19 Lease Financing Short- and Intermediate- Term Funding Alternatives ©2006 Thomson/South-Western

2 Introduction The first half of this chapter deals with lease financing from the perspective of both the owner and the user of an asset It examines the type of analysis that should go into a lease versus borrow-and- purchase decision to maximize shareholder wealth. The second half of the chapter discusses other intermediate-term sources of funding available to a company, such as term loans and equipment loans.

3 Glossary of Leasing Terms This Web site has a glossary of leasing terms for researching the right alternative between leasing or borrowing and purchasing assets:

4 Lease Contract Leases  Alternative to term financing  Arrangements to transfer tax benefits Lessee  Obtains use of an asset  Specific period of time  Ownership to lessor  Agrees to make a series of payments to lessor

5 Types of Leases Operating lease Service lease Maintenance lease  Maintenance and insurance included Financial lease  Noncancelable  Lessee responsible for  Maintenance Insurance Property taxes  Direct lease  Sale and leaseback Leveraged lease Three-party financial lease  Lessee Lessor Lender

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7 Sale and Leaseback Transaction Investigate the sale and leaseback transaction at this Web site: 97/focus5.html

8 Advantages to Leasing Flexible Convenient Lower payments Avoid some risk of obsolescence Smoother earnings and EPS 100% financing Liquidity

9 Disadvantages to Leasing More expensive Salvage value foregone Difficult approval for modifications May not be canceled

10 Tax Considerations A lease must have economic benefits separate from tax considerations. Recognized by IRS as a lease (Rules)  Remaining useful life < 30 years  Reasonable ROI  Renewal options  Purchase options  Level schedule of lease payments  20% equity  Property valuable only to the lessee

11 Leases and Accounting Practices Types of Leases  Financial leases  Operating leases FASB requires that leases be capitalized. Value of lease  Equal to the PV of the lease payments  Discounted at the firm’s borrowing rate for a secured loan with similar maturity Disclosure of details in footnotes

12 Footnotes: Financial Leases As of the date of the balance sheet  Gross amount of assets by major classes  Amount of accumulated lease amortization  Future minimum lease payments In total for each of the next five fiscal years

13 Footnotes: Operating Leases As of the date of the latest balance sheet  Future minimum rental payments required In total for each of the following five fiscal years  An income statement is presented for rental expense in each period

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15 Lease Payments: Lessor’s perspective Lessor’s required payment three-step process Step 1: Compute the lessor’s amount to be amortized Initial outlay Less: PV of after-tax salvage Less: PV of depreciation tax shelter Equals: Amount to be amortized

16 Lease Payments (continued) Step 2: Compute after-tax lease income required Amount to be amortized = PV of after-tax lease payment Step 3: Compute before-tax lease payment Lease Payment = After-tax lease income required 1 – lessor’s marginal tax rate

17 Lease vs. Borrowing to Buy Compute the NAL (net advantage to leasing) If NAL is positive, it is cheaper to lease. If NAL is negative, it is cheaper to own.

18 Factors affecting the NAL Considerations  Installed costs  PV of after-tax lease payments  PV of depreciation tax shield  PV of after-tax operating costs if owned  AND PV of after-tax salvage value at the lessee’s weighted cost of capital

19 Small Firms Reasons for leasing  Less cash required upfront  Better protection against obsolescence  Quicker approvals  Fewer restrictive covenants Expensive reasons  High interest cost  Loss of tax benefits

20 Term Loan Maturity Sources Less expensive Better suited Working capital Default provisions Amortization Interest costs Loan agreements Warrants Security provisions Covenants

21 Computing the annual payment PVAN 0 = PMT (PVIFA i, n ) PMT = PVAN 0 PVIFA i, n

22 Sources of Term Loans Banks Insurance companies Pension funds Government agencies Equipment suppliers  Conditional sales contracts  Chattel mortgages

23 Government Agencies SBA  Participation loans SBICs IDAs  Municipal bonds

24 Security Provisions Dependent on the borrower’s credit standing Provisions  Assignment of payments due from a particular contract  Assignment or pledging of inventories, A/R or securities  Floating lean  Mortgage  Life insurance  Pledge of marketable securities

25 Covenants Affirmative Negative Restrictive