A financial or capital lease is noncancellable

Document Sample
A financial or capital lease is noncancellable Powered By Docstoc

                                Lease Financing

Leasing is a means of obtaining use of an asset for a period of time without owning the asset. In
the lease contract, the property owner (the lessor) agrees to permit the property user (the lessee)
to make use of the property for a stated period of time in exchange for a series of periodic

I.     In a “true lease” (the focus of this chapter), the lessor holds legal title to the asset while
       the lessee has no ownership interest in the asset.

       A.      There are two major classes of true leases

               1.     An operating lease, sometimes called a service or maintenance lease, is an
                      agreement for period to period use of an asset. Maintenance and insurance
                      are usually included in the lease.

               2.     A financial or capital lease is noncancellable. The lessee is usually
                      responsible for maintenance and possibly for insurance and property taxes.

                      a.      A financial lease may originate as a direct lease in which the lessee
                              acquires use of an asset it has not owned.

                      b.      A financial lease may originate as a sale and leaseback in which
                              the lessor purchases the asset from the lessee and then leases it
                              back to the lessee.

               3.     A leveraged lease is a three-party financial lease consisting of the lessee
                      who acquires use of the asset, the lessor who holds an equity interest in the
                      asset, and a lender who finances the purchase of the asset by the lessor.

II.    There are a number of potential advantages and disadvantages to leasing.
                                                                               Lease Financing155

       A.     Advantages:
              1.    Lease agreements tend to be more flexible than loan agreements
                    particularly with regard to restrictive covenants.

              2.     Leasing may effectively allow you to depreciate land.

              3.     Payments may be lower because of the tax benefits to the lessor.

              4.     The lessee may avoid some of the risk of obsolescence.

              5.     For small or marginally profitable firms leasing may be the only source of
                     financing available.

              6.     Earnings are smoother and EPS in the early years is higher under leasing
                     because the accelerated depreciation does not show on the lessee's income

              7.     Leasing provides essentially 100% financing.

              8.     Leasing can reduce pressures on the lessee's liquidity.

              9.     Leasing may permit divisional/plant managers the flexibility in acquiring
                     assets if lease payments are not subject to internal capital budgeting

       B.     Disadvantages:
              1.    Leasing is often more expensive than ownership.

              2.     The lessee loses the benefit of the salvage value. This is particularly
                     significant in real estate.

              3.     Approval for improvements in leased real estate may be difficult to obtain.

              4.     Financial leases may not be canceled without a substantial penalty.

III.   Leasing assets involves a number of tax and accounting considerations.

       A.     Often one of the advantages of true leases is derived from tax considerations.

              1.     Care must be taken that the arrangement is recognized as a lease rather
                     than an installment purchase plan by the IRS. To meet IRS requirements
                     for a lease, the following guidelines are considered.
                     a.      The remaining useful life of the equipment at the end of the lease
                             must be the greater of 1 year or 20% of the cost of the property.
156 Chapter 19

                   b.      Leases may not exceed 30 years for tax purposes.

                   c.      The lessor must receive a reasonable return of investment.

                   d.      Renewal options must be closely related to the economic value of
                           the asset.

                   e.      If the agreement contains a purchase option at the end of the lease,
                           the purchase price must be based on the asset's market value at the

                   f.      For leveraged leases, the lessor must provide at least 20% equity.

                   g.      Property valuable only to the lessee may not be leased.

            2.     IRS restrictions are designed to prohibit lease transactions set up purely to
                   speed up tax deductions.

      B.    The Financial Accounting Standards Board requires that financial leases be

            1.     A liability equal to the present value of the lease payments discounted at
                   the firm's borrowing rate for a secured loan of similar maturity is shown.

            2.     The asset value of the lease is also reported.

            3.     Further details must be provided in the footnotes to the financial

IV.   Many small firms have sought lease financing as an alternative to traditional bank
      financing, particularly when credit is tight.

      A.    The entrepreneurial firms cited several reasons for leasing, including (1) less cash
            required upfront, (2) better protection against obsolescence at the end of the lease
            term, (3) quicker approvals from lessors than from lenders, and (4) fewer
            restrictive covenants from lessors than from lenders.

      B.    These advantages may be expensive. (1) The effective interest costs of leasing are
            often quite high compared to borrowing. (2) The lessee must give up the tax
            benefits of ownership (the asset's depreciation tax shields).

V.    Determining lease payments from the lessor's perspective consists of present value
      analysis similar to capital budgeting decisions.
                                                                              Lease Financing157

      A.     The lessor's required payment is an annuity payment than can be found with this
             three-step process:
                     Step 1: Compute the lessor's amount to be amortized

                                    Initial Outlay
                                    Less: Present value of after-tax salvage
                                    Less: Present value of depreciation tax shelter
                                    Equals: Amount to be amortized

                    Step 2: Compute after-tax lease income requirement

                                    Amount to be amortized =
                                         Present value of after-tax lease payment

                    Step 3: Compute before-tax lease payment

                                                  After - tax lease income requirements
                             Lease payment =
                                                      1 - lessors' marginal tax rate

      B.     An example of finding the required lease payment from the lessor's perspective is
             given in Problem 1. There are a couple of things to keep in mind.

             1.     The discount rate is the lessor's after-tax required rate of return.

             2.     Lease payments are usually due at the beginning of the period, in which
                    case the computation of the present value of the lease payments must be
                    for an annuity due rather than an ordinary annuity.

VI.   Lease-Buy analysis from the lessee's perspective compares leasing to the alternative to
      borrowing to buy.

      A.     The basic approach of the lease-buy analysis model is to compute the net
             advantage to leasing (NAL):

                            Installed cost of the asset
             Less:          Present value of the after-tax lease payment
             Less:          Present value of the depreciation tax shield
             Plus:          Present value of after-tax operating costs incurred if owned but not
                            if leased
             Less:          Present value of the after-tax salvage value
             Equals:                Net Advantage to Leasing (NAL)
      B.     If the NAL is positive, it is cheaper for the lessee to lease the asset than to borrow
             and buy it. If the NAL is negative, leasing is unattractive. It is easy to see how
             each of the items above affects the attractiveness of leasing. For example, a larger
158 Chapter 19
            lease payment reduces the NAL.

      C.    Problem 2 illustrates the calculation of the lessee's net advantage of leasing.
            There are several things to keep in mind.

            1.     The installed cost is the purchase price plus installation and shipping

            2.     The present value of the after-tax lease payment is found by discounting at
                   the lessee's after- tax marginal cost of borrowing. The lease payment is
                   usually an annuity due.

            3.     The annual depreciation tax shield is the depreciation times the lessee's
                   marginal tax rate. The present value of the depreciation tax shield is found
                   using the lessee's after-tax marginal cost of borrowing.

            4.     If leased, some operating costs (such as property tax payments, insurance,
                   and some maintenance costs) may be paid by the lessor. If so, these
                   savings are discounted at a rate reflecting their relative certainty,
                   frequently the lessee's after-tax marginal cost of borrowing.

            5.     Because the salvage value belongs to the lessor, this amount lost to the
                   lessee is discounted at a rate reflecting its uncertainty, frequently the
                   lessee's weighted cost of capital (which is higher than the after-tax cost of

Shared By: