LEASING Corporation lease both short term and long term rental agreement (more than five years) Every lease contract has two parties : Lessee is the user of leased asset (the user of equipment) Lessor is the owner of a leased A lease is a contractual agreement between a lessee and lessor. Because the user can also buy the asset, leasing and buying involve alternative financing arrangements for the use of an asset. The lessor is independent leasing company who purchased the equipment from a manufacturer such as IBM or Apple (Lease of this type are called direct leases) A manufacturer like IBM could lease its own computers (Lease of this type are called sales type leasing) Financial Management

Firm U buys and uses asset: financing raised by debt and equity Lessor buys asset Buy Firm U buys and uses asset: financing raised by debt and equity Lease Firm U lease asset from lessor: The lessor owns the asset Manufacturer of asset Firm U buys asset form manufacturer Firm U Uses asset Owns asset Creditors and equity shareholders supply financing to Firm U Equity shareholders Creditors Lessor Does not uses asset Firm U leases asset form lessor Creditors and shareholders supply financing to lessor FIGURE 21.1 Buying versus Leasing Lessee (Firm U) Does not own asset

Operating lease : a lease where the lessee received an operator along with the equipment. Operating leases are usually not fully amortized Operating leases usually require the lessor to maintain and insure the leased assets. Perhaps the most interesting feature of an operating lease is the cancellation option. Financial Lease are the exact opposite of operating leases : Financial lease do not provide for maintenance or service by the lessor Financial lease are fully amortized The lessee usually has a right to renew the lease on expiration Financial lease cannot be canceled. Two special types of financial lease : A sale and lease-back occurs when a company sell an asset it owns to another firm and immediately leases it back. Leverage lease : The lessee uses the assets and makes periodic lease payment. The lessor purchases the assets, delivers them to the lessee, and collects the lease payments. The lenders supply the remaining financing and receive interest payments from lessor.

In the USA before November 1976, financial leases were off balance-sheet financing (Lessee needed only to report information on leasing activity in the footnotes of their financial statements) ‘Accounting for leases’, under FAS 13, certain lease classified as capital leases. For capital lease, the present value of the lease payment appears on the value of the lease payment appears on the right-hand side of the balance sheet. The identical value appears on the left hand side of the balance sheet as an asset. In order to implement this new requirement the FASB had to come up with objective rules for distinguishing between operating and capital (financial) lease. They defined capital leases as lease which meet any one of the following requirements : The lease agreement transfers ownership to the lessee before the lease expires. The lessee can purchase the asset for a bargain price when the lease expires. The lease term is 75% or more of the estimated economic life of the asset. The present value of the lease payment is at least 90% of the assets value. All other leases are operating leases as far as the accountants are concerned.

TABLE 21.1 Example of Balance Sheet under FAS 13 Truck is purchased with debt (the company owns a $100,000 truck) Truck $100.000 Debt Land 100.000 Equity 100000 Total Assets $200.000 Total debt plus equity Operating lease (the company has an operating lease for the truck) $0 Capital lease (the company has a capital lease for the truck) Asset under capital lease Obligation under capital lease  

Financial leases may be evaluated by discounting the lease cash flows at the after-tax interest rate that the firm would pay on an equivalent loan. # Example : case xomox (manufactures pipe) currently has a five years backlog of pip orders for the Trans-Honduran Pipeline. IBMC makes a pipe-boring machine that can be purchased for $10,000. xomox has determined that it needs a new machine, & the IBMC will save xomox $6,000 per year for the next five years. Xomox has a corporate tax rate of 34% ; straight-line depreciation & worthless after five years. However, Friendly Leasing Corporation has offered to lease the same pipe-boring machine to Xomox for $2,500 per year for five years. Simon Smart, a recently hired MBA, has been asked to calculated the incremental cash flows leasing the IBMC machine in lieu of buying it.

Cash flows to friendly leasing as lessor of IBMC Pip-Boring Machine : exactly the opposite of those of Xomox. Good Reasons for leasing Taxes may be reduced by leasing The lease contract may reduce certain types of uncertainty Transaction costs can be higher for buying an asset and financing it with debt or equity than for leasing the asset Bad Reasons for Leasing Leasing and accounting Income : Firm’s balance sheet shows fewer liabilities with an operating lease than with either a capitalized lease or a purchase financed with debt. One Hundred-Percent Financing : It is often claimed that leasing provides 100%, whereas secured equipment loans require an initial down payment.

TABLE 21.2 Cash Flows to Xomox from Using the IBMC Pipe-Boring Machine: Buy Versus Lease   Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Buy Cost of machine -$10,000 After-tax operating savings [$3,90 = $6,000 x (1 - 0.34)] $3.960 Depreciation tax benefit 680 $4.640 Lease Lease payments -$2.500 Tax benefits of ($850 = $2,500 x 0.34) 850 After-tax operating savings 3960 Total $2.310 Depreciation is straight-line. Because the depreciable base is $10,000, depreciation expense per year is $10,000/5 = $2,000 The depreciation tax benefit per year is equal to Tax rate x Depreciation expense per year = Depreciation tax benefit 0.34 x $2,000 = $680

