Leases

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					                       LEASES
    Why Lease?
    Types of Leases
          Operating
          Capital

    Disclosure Requirements for Leases
    Lease or Buy?
    Capitalizing an Operating Lease




Leases                                    1
                           WHY LEASE?

Leases – the right to use property, plant, and
equipment

Corporations (especially capital intensive ones)
cannot operate without long-term assets. To use
assets they must:
        Retain earnings
        Issue stock
        Borrow from bank, or
        Lease
               The subject of
               this section!




Leases                                           2
                       WHY LEASE?
                   Advantages of Leasing

1. Tax benefit to lessor - depreciation deductions
   are retained

2. Flexibility to lessee - lessee can change to
   different asset to accommodate:
          production needs
          obsolescence

3. Tailored financing - lease agreements can be
   designed to fit needs




Leases                                            3
             TYPES OF LEASES

Operating lease – rights of ownership are
maintained with lessor

Capital lease – rights of ownership are
transferred to lessee




Leases                                      4
                TYPES OF LEASES
              How Would You Classify It?

1. You rent tables and chairs for a reception.
               Operating or Capital

2. You rent an apartment for 2 years to go
   to grad school.
             Operating or Capital

3. You lease a car for 5 years. You are
   expected to maintain the car. At the end
   of the lease you can buy it for 10% less
   than ―blue book‖.
            Operating or Capital

4. An airline leases a Boeing 737 for 15
   years from a partnership of investors.
             Operating or Capital




Leases                                           5
                TYPES OF LEASES
              What Do Companies Do?

A survey of 600 large corporations (2000) indicated
that leases were used to the following extent:

Leasing Strategy                     Percent
Operating leases only                   52.3%
Operating and Capital leases            37.8%
Capital leases only                      1.6%
No leases                                8.2%




Leases                                                6
                   TYPES OF LEASES
                     Lease Capitalization
                         ( FAS 13)

Lease must be capitalized if one of the following
exists:

 Title reverts to lessee at end of lease
 A Bargain Purchase Option (BPO) exists
 The lease life > 75% of the assets useful life
 The present value of the minimum lease payments
  > 90% of fair market value (PV of MLP > FMV)


Summarizing, leases are treated as “owned”
if you:
        keep asset after the lease expires
        use the asset most of its life
        pay for most of the asset




Leases                                             7
           INTERNATIONAL STANDARDS

IFRS emphasizes substance rather than form. They do
not outline strict rules:

    Is ownership transferred (same as US)?
    Is there a bargain purchase (same as US) or a bargain
     renewal option?
    Is lease a major part of the asset‘s economic life (unlike US,
     no 75% percentage specified)?
    Is the PV of the MLP equal to substantial all of the FV
     (unlike US, no 90% percentage specified)?
    Are cancellation losses borne by the lessee? (no US GAAP
     equivalent)
    Are changes in the FV of the residual borne by the
     lessee? (no US GAAP equivalent)

IFRS: Refers to ―capital‖ lease as ―financing‖
lease.

Comparison of Capital (Financing) Lease Requirements
                                 US GAAP           IFRS
Ownership Transferred                               
BPO                                                 
Asset Life                          > 75%        major part
PV of MLP                           > 90%        substantial
Lessee cancellation penalty      Not addressed       
FMV risk to lessee               Not addressed       



Leases                                                         8
          DISCLOSURE REQUIREMENTS
                 FOR LEASES

CAPITAL LEASES (treat as bought)
 Gross (undepreciated) value
 Accumulated amortization
 Interest associated with lease agreement

OPERATING LEASES (treat as borrowed)
 Rent expense (for last three years)

FOR BOTH TYPES OF LEASES
 Future minimum lease payments
   - Total amount
   - Individual years for next five years (separately)
   - Netted by executory costs and by interest
 Noncancelable minimum sublease rentals
 Contingent rentals


            How does it look in the annual report?




Leases                                                   9
                     Example of a Lease Note


FROM ASSET SECTION OF BALANCE SHEET:
PROPERTY AND EQUIPMENT:                            2007            2006
Flight equipment                                   9,525          17,641
   Less: Accumulated depreciation                    299           6,800
                                                   9,266          10,841
Ground property and equipment                      1,943            4,575
  Less: Accumulated depreciation                     246            2,838
                                                   1,697            1,737
Flight equipment under capital leases                602              474
   Less: Accumulated amortization                     63              136
                                                     539              338
Advance payments for equipment                       239               57
  Total property and equipment                 11,701             12,973

Flight Equipment
Our active aircraft fleet at December 31, 2007 is summarized in the following
table:
                 Aircraft      Cost
 Aircraft Type                             Total
                 Utilized   ($ millions)
   B-737-800           71            $32    $2,272         Delta‟s planes are worth $29.4
                                                           billion, yet only $9.5 billion
   B-757-200           68           $130    $8,840         shows up on the balance sheet.
   B-767-300            4           $150     $600          Why don‟t the planes I fly show
   B-767-300ER         50           $150    $7,500         up on the balance sheet?
   B-767-400ER         21           $162    $3,402
   B-777-200ER          8           $200    $1,600
   MD-88               63            $45    $2,835
   MD-90               16            $45     $720
   CRJ-100             28            $25     $700
   CRJ-200              5            $35     $175
   CRJ-700             17            $28     $476
                                                                            Delta Pilot
   CRJ-900              8            $35     $280
   Total              578                  $29,400



Leases                                                                         10
                                                                                   In income
                                                                                   statement
Note 7. Lease Obligations

We lease aircraft, airport terminals and maintenance facilities, ticket offices and other
property and equipment from third parties. Rental expense for operating leases, which
is recorded on a straight-line basis over the life of the lease term, totaled $470 million
for the eight months ended December 31, 2007, $261 million for the four months ended
April 30, 2007 and $961 million and $1.1 billion for the years ended December 31, 2006
and 2005, respectively.

The following tables summarize, as of December 31, 2007, our minimum rental
commitments under capital leases and noncancelable operating leases (including
certain aircraft under contract carrier agreements) with initial terms in excess of one
year:

                                                     Capital       Operating
Payments                                             Leases         Leases
2008                                                      $128            758
2009                                                       125            609
2010                                                       125            548
2011                                                       118            417
                                                                                           Not on
2012                                                         84           358              balance
After 2012                                                 112          1,477              sheet
Total minimum lease payments                               692          4,164
Less: amount representing interest                       (148)                            In Current
Present value of minimum lease payments                    544                            Liabilities
Less: current obligations                                  (85)
Long-term capital lease obligations                       $459                             In LT
                                                                                           Liabilities



At December 31, 2007, we operated 137 aircraft under operating leases and 82 aircraft
under capital leases. These leases have remaining terms ranging from 10 months
to nine years.




Leases                                                                            11
Flight Equipment

Our active aircraft fleet at December 31, 2007 is summarized in the following table:

                                 Capital    Operating                    Average
Aircraft Type         Owned      Lease       Lease             Total       Age
B-737-800                 71         —             —               71         7.2
B-757-200                 68          34            18            120        16.3
B-757-200ER              —             2            11             13        10.0
B-767-300                  4         —              17             21        16.9
B-767-300ER               50         —               9             59        11.9
B-767-400ER               21         —             —               21         6.8
B-777-200ER                8         —             —                 8        7.9
MD-88                     63          33            21            117        17.5
MD-90                     16         —             —               16        12.1
CRJ-100                   28          13            49             90        10.3
CRJ-200                    5         —              12             17         5.2
CRJ-700                   17         —             —               17         4.2
CRJ-900                    8         —             —                 8        0.2
Total                    359          82           137            578        12.4

                                These aircraft do not appear
                                on the balance sheet.

Discussion:
    Does Delta seem to prefer operating or capital leases?
    How should we view the $4,164 in operating lease
     payments?
         - Is Delta legally obligated to pay that amount?
         - Should part of that amount be viewed as interest?
         - If so, at what interest rate?

