1. copyright © 2003 McGraw Hill Ryerson Limited 22-1 prepared by: Carol Edwards BA, MBA, CFA Instructor, Finance British Columbia Institute of Technology Fundamentals of Corporate Finance Second Canadian Edition

2. copyright © 2003 McGraw Hill Ryerson Limited 22-2 Chapter 22 Leasing Chapter Outline  What is a lease?  Why Lease?  Valuing Leases  When do Financial Leases Pay?

3. copyright © 2003 McGraw Hill Ryerson Limited 22-3 What is a Lease? Introduction  Firms often lease as an alternative to buying capital equipment.  Computers are frequently leased. So are cars, trucks, railroad cars, ships and planes.  Just about any kind of asset can be leased. Question: What is a lease?

4. copyright © 2003 McGraw Hill Ryerson Limited 22-4 What is a Lease? Terminology  Every lease involves two parties: The lessee is the user of the asset. The lessee makes periodic payments to the owner of the asset, who is known as the lessor.

5. copyright © 2003 McGraw Hill Ryerson Limited 22-5 What is a Lease? Terminology  The lease contract specifies: How often the payments are to be made.  For example, weekly, monthly, semiannually, etc. The types of payments to be made.  Usually lease payments are level payments. When the payments start.  Usually the first payment is made when the contract is signed. Who owns the equipment at the end of the lease.  In most leases, the equipment reverts to the lessor.

6. copyright © 2003 McGraw Hill Ryerson Limited 22-6 What is a Lease? Terminology  An operating lease is a short-term, cancellable lease. Such leases provide for temporary use of an asset.  For example, a company rents a car for 10 days.

7. copyright © 2003 McGraw Hill Ryerson Limited 22-7 What is a Lease? Terminology  A financial lease is a long-term, non-cancellable lease. It may be called a capital lease or a full-payout lease.  For example, a company leases a car for 3 years. Such leases provide for the long- term use of the asset, often for most of its economic life.

8. copyright © 2003 McGraw Hill Ryerson Limited 22-8 What is a Lease? Leasing vs Borrowing  A financial lease has cash flows which are very similar to those of a long-term loan: In both cases, there is an immediate cash inflow because the lessee or borrower is relieved of having to pay for the asset with its own money. The lessee or borrower then assumes a binding obligation to make periodic payments.  This chapter largely involves comparing leases and borrowing as financing alternatives.

9. copyright © 2003 McGraw Hill Ryerson Limited 22-9 Why Lease? Sensible Reasons for Leasing  You will hear financial managers give many different reasons for entering into a lease.  Some of these reasons make sense.  Others are of questionable logical value.  We will look at five good reasons for leasing.  Then we will look at four dubious reasons.

10. copyright © 2003 McGraw Hill Ryerson Limited 22-10 Why Lease? Sensible Reasons for Leasing  Short-term Leases are Convenient. If the asset is only needed for a short period of time, it is usually more convenient and cost efficient to rent it than to buy (and resell) it.  Cancellation Options are Valuable. Leases can give you the option to cancel if the asset is no longer needed. This provides the company with flexibility.

11. copyright © 2003 McGraw Hill Ryerson Limited 22-11 Why Lease? Sensible Reasons for Leasing  Maintenance is Provided. Under a full-service lease, the user receives maintenance and other services. The lessor may be better equipped than the lessee to provide such services. However, bear in mind that higher benefits will always be reflected in higher lease payments.

12. copyright © 2003 McGraw Hill Ryerson Limited 22-12 Why Lease? Sensible Reasons for Leasing  Standardization Leads to Lower Administrative and Transaction Costs. A large lessor which specializes in leasing, say trucks, can use a simple, standard lease contract. This standardization makes it possible to “lend” small sums of money without incurring large investigative, administrative or legal costs. Small companies find leasing a relatively cheap source of financing as compared to the costs of a security issue.

13. copyright © 2003 McGraw Hill Ryerson Limited 22-13 Why Lease? Sensible Reasons for Leasing  Tax Shields Can be Used. The lessor owns the leased asset and deducts the asset’s capital cost allowance (CCA) from its taxable income. If the lessor can make better use of the CCA tax shields than the lessee, then it makes sense for the lessor to own the equipment. The lessor can then pass on the tax benefits to the lessee in the form of lower lease payments.

14. copyright © 2003 McGraw Hill Ryerson Limited 22-14 Why Lease? Some Dubious Reasons for Leasing  Leasing Avoids Capital Expenditure Controls. In some companies, a manager can use leasing to acquire an asset without going through the approval procedures needed to buy it.  For example, some hospitals have found it politically more convenient to lease equipment rather than have to ask the government for funds to purchase it.