TABLE 21.3 Incremental Cash Flow Consequences for Xomox from Leasing instead of Purchasing Lease Minus Buy Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Lease Lease payment -$2.500 tax benefit of lease payment 850 Buy (minus) Cost of machine -(-$100,000) Lost dereciation tax benefit -680 Total $10.000 -$2.330   The botom line presents the cash flows from leasing relative to cash flows from purchase. The cash flows would be exacly the opposite if we considered the purchase relative to the lease. We could have expressed the cash flows from the purchase relative to the cash flows from leasing (the opposite of those in the bottom line of table 21.3) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Net CF from purchase relative to lease -$10,000 $2,330

NPV analysis of the Lease Versus Buy Decision Discount all cash flows at the after-tax interest rate. Xomox’s incremental cash flows from leasing versus purchasing are Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Net CF from lease relative to purchase alternative $10,000 -$2,330 Let us assume that xomox can either borrow or lend at the interest rate of 7.57575 percent. If the corporate tax rate is 34%, the correct discount rate is the after-tax rate of 5% (7.57575% x (1 – 0.34). So, NPV = $10,000 - $2,330 x A50.05 = -$87.68 Because the NPV of the incremental cash flows from leasing relative to purchasing is negative, Xomox prefers to purchase. We describe the precise method for calculating the difference in optimal debt levels between purchase and lease in the Xomox example. Increase in optimal debt level from purchase alternative relative to lease alternative : $10,087.68 = ($2,330/1.05) + ($2,330/1.052) + ($2,330/1.053) + ($2,330/1.054) + ($2,330/1.055)

TABLE 21.6 Calculation of Increases in Optimal Debt Level if Xomox Purchases instead of Leases Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Outstanding balance of loan Interest Tax deduction on interest After-tax interest expense Extra cash that purchasing firm generates over leasing firm Repayment of loan $10,087.68 $8,262.07* 764.22 259.83 $ 504.39 $2,330.00 $1,825.61* $6,345.17 625.91 212.81 $ 413.10 $1,916.90 $4,332.42 480.69 163.44 $ 317.25 $2,012,75 $2,219.05 328.22 111.59 $ 216.63 $2,113.37 $ 0 168.11 57.16 $ 110.95 Assume that there two otherwise-identical firms where one leases and the other purchases. The purchasing firm can borrow $10,087.68 more than the leasing firm. The extra cash flow each year of $2,330 from purchasing instead of leasing can be used to pay off the loan in five years. *$8,262.07 = $10,087.68 - $1,825.61 *$1,825.61 = $2,330 - $504.39   TWO METHODS FOR CALCULATING NET PRESENT VALUE OF LEASE RELATIVE TO PURCHASE* Method 1 : Discount all cash flows at the after-tax interest rate -$87.68 = $10,000 - $2,330 x A50.05 Method 2 : Compare purchase price with reduction in optimal debt level under leasing alternative -$87.68 = $10,000 - $10,087.68 Purchase Reduction in Price optimal debt level if leasing * Because we are calculating the NPV of the lease relative to the purchase, a negative value indicates that the purchase alternative is preferred.

TABEL 21.7 Cash Flows to Friendly Leasing as Lessor of IBMC Pipe-Boring Machine Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Cash for machine -$10,000 Depreciation tax Benefit ($680 = $2,000 x 0.34 ) $ 680 After-tax lease Payment [$1,650 = $2,500 x (1 – 0.34)] . 1,650 Total $ 2,330 These cash flows are the opposite of the cash flows to Xomox, the lessee (see the bottom line of Table 21.3)

TABEL. Cash Flows consequences of the lease contract offered to Greymare Bus Lines (in thousands) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Cost of new bus + 100 Loss Depreciation tax shield -6.8 -10.88 -6.53 -3.92 -1.96 Lease payment -20.6 -20.0 Tax shield of lease payment +7.0 Cash flow of lease +79.60 -24.48 -20.13 -17.52 -25.56 Since G can borrow at 10%, we should discount the lease cash flows at r*=.10(1 - .34) = .066

What-Not, Inc. before tax borrowing rate on long term debt is 12%. Example 2. What-Not, Inc. is evaluated the lease of a minicomputer which, if purchased, would cost $150,000. Its estimated useful life is 5 years, at the end of which time it will be obselete. The annual lease payments are $35,000 payable in six installments, the first being payable when the contract is signed. The company is in the 34% marginal income tax bracket. What-Not, Inc. before tax borrowing rate on long term debt is 12%. Set up a statement of cash flow consequences of the lease contact. Estimate the NPV at 12% of the lease arrangement cash flow consequences of the lease contact (value to lease) 1 2 3 4 5 Cost of comp Lost depr.tax shield Lease payment Tax shield of lease payment Cash flow of lease 150 -10,20 -35 11,90 116.70 -16,32 -39.42 -9,79 -32.89 -5,88 -28.98 -2,94 -26.04 Lost depr. Tax shield = cost x depr.rate x marginal tax rate Rate year 1 = 150 x 0.32 x 0.34 = 16.32, 2=19.2, 3 = 11.52, 4 = 11.52, 5 = 5.76 After tax borrowing rate = (1 – 0.34)(12%) = 7.92% NPV = 116.70-(39.42/1.0792) - … -(26.04/1.07925) = -$10.268