    Under capital leases, Delta must pay $128 in 2008. Why is
     the current obligation only $85?




Leases                                                                              12
                    LEASE OR BUY?
                  (Expense or Capitalize?)

Pecos Corp. began the year with the following asset structure:
Pecos Corp.
Balance Sheet
Assets                       Equities
Cash            $20,000      Accounts Payable   $10,000
Supplies         10,000      Common Stock        20,000
 Total Assets   $30,000       Total Equities    $30,000

Pecos Corp. needs a $100,000 machine that will produce $25,000
of revenue for $10,000 in production expenses ($15,000 in gross
profit and cash flow per year).


Option 1: Buy or Capital Lease (effects are similar)
Pecos can acquire the machine by borrowing $100,000. During
the first year Pecos would pay $9,000 principal and $1,000
interest. The machine will be depreciated at $9,000 per year.


Option 2: Operating Lease
Pecos can lease the machine for $10,000 per year (under an
operating lease).




Leases                                                     13
                     Option 1: Capitalizing
                     Purchase the Machine
Entries throughout the year:

Machine                     100,000                      This action is known
                                                         as “capitalization.”
      Loan Payable                        100,000

Cash                            25,000
         Revenue                           25,000

Cost of Goods Sold              10,000
      Cash                                 10,000

Loan Payable                     9,000
Interest Expense                 1,000
       Cash                                10,000

Depreciation Expense           9,000
      Accumulated Depreciation              9,000


Pecos Corp.
Income Statement
Revenue                    $25,000
Production Expenses        -10,000
Depreciation Expense        -9,000
Interest Expense            -1,000
Net Income                  $5,000

Pecos Corp.
Balance Sheet
Assets                                   Equities
Cash                  $25,000            Accounts Payable       $10,000
Supplies               10,000            Loan Payable            91,000
Machine (Net)          91,000            Common Stock            20,000
                                         Retained Earnings        5,000
 Total Assets        $126,000              Total Equities      $126,000

Cash Flow - Operations = NI + Depreciation = $5,000 + $9,000 = $14,000
Note: Loan Payment of $9,000 is a use in financing.


Leases                                                                      14
            Option 2: Expensing
  Lease the Machine under Operating Lease
Entries throughout the year:

Leasing Expense                10,000
      Cash                              10,000

Cash                           25,000
         Revenue                        25,000
                                                        Same as for
Cost of Goods Sold             10,000                   purchase.
      Cash                              10,000



Pecos Corp.
Income Statement
Revenue                    25,000
Production Expenses       -10,000
Leasing Expense           -10,000
Net Income                  5,000



Pecos Corp.
Balance Sheet
Assets                              Equities
Cash                 $25,000        Accounts Payable     $10,000
Supplies              10,000        Common Stock          20,000
                                    Retained Earnings      5,000
 Total Assets        $35,000         Total Equities      $35,000

Cash Flow - Operations = NI + Depreciation = $5,000 + $0 = $5,000




Leases                                                                15
                   LEASE OR BUY?

Summary of Results
                             Option 1     Option 2
                             Buying       Leasing
Net Income                       $5,000      $5,000
Total Assets                  $126,000      $35,000
Total Liabilities             $101,000      $10,000
Total Stockholders‘ Equity     $25,000      $25,000
CF - Operations                $14,000       $5,000
CF - Financing                 ($9,000)            0
CF - Total                       $5,000      $5,000


Ratio Analysis
                     Option 1 Option 2
                     Buying    Leasing
Return on Assets         3.9%    14.3%
Return on Equity       20.0%     20.0%
CFO to Assets          11.1%     14.3%
CFO to Equity          56.0%     20.0%
Debt to Equity            4.04     0.40




Leases                                           16
          ANALYZING OPERATING LEASES
 Does Expensing or Capitalization Make a Difference?

