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Leasing

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					                              Leasing

Lessor owns an asset; lessee uses the asset in return for paying
lease payments to the lessor. Leasing is similar to renting or hiring,
which can be either short-term or long-term. But a long-term lease
can (indirectly) provide for an ultimate transfer of ownership from
the lessor to the lessee.

Long-term leasing is therefore an alternative to owning (rather than
buying) an asset.

But sometimes owning is not an option because the asset is only
required for a short time. For example, if specialist equipment is
only required for a short time, it would be hired rather than owned.
If an asset is required for a longer time, it could be leased by way of
an operating lease.

Operating lease payments are accounted for as expenses. There is
no record on the balance sheet. An ongoing operating lease is
therefore a form of off balance sheet finance. For example, a
transport company can (operating) lease its prime-movers, which
will therefore not appear as assets on its balance sheet. The
company may then have a smaller asset base and therefore look
better in terms of rates of return (although net asset backing per
share will be unaffected).

A finance lease is a long-term arrangement that gives the lessee an
option to acquire ownership of the leased asset on expiration of the
FIN211                                                                  9B



lease. A finance lease contract has an agreed residual value, on
payment of which, ownership passes to the lessee. There is no
obligation on the lessee.

If the lessee does not exercise the option, possession of the asset
reverts to the lessor, who will then sell the asset. If the net proceeds
of the sale (i.e. the disposal value of the asset – a different concept
to residual value) are less than the asset’s agreed residual value, the
lessee is obligated to reimburse the difference to the lessor.

If the net proceeds of the sale exceed the asset’s agreed residual
value, the difference is retained by the lessor.

If the lessor would prefer to avoid the hassle of taking back a leased
asset in order to sell it, the lease contract will include a residual
value calculated to be less than the leased asset’s expected market
(or disposal) value on expiry of the lease. This gives the lessee an
incentive to pay the residual value and acquire ownership of the
leased asset when the lease expires.

A finance lease is an alternative to ownership and borrowing. The
basic axiom here is: ‘if there’s no need to borrow, there’s no need
to lease’. Lease payments are similar to loan repayments, except
lease payments occur at the beginning of a period; loan repayments
at the end.

The net proceeds of a lease are the amount saved when possession
of the leased asset is first acquired. For example, if the asset is not



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FIN211                                                                  9B



currently owned, the net proceeds of the lease are the acquisition
cost of the asset, less the first lease payment.

If the asset is currently owned, the net proceeds of the lease are the
proceeds from disposing of the asset, less the first lease payment.
This arrangement is called a sale lease-back and is sometimes used
in real estate deals; e.g. Woolworths develop a shopping complex,
which they then sell and lease back from the purchaser.

Why lease, rather than borrow and own? It may be cheaper to
lease. This could be because the lessor (i) can gain greater benefits
from depreciation tax shields than the lessee; (ii) can acquire the
leased assets at a lower cost than the lessee, or (iii) has access to
lower cost finance than the lessee.

For example, leased motor vehicles can usually be purchased at a
substantial discount by lessors.

Who are the lessors? Lessors may be specialists in handling
particular types of leased assets, especially motor vehicles. A bank
or other financial institution may lend to the lessor, who then buys
and leases out the assets. The lessee may then pay lease payments
to the lender, who will offset those receipts against loan repayments
from the lessor. This is a form of novated lease.

A leveraged lease involves the lessor borrowing in order to acquire
the asset(s) to be leased. This could entail risk-sharing with the
lender, or it may simply provide the lessor with a means of


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FIN211                                                            9B



increasing profit when lease receipts exceed loan repayments (i.e.
when the lessor’s cost of borrowing is less than the implied interest
cost of the lease).

Evaluating a finance lease. Net advantage of leasing (NAL) = net
proceeds of the lease (NPL) less the present value of borrowing
(PVB). PVB is the present value of the lease payments discounted
at an appropriate cost of borrowing.

Tax category 1: Discount before-tax cash flows at the equivalent
before-tax cost of borrowing. Note that ‘cost of borrowing’ must
relate to borrowing a similar amount to the net proceeds of the lease
over a period similar to the term of the lease.

Example

See p 544 [534 3rd edn]

Value of asset: $15,000.

Lease payments: $2,618.19 at the start of each year for the next five
years.

Residual value: $6,000 at the end of five years.

Cost of borrowing: 8%.

1.       What are the net proceeds of the lease?
Ans. $15,000  $2,618.19 = $12,381.81

2.       What are the lease cash flows (to be discounted)?

Ans. 4  $2,618.19 + $6,000

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FIN211                                                            9B



3.       What is the PVB? (That is, how much could be borrowed at
         8% when repayment of the loan is the same as the lease
         payments?)

