© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Leasing Chapter Twenty-Two Prepared by Anne Inglis, Ryerson University

22.1 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Key Concepts and Skills Understand the basic lease terminology Understand the criteria for a capital lease vs. an operating lease Understand the typical incremental cash flows to leasing Be able to compute the net advantage to leasing

22.2 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Chapter Outline Leases and Lease Types Accounting and Leasing The Cash Flows from Leasing Lease or Buy? A Leasing Paradox

22.3 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Lease Terminology 22.1 Lease – contractual agreement for use of an asset in return for a series of payments Lessee – user of an asset; makes payments Lessor – owner of the asset; receives payments Direct lease – lessor is the manufacturer Captive finance company – subsidiaries that lease products for the manufacturer

22.4 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Figure 22.1

22.5 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Types of Leases Operating lease –Shorter-term lease –Lessor is responsible for insurance, taxes and maintenance –Often cancelable Financial lease (capital lease) –Longer-term lease –Lessee is responsible for insurance, taxes and maintenance –Generally not cancelable –Specific capital leases Tax-oriented Leveraged Sale and leaseback

22.6 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Lease Accounting 22.2 Leases are governed by CICA 3065 Financial leases are essentially treated as debt financing –Present value of lease payments must be included on the balance sheet as a liability –Same amount shown on the left side of the balance sheet Operating leases are still “off-balance-sheet” and do not have any impact on the balance sheet itself

22.7 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Criteria for a Capital Lease If one of the following criteria is met, then the lease is considered a capital lease and must be shown on the balance sheet –Lease transfers ownership by the end of the lease term –Lessee can purchase asset at below market price –Lease term is for 75 percent or more of the life of the asset –Present value of lease payments is at least 90 percent of the fair market value at the start of the lease

22.8 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Incremental Cash Flows 22.4 After-tax lease payment (outflow) –Lease payment*(1 – T) Lost depreciation tax shield (outflow) –Depreciation * tax rate for each year Initial cost of machine (inflow) –Inflow because we save the cost of purchasing the asset now May have incremental maintenance, taxes or insurance depending on the type of lease and whether the leased asset is replacing one currently owned

22.9 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example: Lease Cash Flows ABC, Inc. needs new cars. The equipment cars would cost $10,000 each if purchased and would be depreciated at a CCA rate of 40%. They would help the sales force generate $6,000 in additional sales per year for 5 years. No salvage is expected after the 5 years. Alternatively, the company can lease the cars for $2,500 per year and payments are due at the beginning of the year. The marginal tax rate is 40%. What are the incremental cash flows?

22.10 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example: Lease Cash Flows continued –What are the incremental cash flows? After-tax lease payment = 2,500(1 -.4) = 1,500 (outflow years 1 - 5) Cost of the car = 100,000 (inflow year 0) Lost depreciation tax shield –Table 22.2: Tax shield on CCA for car

22.11 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Lease or Buy? 22.5 The company needs to determine whether it is better off borrowing the money and buying the asset or leasing Compute the NPV of the incremental cash flows Appropriate discount rate is the after-tax cost of debt since a lease is essentially the same risk as a company’s debt

22.12 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Net Advantage to Leasing The net advantage to leasing (NAL) is the same thing as the NPV of the incremental cash flows –If NAL > 0, the firm should lease –If NAL < 0, the firm should buy Consider the previous example. Assume the firm’s cost of debt is 11%. –After-tax cost of debt = 10(1 -.4) = 6.6% –NAL = -119 Should the firm buy or lease?

22.13 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. A Leasing Paradox 22.6 If the lessor and lessee have the same effective tax rate, then leasing is a zero sum game When their tax rates differ, then leasing has benefits for both parties –The company in the higher tax bracket can benefit from being a lessor, because they can use the CCA tax shields –The CCA tax shields are worth less to the lessee because the lessee faces a lower tax rate or may not have enough taxable income to absorb the accelerated tax shields in the early years