10. COMMITMENTS AND CONTINGENCIES
Lease Commitments

BNSF Railway has substantial lease commitments for locomotives, freight cars,
trailers and containers, office buildings and other property, and many of these
leases provide the option to purchase the leased item at fair market value at the    Making
end of the lease. However, some provide fixed price purchase options. Future         these
minimum lease payments (which reflect leases having non-cancelable lease             capital
terms in excess of one year) as of December 31, 2006, are summarized as              leases.
follows (in millions):

                                               Capital    Operating
December 31,                                   Leases       Leases
2007                                             $154          $640
2008                                              146           686
2009                                              116           621
2010                                                81          569
2011                                                41          530
Thereafter                                        170         4,450
Total                                             708        $7,496
Less amount representing interest                 (99)
Present value of minimum lease payments          $609

Lease rental expense for all operating leases was $665 million, $565 million
and $496 million for the years ended December 31, 2006, 2005 and 2003,
respectively.
                                                  Related to
                                                  operating leases.




Question: What if BNSF treated all leases as capital
leases?




Leases                                                                          17
                            Approximating a
                          Capitalized Obligation
                                                                                          BNSF‘s stated
The present value of the operating lease payments might be                                average interest
                                                                                          rate is 7.3%
approximated by:

                                                       PV of                Implied
    Year         Payment PV at 7%
                                                      Payment               Interest
  2007              $640              0.935             $598                   $42
  2008               686              0.873             $599                   $87
  2009               621              0.816             $507                  $114              $1,986
  2010               569              0.763             $434                  $135              ($4,741 -
                                                                                                $2,755)
  2011               530              0.713             $378                  $152              relates to
 After ‗11          4,450             0.500            $2,225                $2,225             payment of
                                                                                                ―principal‖
                   $7,496                              $4,741                $2,755
Note: This example assumes that (1) 7% is an appropriate discount rate and (2) differences in PV factors
after 6 years are immaterial. (See Appendix A)

Assuming BNSF capitalized these leases, the financial effect would be:
                                  Actual                                    Revised
                                           Adjustment
                                   2006                                      2006
 Total Debt                       $21,247      $4,741                        $25,988
 Total Equity                     $10,396                                    $10,396
 Debt / Equity                        2.04                                       2.50
 Net Income                         $1,887                                    $1,887
 Total Assets                     $31,643      $4,741                        $36,384
 Return on Assets                   5.96%                                      5.19%
Note: It is more difficult to estimate the asset. Many analysts assume: (1) the asset to be approximately
equal to the liability and (2) operating rent expense is approximately equal to depreciation expense had
the lease been capitalized.




Leases                                                                                         18
         APPROXIMATING CAPITALIZED
               OBLIGATIONS
             Interest Expense Determination


    Most recent interest rate
    Average interest rate

                     Interest Expense
                 Average Long-Term Debt


Example: BNSF

Suppose that BNSF reports an interest expense of $485
million and average long term debt of $6,912 million

     Interest Expense             485
 Average Long-Term Debt
                             =           =   7.01%
                                 6,912

On the other hand, BNSF has debt due in 2047 at 5.7%.
That may be a more appropriate rate.




Leases                                               19
                              Appendix A
Treatment of payments beyond five years is somewhat subjective. A more
detailed approach might be to estimate payments for years 6 to 10.

           Year            Payment     PV at 7%    PV of Payment
           2007                 $640       0.935           $598
           2008                  686       0.873           $599
           2009                  621       0.816           $507
           2010                  569       0.763           $434
           2011                  530       0.713           $378
         2012 est                495       0.666           $330
         2013 est                460       0.623           $286
         2014 est                425       0.582           $247
         2015 est                390       0.544           $212
         2016 est                355       0.508           $180
         After ‗16*            2,325     ≈ 0.400           $930
                              $7,496                     $4,702
Red items are estimated.