15. copyright © 2003 McGraw Hill Ryerson Limited 22-15 Why Lease? Some Dubious Reasons for Leasing  Leasing Preserves Capital Leasing companies provide 100% financing, allowing the company to save its own cash for other things. However, buying an asset, and using it as collateral to borrow money leaves the company in the same position.  The firm has money in the bank, the use of an asset and a liability to make payments.  What’s so special about leasing?

16. copyright © 2003 McGraw Hill Ryerson Limited 22-16 Why Lease? Some Dubious Reasons for Leasing  Leases May Be Off-Balance-Sheet Financing. In off-balance-sheet financing, a company has financing that is not shown as a liability on its balance sheet. Instead, the lease is recorded as an operating lease, meaning it appears as an expense on the income statement. This makes the firm’s balance sheet ratios look stronger.

17. copyright © 2003 McGraw Hill Ryerson Limited 22-17 Why Lease? Some Dubious Reasons for Leasing  Leasing Affects Book Income Leasing can make the firm’s balance sheet and income statement look better. It does this by increasing book income or decreasing book asset value, or both. However, leasing’s impact on book income should have no effect on firm value.  In efficient markets, investors will look through the firm’s accounting results to the true value of the asset and the liability incurred to finance it.

18. copyright © 2003 McGraw Hill Ryerson Limited 22-18 Why Lease? Off-Balance-Sheet Financing  In Canada, companies must distinguish between an operating lease and a financial lease: An operating lease involves temporary use of the asset. A financial lease, by contrast, is a long-term commitment of the lessee to use and pay for the asset over the bulk of that asset’s life.  That is, the lease is really just a form of financing so that the lessee can acquire the asset without immediately putting up its own cash.

19. copyright © 2003 McGraw Hill Ryerson Limited 22-19 Why Lease? Off-Balance-Sheet Financing  The criterion for determining whether a lease is an operating or financial lease is who bears the risks and rewards of ownership of the assets. In an operating lease, the lessor bears the risks and rewards, because the lease is very short- term. In a financial lease, although the lessor is the legal owner of the asset, the risks and rewards of ownership have been transferred to the lessee.

20. copyright © 2003 McGraw Hill Ryerson Limited 22-20 Why Lease? Off-Balance-Sheet Financing  A lease defined as a financial lease must be capitalized to the balance sheet. To capitalize a lease, the present value of the lease payments is calculated and shown as a debt on the right hand side of the balance sheet. The same amount is shown as a fixed asset on the left hand side.  This asset is amortized just as any other long-term asset would be.

21. copyright © 2003 McGraw Hill Ryerson Limited 22-21 Valuing Leases Operating Leases  If your firm is considering an operating lease, you should determine whether it is cheaper to: Lease the asset for the time your firm needs it. Buy the asset.  You can calculate the equivalent annual cost of buying the asset. This was covered in Chapter 6.  Compare the equivalent annual cost of buying the asset to the lease payment.

22. copyright © 2003 McGraw Hill Ryerson Limited 22-22 Valuing Leases Operating Leases  The question is, can you “lease” the asset to yourself more cheaply than you can lease it from a lessor? Generally, the longer you need the asset, the more sense it makes to buy it. Operating leases make sense when:  You need the asset for a short time.  You can cancel the lease, avoiding the risk of obsolescence.  The lessor can offer a good deal on maintenance.

23. copyright © 2003 McGraw Hill Ryerson Limited 22-23 Valuing Leases Financial Leases  When you are considering a financial lease, the decision amounts to “lease versus borrow.” Read through the information for the lease vs borrow decision for Greenfield Construction (GC) to see how this type of analysis is conducted.  It starts on page 663 in your text.  Note the following in your reading: You must collect data on the cost of the machine, the CCA rates for the machine, the firm’s tax rate, and the cash flows and terms of the lease.

24. copyright © 2003 McGraw Hill Ryerson Limited 22-24 Valuing Leases Financial Leases  The data you collect is then laid out in a table like Table 22.1 on page 664. Line 1 shows that GC saved $100,000 by not having to use its own cash to purchase the backhoe. Line 2 shows the lost CCA tax shields as a negative cash flow.  Had GC borrowed and purchased the equipment, it could have claimed the benefit of the CCA on its tax return.  However, if they lease the equipment, they lose this benefit because the lessor must report the CCA on its tax return.

