment decision would normally be considered first and, if the project were profitable, the alternative of leasing the required assets would be evaluated. However, a project revealing a negative NPV should not necessarily be discarded, as the NPV of a lease can be large enough to ‘rescue’ an otherwise marginally unprofitable project.

18. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–18 The Value of Leasing in Competitive Capital Markets Suppose that all financiers and asset users operate in a perfect capital market where the following conditions apply: – Leasing involves no transactions costs. – Information is costless and freely available. – All parties are subject to the same tax laws and tax rates.

19. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–19 The Value of Leasing in Competitive Capital Markets (cont.) Under these conditions, the cost of leasing an asset should be the same as the cost of buying it. The lease or buy decision should be a matter of indifference. The popularity of leasing has varied over time. It is particularly popular for some types of assets.

20. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–20 The Value of Leasing in Competitive Capital Markets (cont.) This suggests that there are cases where asset users have a systematic preference for leasing or buying. For this to be so, there must be tax differences or imperfections that can make leasing advantageous in some cases.

21. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–21 Establishing an Advantage for Leasing To make leasing attractive to the user of an asset without simultaneously making leasing unattractive to the lessor requires some departure from the perfect-market conditions. The symmetry between the positions of the two parties needs to be broken: – Quantity discounts available to specialty lessors. – Differences in tax positions of the parties.

22. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–22 Taxes and the Size of Leasing Gains The NPV of a lease to the lessee (NPV LES ) can be expressed as: Similarly, the NPV to the lessor (NPV LOR ) will be:

23. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–23 Taxes and the Size of Leasing Gains (cont.) A lease can affect the present value of the government’s tax receipts in two ways: – The government gains, in that it can tax the lease rentals received by the lessor. – The government loses, in that the lessor is able to claim deductions for depreciation on the leased asset. The net result is that the government can lose through deferral of tax receipts — this net loss by the government is why the lease is advantageous to the parties to the lease.

24. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–24 Taxes and the Size of Leasing Gains (cont.) Other things being equal, the government’s net loss will be larger in present value terms if: – Lessor’s tax rate is much greater than the lessee’s. – Depreciation tax savings are received early. – The term of the lease is long and the lease rentals are paid late. – Interest rate is high.

25. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–25 Leasing and the Imputation Tax System Under the imputation tax system any advantage associated with deferring a company’s tax payments is likely to be small. – This is because company tax is, from the viewpoint of resident shareholders, only a withholding tax (effective rate of company income tax is low). – Hence, any tax advantage from leasing must also be small.

26. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–26 Evaluation of Operating Leases Cancellable long-term operating leases – Enable a company to obtain insurance against an unexpectedly large decline in the value of an asset. – The cancellation clause in an operating lease is equivalent to an American put option held by lessee. – Could evaluate lease using an option pricing model but this is likely to be complex. – Suggested that an operating lease should first be evaluated as if it were a finance lease, then assessed as to whether this cost is reasonable, given the risks transferred to the lessor.

27. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–27 Evaluation of Operating Leases (cont.) Cancellable short-term operating leases – When a business requires an asset for a period significantly less than its economic life, a short-term lease will frequently prove to be the most economic means of acquiring the asset’s services. – The alternative of buying the asset and then selling it shortly after (sale and buyback arrangement) is likely to be more inconvenient and involve greater transaction costs.

28. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–28 Possible Advantages of Leasing Company taxation – Advantages may arise from the deferral of taxes. – Firms with lower marginal tax rates use leasing more than firms with high marginal tax rates, found by Graham, Lemmon and Schallheim (1998) for US. – Cross-border leases take advantage of the differences between the tax environments in different countries. – Possible advantages where lessors are able to choose between different accounting methods to calculate their taxable income.

29. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–29 Possible Advantages of Leasing (cont.) Conservation of capital – By leasing, a company can conserve its capital for investment elsewhere (leasing provides ‘100 per cent financing’). – Problems with this argument:  Lease rentals are typically payable in advance, so the finance provided can be considerably less than the purchase price.  There are other forms of debt that place less stress on a company’s cash flow.  Not sufficient to look only at the immediate cash effect of leases.

30. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–30 Possible Advantages of Leasing (cont.) ‘Off-balance sheet’ finance – Because in the past lessees have not been required to report their lease obligation on the balance sheet, they can use leasing to increase their access to debt. – However, AASB 117 now requires the capitalisation of finance lease obligations, which means that any potential ‘off-balance sheet’ advantage for leasing should no longer be available.

31. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–31 Possible Advantages of Leasing (cont.) Cost of capital – If the lessor’s cost of capital is lower (higher) than that of the potential lessee, the existence of competitive capital markets will result in leasing (buying) being preferred to buying (leasing). – The circumstances when the cost of capital of the lessor and lessee will differ depend on the risks associated with using the asset. – Miller and Upton (1976) — cost of capital for leasing and buying should be the same, otherwise one would dominate the other in marketplace.

32. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–32 Possible Advantages of Leasing (cont.) Transaction costs – If a lessee defaults, the lessor, as owner of the asset, can immediately repossess it. – However, a secured lender is likely to face considerable delay and greater costs, because it may be necessary for the defaulting borrower to be liquidated.

33. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–33 Possible Advantages of Leasing (cont.) Agency costs – Leasing and debt are not perfect substitutes as they can differ in terms of incentive effects and control of agency costs. – Remuneration packages can create incentive to lease rather than purchase — impact on ROI, to which pay packages may be linked — Smith and Wakeman (1985). – If manager has large equity stake in company, may prefer to lease assets to reduce personal exposure to specific asset risk — Mehran, Taggart and Yermack (1999).

34. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–34 Leasing Policy Why does a business lease some assets, while purchasing other similar assets? Sensitivity to use and maintenance decisions: – A lessee does not have a right to the salvage value of an asset at the end of the lease. – Therefore, there is less incentive to care for and maintain assets that are leased rather than owned. – Therefore, lessors set lease rentals on the basis of expected levels of abuse. – Consequently, assets that are sensitive to use and maintenance decisions will tend to be purchased.

35. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–35 Leasing Policy (cont.) Specialised assets: – There is an incentive to buy, rather than lease, specialised (or company-specific) assets. – The residual value of such assets tends to be disputed between lessor and lessee, i.e. lessor places lower residual value on asset than lessee. – This leads to unacceptably high lease payments making outright purchase relatively more attractive to potential lessee.

36. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–36 Leasing Policy (cont.) Flexibility and transaction costs: – An operating lease is likely to involve lower costs than purchasing an asset and then selling it. – Leasing may also involve lower search costs and costs of assessing quality.

37. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–37 Leasing Policy (cont.) Comparative advantage in asset disposal: – Three potential sources of comparative advantage in asset disposal by a lessor:  Lower search, information and transaction costs associated with the lessor providing a specialised market for used assets.  Reduced repair and maintenance costs for current machines from reusing components of previously leased machines.  Reduced production costs result from reusing components of previously leased machines in the production of new machines.

38. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–38 Chattel Mortgages and Hire Purchase Chattel mortgages and hire purchase agreements are similar to finance leases. Chattel mortgage (CM) – User purchases goods and financier registers charge over goods as security. – Loan secured over movable property rather than real estate. Hire purchase (HP) – Financier purchases asset and hires it to user for agreed period.

39. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–39 Chattel Mortgages and Hire Purchase (cont.) In the case of a CM or HP agreement, user will be required to make a series of payments or instalments to the financier for an agreed period. A HP agreement will either commit the user to buy the asset or give the user an option to buy it. In the case of HP, the user, rather than the financier, will be entitled to claim deductions for depreciation. During 2003, CM and HP agreements made up 60% of the Australian equipment finance market.

40. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–40 Chattel Mortgages and Hire Purchase (cont.) Equipment finance and the GST. – CM, HP agreements and leasing are treated differently under GST. – CM are treated as a loan (financial supply).  GST applies only to cost of asset, no GST on loan or loan repayments. – Lease rentals are subject to GST. – HP agreements can be split into financial supply and asset purchase components.  No GST on financial supply component, GST applies only to cost of asset. – If GST input credits can be claimed, the GST differences between CM, HP and leasing are not relevant.

41. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 16–41 Summary Reasons for leasing differ between types of lease. Operating lease — separates risk of ownership from use of leased asset. Finance lease — risk of ownership on lessee and lease is an alternative method of finance, reducing transaction costs of obtaining finance. Leasing can be driven by tax benefits — changes in tax rules, government charges and GST treatment can have important effects on leasing arrangements and their popularity. Leasing is more common for general or marketable assets.