Ans. 2,618.19/1.08 + 2,618.19/(1.08)2 + 2,618.19/(1.08)3 +
         2,618.19/(1.08)4 + 6,000/(1.08)5 = $12,755.28

4.       What is the NAL?

Ans. $12,381.81  $12,755.28 = $373.47

5.       Should we lease or borrow?

Ans. Borrow.

6.       Why borrow instead of lease?

Ans. Because the NAL is negative.

7.       Why is the NAL negative?

Ans. Because the implied interest cost of the lease is higher
         than the 8% cost of borrowing.

8.       How much is the implied interest cost of the lease?

Ans. 9%  see p 544 (535 3rd edn).


          Lease evaluation using after-tax cash flows

Example
See p 548 [534 3rd edn].
Value of asset: $15,000

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FIN211                                                           9B




Lease payments: $2,618.19 at the start of each year for the next five
years.
Residual value: $6,000 at end of five years.
Cost of borrowing: 8.0%
Salvage value: $9,000
Depreciation: $2,700 per year
Tax rate: 47%. Tax payments lagged by one year.

1.       What are the net proceeds of the lease?

         Ans. $15,000 - $2,618.19 = $12,381.81

2.       What are the lease cash flows (to be discounted)?
Years 1-4:
(Depreciation of $2,700 less lease payments of $2,618.19)  0.47
= $38.45 tax saving forgone by leasing.

Therefore differential cash flow = $2,618.19  $38.45
= $2,656.64

Year 5:

Differential cash flow = $6,000  $38.45 = $6,038.45

Year 6:
Disposal profit if owning = $9,000 – $1,500 = $7,500
Disposal profit if leasing = $9,000 – $6,000 = $3,000

Additional tax liability if owning = ($7,500  $3,000)  0 .47

= $2,115


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FIN211                                                              9B



3.       What is the after-tax cost of borrowing?

         Ans. 8.0% x 0.53 = 4.24%


4.       What is the PVB? (That is, how much could be borrowed at
         8.0% when repayment of the loan is the same as the lease
         payments?)

         Ans. 2,656.64/1.0424 + 2,656.64/(1.0424)2 +
         2,656.64/(1.0424)3 + 2,656.64/(1.0424)4 +
         6,038.45/(1.0424)5  $2,115/(1.0424)6 = $12,846.76


5.       What is the NAL?

         Ans. $12,381.81  $12,846.76 = $464.95


6.       Should we lease or borrow?
         Ans. Borrow.


7.       Why borrow instead of lease?
         Ans. Because the NAL is negative.


                Cost of bank overdraft finance
The actual cost of bank overdraft finance may be higher than
overdraft rate quoted by the bank due to other bank charges such as
an establishment fee or unused limit fee. A spreadsheet model is
recommended for calculating the effective cost of overdraft finance.




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FIN211                                                                                             9B



Example 7-7: p 194 (189 of 3rd edn)

Overdraft rate:                  18% calculated daily.
Limit:                           $5,000
Establishment fee:               $50
Unused limit fee:                1%
19 September:            Cash cheque for $3,000. Establishment fee charged.
30 September:            Bank fees debited to bank account by bank.
20 October:              Deposit $1,500
10 November:             Cashed cheque for $2,500
30 November:             Pay off account. How much?

                    Template for Problem 7-7: textbook page 189
                                                                 Output
            Input
                                                                              a         b
  Overdraft limit      $5,000                     Total bank charges        $157.23 $107.23
                                              Tot. bank charges: % of av.
Establishment fee        $50                                                5.41%     3.69%
                                                       daily bal.
  Overdraft rate       18.00%                 Average daily interest rate 0.0752% 0.0513%
 Unused limit fee      1.00%                    Annual percentage rate      27.44%    18.71%
                                               EAR (assuming quarterly
                                                                            30.39%    20.07%
                                                   compounding)

                    Ledger account           Cum.                     Bank figures
                                             bank
 Date                                      charges Establish-           Unused Account
         Debits        Credits     Balance  @ av.     ment Fee
                                                               Interest
                                                                        limit fee debits
                                                                                         Balance
                                           daily rate
             $            $           $        $         $         $        $       $       $
19-Sep                -3,050.00 -3,050.00                50.00                         50.00 3,050.00

30-Sep                   -17.13 -3,067.13      -25.22              16.55      0.59     17.13 3,067.13

20-Oct 1,500.00                   -1,567.13    -71.34              30.25      1.06             1,598.44

10-Nov                -2,500.00 -4,067.13      -96.08              16.23      1.96             4,116.63

30-Nov 4,157.23          -90.10        0.00 -157.23                40.11      0.48     90.10      0.00
    Average daily balance         -2,904.79                      Total bank charges   157.23




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