25. copyright © 2003 McGraw Hill Ryerson Limited 22-25 Valuing Leases Financial Leases Line 3 shows the lease payments GC must make. Line 4 shows the tax shield generated by these lease payments.  Lease payments are a tax deductible expense, just like interest.  Thus, the government absorbs part of the cost of the payments.  At a 35% tax rate, GC gets to shield $6,475 per year of its income from the government.

26. copyright © 2003 McGraw Hill Ryerson Limited 22-26 Valuing Leases Financial Leases  The total of these various cash inflows and outflows give you the final line: the Cash Flow of the Lease.  Once you have calculated the cash flow of the lease, you discount those cash flows to get the NPV calculation.  If the NPV of the cash flows is positive, then leasing would be preferred to purchasing. But, what is the appropriate discount rate?

27. copyright © 2003 McGraw Hill Ryerson Limited 22-27 Valuing Leases Financial Leases  What discount rate is used depends on the risks of the cash flows.  Typically, lease payments are considered as safe as the interest and principal payments on a secured loan issued by the lessee. They are also a tax deductible expense.  Thus, the lease payments would be discounted at the after-tax cost of GC’s secured debt. You have learned that this would be r D (1-T). In GC’s case, the appropriate discount rate would be: 10% (1-0.35) = 6.5%

28. copyright © 2003 McGraw Hill Ryerson Limited 22-28 Valuing Leases Financial Leases  However, the other cash flows may have a different risk: For example, even if the company were confident it could make the lease payments, it may be less confident that it will have enough taxable income to fully utilize the tax shields. In that case, the cash flows from the tax shields should be discounted using a higher rate than the one used for the lease payments.  In theory, a lessee could use different discount rates, depending on the risk of the cash flows, for each line of Table 22.1.

29. copyright © 2003 McGraw Hill Ryerson Limited 22-29 Valuing Leases Financial Leases  In practice, well-established, profitable firms usually find it reasonable to simplify by discounting all of the cash flows at a single rate.  That rate is the company’s after-tax cost of debt.  For GC, we have already calculated this rate to be 6.5%.

30. copyright © 2003 McGraw Hill Ryerson Limited 22-30 Valuing Leases Financial Leases  If you discount the cash flows of the lease in Table 22.1 at 6.5%, you find the NPV of the lease to be -$221.  Since the lease has a negative NPV, GC is better off buying the backhoe than leasing it.

31. copyright © 2003 McGraw Hill Ryerson Limited 22-31 Valuing Leases Financial Lease Evaluation  Note that a positive NPV on a lease calculation means that if the firm acquires the asset, leasing it would be advantageous.  However, it does not prove that you should acquire the asset. To acquire the asset, the decision to purchase it (not lease it!) would have to have a positive NPV.  However, sometimes favourable lease terms can rescue a negative NPV project which otherwise should be rejected.

32. copyright © 2003 McGraw Hill Ryerson Limited 22-32 Valuing Leases Financial Lease Evaluation  For example, suppose GC had done an analysis of purchasing the backhoe and discovered it had a NPV of –$5,000. The equipment manufacturer could rescue the deal by offering to lease the equipment to GC. If it made the NPV of the lease equal to $8,000, then the value of the combined purchase and financing deal would be $3,000 and GC should accept the deal. That is, the NPV of acquiring a piece of equipment equals the sum of the NPV of the equipment and the NPV of the lease.

33. copyright © 2003 McGraw Hill Ryerson Limited 22-33 Valuing Leases Financial Lease Evaluation - Variations  We have seen that as it stands the lease for the backhoe has a NPV of -$221 and should be rejected.  Suppose the manufacturer offers to provide routine maintenance which would otherwise cost GC $2000 per year.  In addition, you realize you forgot to include the $10,000 salvage value of the backhoe in your calculations. How would these changes affect the decision?

34. copyright © 2003 McGraw Hill Ryerson Limited 22-34 Valuing Leases Financial Lease Evaluation - Variations  Maintenance and salvage value are harder to predict than the cash flows shown in Table 22.1. Thus, they normally carry a higher discount rate.  Suppose you decide to use GC’s after-tax discount rate for the project, which is 12%. Thus, each of these new cash flows would be discounted at 12%.

35. copyright © 2003 McGraw Hill Ryerson Limited 22-35 Valuing Leases Financial Lease Evaluation - Variations  The value of the maintenance savings is the present value of a 7 year annuity due of $2000 per year discounted at 12%. You would use an annuity due because these expenses are paid at the the start of each year.  The present value of the maintenance savings is $10,223. Thus, not having to pay the maintenance expenses makes the NPV of the lease positive. But what about the salvage value?

