1. PowerPoint Presentation prepared by Traven Reed Canadore College

2. chapter 15 Lease Financing

3. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-3 Corporate Valuation and Lease Financing

4. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-4 Topics in Chapter Types of leases Tax treatment of leases Effects on financial statements Lessee’s analysis Lessor’s analysis Other issues in lease analysis

5. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-5 Who are the two parties to a lease transaction? The lessee, who uses the asset and makes the lease, or rental, payments. The lessor, who owns the asset and receives the rental payments. Note that the lease decision is a financing decision for the lessee and an investment decision for the lessor.

6. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-6 What are the five primary lease types? Operating lease –Short-term and normally cancelable –Maintenance usually included Financial lease –Long-term and normally noncancelable –Maintenance usually not included Sale and leaseback Combination lease "Synthetic" lease

7. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-7 How are leases treated for tax purposes? Leases are reviewed by CRA to determine if they are an actual lease or conditional sale. For an actual lease the full lease payment is deductible. If the lease did not meet the CRA guidelines then the lessee would treat the asset as a purchase and only deduct CCA and the interest portion of the lease payments.

8. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-8 How does leasing affect a firm’s balance sheet? For accounting purposes, leases are classified as either capital or operating. Capital leases must be shown directly on the lessee’s balance sheet. Operating leases, sometimes referred to as off-balance sheet financing, must be disclosed in the footnotes. Why are these rules in place?

9. CH15 CICA Section 3065 Firms entering a financial lease contract are obligated to make lease payments as if they had signed a loan agreement Fail to make lease payments is taken as a default on interest/principal can bankrupt a firm To capitalize a lease, the present value of the lease payments is shown as debt. The same amount is shown as a fixed asset. Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-9

10. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-10 Impact on a firm’s capital structure Leasing is a substitute for debt. As such, leasing uses up a firm’s debt capacity. Assume a firm has a 50/50 target capital structure. Half of its assets are leased. This has the effect of raising its true debt ratio, and thus its true capital structure is changed.

11. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-11 Lessee’s Evaluation 2-year-life equipment cost: $100. Loan rate on equipment = 10% Marginal tax rate = 40% Class 12, 100% CCA rate If borrow and buy, a 2-year simple loan requires $10 interest at ending of each year and $100 repayment at = 2 Residual value at t = 2: $0 Maintenance cost: $0

12. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-12 Other Information for Lease If the equipment is leased: –Lease contract runs for 2 years –Lease meets CRA guidelines to deduct lease payments for tax purposes –Lease payment will be $55 at the end of each year

13. CH15 CCA Schedule for Owning Owner is entitled to the CCA and the interest deductions Note the CCA tax shield for Year 1, is: $100 x 1 x ½ = $ 50 $ 50 x 0.40 = $ 60 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-13 YearUCC before CCA CCA @100% UCC after CCA Tax Saving from CCA 1$100$50 $20 250 020

14. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-14 Cash Flow Time Line: Borrow-to-buy 012 Equipment cost($100) Inflow from loan100 Interest expense($10) Interest tax savings44 Principal repayment($100) CCA tax savings20 NCF0$14($86) PV@6% cost of buying=$63.33

15. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-15 Why use 6% as the discount rate? Leasing is similar to debt financing. –The cash flows have relatively low risk; most are fixed by contract. –Therefore, the firm’s 10% cost of debt is a good candidate. The tax shield of interest payments must be recognized, so the discount rate is: 10%(1 - T) = 10%(1 - 0.4) = 6.0%

16. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-16 Cash Flow Time Line: Leasing PV cost of leasing @ 6% = $60.50 012 Lease pmt($55) Tax savings from payment 22 NCF0($33)

17. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-17 What is the net advantage to leasing (NAL)? NAL = PV cost of owning - PV cost of leasing = $63.33 - $60.50 = $2.83 > 0 Should the firm lease or buy the equipment? Why? Lease because NAL > 0 implying leasing is cheaper than buying.

18. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-18 Note that we have assumed the company will not continue to use the asset after the lease expires; that is, project life is the same as the term of the lease. What changes to the analysis would be required if the lessee planned to continue using the equipment after the lease expired? What is the net advantage to leasing (NAL)? (cont’d)

19. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-19 Residual Value Consideration In leasing, the asset’s value at the end of the lease is called residual value. Assume the RV could be $0 or $400,000, with an expected value of $200,000. How could this risk be reflected? The discount rate applied to the residual value inflow (a positive CF) should be increased to account for the increased risk. All other cash flows should be discounted at the original 6% rate.

20. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-20 If the residual value were included as an outflow (a negative CF) in the cost of leasing cash flows, the increased risk would be reflected by applying a lower discount rate to the residual value cash flow. Again, all other cash flows have relatively low risk, and hence would be discounted at the 6% rate. Residual Value Consideration (cont’d)

21. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-21 Effect of Increased Residual Value Uncertainty The lessor owns the equipment when the lease expires. Therefore, residual value risk is passed from the lessee to the lessor. Increased residual value risk makes the lease more attractive to the lessee.

22. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-22 Lessor’s analysis on the lease transaction To the lessor, writing the lease is an investment. Therefore, the lessor must compare the return on the lease investment with the return available on alternative investments of similar risk.

23. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-23 Lessor Evaluation Lease payment = $320,000 at the beginning of each year Cost of equipment = $1,000,000 Loan rate on equipment = 10% Marginal tax rate = 40% Class 43, 30% CCA rate 4- year maintenance contract costs $20,000 at the beginning of each year Residual value at t = 4: $200,000

24. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-24 Time Line: Lessor’s Analysis (In Thousands) 01234 Cost-1,000 CCA tax shield6010271.449.98 Maint-20 Tax sav8888 Lse pmt320 Tax-128 RV200 RV tax-80 NCF-804240282251.4169.98

25. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-25 The NPV of the net cash flows, when discounted at 6%, is $19,114 Should the lessor write the lease? Why? Yes! If the lease’s NPV is greater than zero, then the lease should be written. Time Line: Lessor’s Analysis (In Thousands – cont’d)

26. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-26 Remarks If all inputs for leasing analysis are symmetrical between lessee and lessor, leasing is a zero-sum game. The lessor’s cash flows would be equal, but opposite in sign, to the lessee’s NAL. What are the implications? Differences between lessees and lessors must exist to support a lease

27. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-27 Issues of Cancellation Clause A cancellation clause would lower the risk of the lease to the lessee but raise the lessor’s risk. To account for this, the lessor would increase the annual lease payment or else impose a penalty for early cancellation.

28. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-28 Other Issues in Lease Analysis Do higher residual values make leasing less attractive to the lessee? Is lease financing more available or “better” than debt financing? Is the lease analysis presented here applicable to real estate leases? To auto leases?

29. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-29 Would spreadsheet models be useful in lease analyses? What impact do tax laws have on the attractiveness of leasing? Other Issues in Lease Analysis (cont’d)

30. CH15 Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-30 Numerical analyses often indicate that owning is less costly than leasing. Why, then, is leasing so popular? Provision of maintenance services. Risk reduction for the lessee. –Project life –Residual value –Operating risk Portfolio risk reduction enables lessor to better bear these risks.

31. CH15 Reasons for Leasing Leasing is driven by various differences between lessees and lessors. Top three motivations: –Tax rate differentials –Lessors are often better to bear the residual value risk than lessees –Lessors can maintain the leased asset more efficiently than lessees Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-31