23-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Twenty-three Leasing

23-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 23.1The Nature of Leases 23.2Types of Leases 23.3A Brief Look at Accounting for Leases 23.4Taxation and Leases 23.5An Evaluation of Leasing 23.6The Role of the Residual Value 23.7Setting Lease Premiums 23.8Alleged Advantages and Disadvantages of Leasing Summary and Conclusions Chapter Organisation

23-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Objectives Understand the characteristics of the different types of leases. Explain how leases are recorded in a firm’s accounting records. Identify the tax implications of leases. Evaluate a lease by calculating the net advantage of leasing (NAL). Explain the calculation of lease premiums. Discuss the advantages and disadvantages of leases.

23-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Leasing What is a lease? –A lessee (user) enters an agreement in which they make lease payments to the lessor (owner) in return for the use of the leased property/asset. Who are the major providers of lease finance in Australia? – Finance companies and banks. What assets are leased? –Any asset including photocopiers, cars, construction equipment, computers, shop/office fittings and equipment.

23-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Leasing versus Buying Manufacturer of asset Manufacturer of asset Sass arranges financing and buys asset from manufacturer Sass 1. Uses asset 2. Owns asset Lessor 1. Owns asset 2. Does not use asset Lessee (Sass) 1. Uses asset 2. Does not own asset Sass buys asset and uses asset; financing raised by debt Sass leases asset from lessor; the lessor owns the asset Sass leases asset from lessor Lease Buy

23-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Types of Leases Operating leases (service leases) Finance leases (capital leases) Two special types of finance leases are: –Sale and leaseback agreement –Leveraged lease.

23-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Operating Leases Short-term lease. Cancellable prior to the expiry date at little or no cost. Lessor is responsible for maintenance and upkeep of asset. The sum of the lease payments does not provide for full recovery of the asset’s costs. Includes telephones, televisions, computers, photocopiers, cars.

23-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Financial Leases Long-term lease. Non-cancellable (without penalty) prior to expiry date. Lessee is responsible for the maintenance and upkeep of the asset. Lease period approximates asset’s economic life. The sum of the lease payments exceeds the asset’s purchase price. Includes specialist equipment, heavy industrial equipment.

23-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Residual Value Clause Lease continues for its full term –Lessee can purchase the asset for its residual value, return the asset to the lessor (paying any shortfall from residual value) or renew the lease. Lease is cancelled during its initial term –Lessee must pay outstanding premiums (less interest component) plus residual value of asset.

23-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Types of Financial Leases Sale and leaseback agreements –Companies sell an asset to another firm and immediately lease it back. Enables the company to receive cash and yet maintain use of the asset. –Commonly used by banks and large retailers in relation to branch property. Leveraged leases –The lessor arranges for funds to be contributed by one or more parties—form of risk-sharing and transferring tax benefits. –Often used to finance large-scale projects.

23-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan A. Balance Sheet with Purchase (company finances $ truck with debt) Truck$ Debt$ Other assets Equity Total assets$ Debt plus equity$ B. Balance Sheet with Operating Lease (co. finances truck with an operating lease) Truck$ 0Debt$ 0 Other assets Equity Total assets$ Debt plus equity$ C. Balance Sheet with Financial Lease (co. finances truck with a financial lease) Assets under financialObligations under lease$ financial lease $ Other assets Equity Total assets$ Debt plus equity$ Leasing and the Balance Sheet

23-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Criteria for a Financial Lease AAS17 ‘Accounting for Leases’ states that a financial lease occurs where substantially all risks and benefits pass to the lessee. A financial lease must be disclosed on the Balance Sheet if at least one of the following criteria is met: –the lease term is 75 per cent or more of the estimated economic life of the asset –the present value of the lease payments is at least 90 per cent of the fair market value of the asset at the start of the lease.

23-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Leasing and Taxation Lease premiums paid under a lease contract are tax deductible. Any payment relating to the ultimate purchase of the asset is not deductible. The residual payment does not qualify as a tax deduction. Any profit made on the asset previously leased is subject to capital gains tax.

23-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Lease versus Buy Macca Co. has to decide whether to borrow the $ needed to purchase a new gadget machine (with a borrowing cost of 10 per cent) or to lease the machine for $4 000 per annum. If purchased, the asset could be depreciated using the straight-line method over the three-year life. The company tax rate is 30 per cent. Under the lease agreement, Macca Co. would be responsible for maintaining the machine.

23-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Lease versus Buy: Repayment Schedule

23-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Lease versus Buy: Tax Subsidises Borrowing

23-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Lease versus Buy: Tax Subsidises Leasing

23-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Lease versus Buy: Net Advantage of Leasing The advantage is greater than zero so Macca Co. should lease.

23-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Residual Value The residual value is the amount for which the asset may be purchased by the lessee from the lessor at the end of the lease term. The salvage value is the amount the asset can be sold for in the market place by the lessee (once they have acquired the asset). In the previous example, assume a residual value of $2,000 and a salvage value of $1500.

23-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Lease the Asset with Residual Value

23-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Borrow to Purchase the Asset with Residual Value

23-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Net Advantage of Leasing

23-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Setting Lease Premiums Commercial practice in Australia is for lease premiums to be paid in advance.

23-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Lease Premiums KAZ Co. has started a four-year lease of a photocopier which has a $ purchase price. Had the company purchased the copier, the interest rate quoted on borrowings was 1.5 per cent per month. KAZ has agreed with the lessor to a residual value of $ at the end of four years. What will be the amount of the lease premiums?

23-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Solution—Lease Premiums

23-26 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Alleged Advantages of Leases Financial: –No restrictions on future borrowing. –Can be tailored to suit firm’s needs. –Eliminates the need to raise extra capital. –No unnecessary financial outlay. –May be excluded from the Balance Sheet. –Facilitates financing capital additions on a piecemeal basis. –Is an allowable cost under government contracting. –Offers tax advantages.

23-27 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Alleged Advantages of Leases Operating: –Frees up capital for alternative uses. –Increases the company’s working capital. –Provides greater control due to greater certainty in future outlays. –Assures more competent upkeep of asset. Risk: –Avoids the risk of obsolescence. –Avoids the equipment disposal problem. –Future outlays cost less in real terms due to inflation.

23-28 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Alleged Disadvantages of Leasing Interest cost often higher. May not offer the right to the residual value of the asset. Allows the acquisition of assets without submitting formal capital expenditure procedures. May cause distortions in the evaluation of interfirm and interdivision performance. Lacks the prestige associated with ownership.

23-29 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Good Reasons for Leasing Taxes may be reduced by leasing due to differential tax rates or deductions. The lease contract may reduce certain types of uncertainty that might otherwise decrease the value of the firm. Leasing reduces the impact of obsolescence of an asset on a firm (but there is a cost for this). Transaction costs may be lower for a lease contract than for buying the asset. Leasing may require fewer (if any) restrictive covenants than secured borrowing.

23-30 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Bad Reasons for Leasing The perception of 100 per cent financing. The apparent low cost. Using leasing to artificially enhance accounting income.

23-31 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Summary and Conclusions Leases can be separated into two types: financial and operating. Financial leases must be reported on a firm’s Balance Sheet; operating leases are not. Taxes are an important consideration in leasing. A long-term financial lease is a source of financing much like long-term borrowing and can be evaluated using NPV. The lease premium is set by the lessor to recover the principal that is tied up in the asset and a component for interest on that principal. Three elements may create economic advantages for the parties to a lease: differential taxation rates, reducing uncertainty, and avoiding transaction costs.