36. copyright © 2003 McGraw Hill Ryerson Limited 22-36 Valuing Leases Financial Lease Evaluation - Variations  Remember, GC does not legally own the backhoe.  Thus, like the CCA tax shields, GC loses the salvage value of the asset. At the end of the lease, it must return the asset to the lessor, rather than selling it and pocketing the cash. After taxes, the present value of the lost salvage value is -$4,524.

37. copyright © 2003 McGraw Hill Ryerson Limited 22-37 Valuing Leases Financial Lease Evaluation - Variations  Thus, the revised NPV for the project is: NPV = -$221 + $10,223 - $4,524 = $7,730  With a positive NPV, the project is now acceptable.

38. copyright © 2003 McGraw Hill Ryerson Limited 22-38 When Do Financial Leases Pay? Taxes and the Lessor  So far, we have examined leases from the perspective of the lessee.  However, the perspective of the lessor is easy to calculate if both the lessor and lessee are in the same tax bracket: The lessor’s position is merely the mirror image of the lessee’s position. Every outflow of the lessee is an inflow to the lessor and vice versa.

39. copyright © 2003 McGraw Hill Ryerson Limited 22-39 When Do Financial Leases Pay? Taxes and the Lessor  Thus, for the GC lease of the backhoe, the cash flows for the lessor would be identical to those in Table 22.1, except that the signs would be reversed.  Thus, the value of the lease to the lessor is +$221.  In this case, the value to the lessee and lessor offset exactly: That is, the lessor can only win at the lessee’s expense, and vice versa.

40. copyright © 2003 McGraw Hill Ryerson Limited 22-40 When Do Financial Leases Pay? Taxes and the Lessor  However, both the lessor and lessee can win if they have different tax rates.  They do so because they can cause the government to suffer a net loss in the present value of the tax receipts it would have gained from the lease.  The lessor and lessee can split any cash flows they can hive-off at the government’s expense.

41. copyright © 2003 McGraw Hill Ryerson Limited 22-41 When Do Financial Leases Pay? Taxes and the Lessor  For example, suppose GC pays no taxes, so that T c = 0. The discount rate would be 10%(1-0%) = 10%  In this case, the cash flows of the equipment lease would be:

42. copyright © 2003 McGraw Hill Ryerson Limited 22-42 When Do Financial Leases Pay? Taxes and the Lessor  Discounting these cash flows as an annuity due at 10% gives a NPV of $928.  In this case, the lessor, which is in a 35% tax bracket, sees the lease as having a NPV of +$221.  However, GC, with a zero tax rate, now sees the lease as worth $928.  This gain in value is at the expense of the government, which sees a reduction in its tax receipts as a result of the changed situation.

43. copyright © 2003 McGraw Hill Ryerson Limited 22-43 When Do Financial Leases Pay? Taxes and the Lessor  Other things being equal, the potential gains to the the lessor and lessee are highest when: The lessor’s tax rate is substantially higher than the lessee’s. The CCA tax shield is received early in the lease period. The lease period is long and the lease payments are concentrated toward the end of the period. The interest rate (r D ) is high: if r D were zero, there would be no advantage to be reaped.

44. copyright © 2003 McGraw Hill Ryerson Limited 22-44 Summary of Chapter 22  A lease is just an extended rental agreement.  The owner of the equipment (the lessor) allows the lessee to use the equipment in return for regular lease payments.  Short-term cancellable leases are called operating leases. They do not appear on the balance sheet. The only entry is to the income statement.  Long-term, non-cancellable leases are called financial leases or capital leases or full-payout leases.

45. copyright © 2003 McGraw Hill Ryerson Limited 22-45 Summary of Chapter 22  A financial lease must be capitalized on the lessee’s balance sheet.  Operating leases are attractive if the lease payment is less than the user’s equivalent annual cost of buying the equipment.  Operating leases make sense if: The equipment is needed for a short period of time. The lessor is better able to deal with the risks of obsolescence. There are valuable options attached to the lease.

46. copyright © 2003 McGraw Hill Ryerson Limited 22-46 Summary of Chapter 22  A financial lease is like taking out a loan to buy the equipment, thus the analysis is calculated on the lease versus borrow basis.  Each of the cash flows of the lease must be discounted at the discount rate which is appropriate to that cash flow.  Most often, the after-tax cost of debt is used as the discount rate.  Salvage value, maintenance costs and different tax rates for the lessor and lessee can significantly impact the NPV of a lease.