Assuming BNSF capitalized these leases, the financial effect would be:
                            Actual                   Revised
                             2006                     2006
Total Debt                   $21,247      $4,702       $25,949
Total Equity                 $10,396                   $10,396
Debt / Equity                   2.04                      2.50
Net Income                    $1,887                    $1,887
Total Assets                 $31,643      $4,702       $36,345
Return on Assets              5.96%                     5.19%




Leases                                                             20
                    ANALYSIS OF LEASES
                        Lease Utilization Ratios
                                                           Operating leases are
1.       Operating Lease Utilization                       leases that are treated
                                                           as if they are borrowed
                                                           or “rented.”
Indicates: degree to which operating leases are utilized

              Operating Lease        =   Operating Lease Expense
                Utilization                         Sales

Interpretation:
Higher – the company uses operating leases to gain access to fixed
assets. Assets may be understated resulting in overstated ROA. Liabilities
may be understated resulting in a lower debt to equity ratio.



2.       Capital Lease Utilization                         Capital leases are treated
                                                           as if they are owned: (1)
                                                           placed on the balance
Indicates: degree to which capital leases are utilized     sheet and (2) amortized
                                                           over their life.
           Capital Lease    =    Gross Capital Leases
              Utilization            Total Assets

Interpretation:
Higher – the company uses capital leases to gain access to fixed assets




Leases                                                               21
                         Additional Example


At December 31, 2000, the scheduled future minimum lease payments under capital
leases and the scheduled future minimum lease rental payments required under aircraft
and engine operating leases, that have initial or remaining noncancellable lease terms
in excess of one year, are as follows (in millions):

                                                Capital           Operating
Year ending December 31,                        Leases              Leases
2001                                               $ 47             $ 859
2002                                                 47                 814
2003                                                 31                 766
2004                                                 28                 709
2005                                                 29                 688
Later years                                         180               6,387
Total minimum lease payments                        362             $10,223
Less: amount representing interest                  126
Present value of capital leases                     236
Less: current maturities of capital leases           32
Long-term capital leases                          $204

At December 31, 2000, the Company, including Express, had 386 and 12 aircraft under
operating and capital leases, respectively. These leases have remaining lease terms
ranging from one month to 23 years. The Company's total rental expense for all
operating leases, net of sublease rentals, was $1.2 billion, $1.1 billion and $922 million
in 2000, 1999 and 1998, respectively.

(in $Millions)         2000             1999
Net Income                 342              455
Total Debt               8,041            6,630
Total Equity             1,160            1,593
Total Assets             9,201            8,223




Leases                                                                           22
                            Discussion Questions
1. What amount was recognized on the income statement as a ―lease expense‖ during
   2000?
         $1.2 billion (from operating leases only; capital leases are depreciated)

2. What is the total amount recognized in the liability section of the 2000 balance sheet
   as a result of lease agreements?
         $236 million ($204 million in LT and $32 million in ST, from capital leases
         only)

3. If Continental could borrow at a 10% rate for long-term collateralized loans, what
   would be the approximate increase in the liability recognized on the balance sheet if
   Continental were required to capitalize the leases currently classified as operating
   leases?

                                              PV            PV of
       Year               Payment         at 10%         Payment
       2001                $ 859           0.909              781
       2002                    814         0.826              672
       2003                    766         0.751              575
       2004                    709         0.683              484
       2005                    688         0.621              427
     After „05               6,387        ≈0.500            3,194
                                                           $6,133

4.       Assuming Continental capitalized these leases, what would be the effect on the
         debt to equity ratio and the return on asset ratio?

                                  Actual                               Revised
                                                   Adjustment
                                   2000                                 2000
Total Debt                            $8,041              $6,133          $14,174
Total Equity                          $1,160                               $1,160
Debt / Equity                            6.93                                12.22
Net Income                               $342                                $342
Total Assets                          $9,201              $6,133          $15,334
Return on Assets                       3.72%                                2.23%




Leases                                                                          23
5. Assuming moderate growth, what would you predict the cash payments for leases to
   be in the year 2001? Show your calculations and state any assumptions you might
   make.
         Assuming 5% growth per year:
         ($47 million + $859 million) X 1.05 = $951.3 million


6. Delta must make a $47 capital lease payment in 2001. Why do they show only $32
   as a current maturity of capital leases?
         The $15 represents interest paid on capital leases during 2001.




Leases                                                                     24

				
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