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									Chapter 22


                 Prepared by Anne Inglis, Ryerson University

McGraw-Hill Ryerson                                 © 2007 McGraw-Hill Ryerson Limited
     Key Concepts and Skills
• Understand the basic lease terminology
• Understand the criteria for a capital lease
  vs. an operating lease
• Understand the typical incremental cash
  flows to leasing
• Be able to compute the net advantage to
• Understand the good reasons for leasing
  and the dubious reasons for leasing
         Chapter Outline
• Leases and Lease Types
• Accounting and Leasing
• Taxes, Canada Revenue Agency (CRA),
  and Leases
• The Cash Flows from Leasing
• Lease or Buy?
• A Leasing Paradox
• Reasons for Leasing

     Lease Terminology 22.1
• Lease – contractual agreement for use of
  an asset in return for a series of payments
• Lessee – user of an asset; makes
• Lessor – owner of the asset; receives
• Direct lease – lessor is the manufacturer
• Captive finance company – subsidiaries
  that lease products for the manufacturer
Figure 22.1

         Types of Leases

• Operating lease

• Financial lease (also called a
  capital lease)

           Operating Lease
• Shorter-term lease
• Lessor is responsible for insurance, taxes
  and maintenance
• Often cancelable

           Financial Lease
• Longer-term lease
• Lessee is responsible for insurance, taxes
  and maintenance
• Generally not cancelable
• Specific capital leases
  • Tax-oriented
  • Leveraged
  • Sale and leaseback

      Lease Accounting 22.2
• Leases are governed by CICA 3065
• Financial leases are essentially treated as
  debt financing
  • Present value of lease payments must be
    included on the balance sheet as a liability
  • Same amount shown on the left side of the
    balance sheet
• Operating leases are still “off-balance-
  sheet” and do not have any impact on the
  balance sheet itself
     Criteria for a Capital Lease
• If one of the following criteria is met, then the lease is
  considered a capital lease and must be shown on
  the balance sheet
   • Lease transfers ownership by the end of the lease
   • Lessee can purchase asset at below market price
   • Lease term is for 75 percent or more of the life of
      the asset
   • Present value of lease payments is at least 90
      percent of the fair market value at the start of the
                  Taxes 22.3
• Lessee can deduct lease payments for income
  tax purposes under specific circumstances
  • Lease must be primarily for business purposes and
    not just to avoid taxes
  • Does not apply to conditional sales agreements
  • Lessee cannot automatically acquire title of the
    property after payment of a specified amount in the
    form of rentals
  • Lessee cannot be required to buy the property during
    or at the termination of the lease
  • Lessee cannot have the right during or at the
    expiration of the lease to acquire the property at a
    price less than fair market value                    22-10
  Incremental Cash Flows 22.4
• After-tax lease payment (outflow)
  • Lease payment*(1 – T)
• Lost depreciation tax shield (outflow)
  • Depreciation * tax rate for each year
• Initial cost of machine (inflow)
  • Inflow because we save the cost of purchasing
    the asset now
• May have incremental maintenance, taxes
  or insurance depending on the type of
  lease and whether the leased asset is
  replacing one currently owned         22-11
  Example: Lease Cash Flows
• ABC, Inc. needs new cars. The equipment
  cars would cost $10,000 each if purchased
  and would be depreciated at a CCA rate of
  40%. They would help the sales force
  generate $6,000 in additional sales per
  year for 5 years. No salvage is expected
  after the 5 years. Alternatively, the
  company can lease the cars for $2,500 per
  year and payments are due at the
  beginning of the year. The marginal tax
  rate is 40%. What are the incremental
  cash flows?                              22-12
Example: Lease Cash Flows
• What are the incremental cash flows?
  • After-tax lease payment = 2,500(1 - .4) = 1,500
    (outflow years 1 - 5)
  • Cost of the car = 100,000 (inflow year 0)
  • Lost depreciation tax shield
• Table 22.2: Tax shield on CCA for car

         Lease or Buy? 22.5
• The company needs to determine whether
  it is better off borrowing the money and
  buying the asset or leasing
• Compute the NPV of the incremental cash
• Appropriate discount rate is the after-tax
  cost of debt since a lease is essentially the
  same risk as a company’s debt

    Net Advantage to Leasing
• The net advantage to leasing (NAL) is the
  same thing as the NPV of the incremental
  cash flows
  • If NAL > 0, the firm should lease
  • If NAL < 0, the firm should buy
• Consider the previous example. Assume
  the firm’s cost of debt is 11%.
  • After-tax cost of debt = 10(1 - .4) = 6.6%
  • NAL = -119
• Should the firm buy or lease?                  22-15
       A Leasing Paradox 22.6
• If the lessor and lessee have the same effective tax
  rate, then leasing is a zero sum game
• When their tax rates differ, then leasing has benefits
  for both parties
   • The company in the higher tax bracket can benefit
      from being a lessor, because they can use the
      CCA tax shields
   • The CCA tax shields are worth less to the lessee
      because the lessee faces a lower tax rate or may
      not have enough taxable income to absorb the
      accelerated tax shields in the early years

Good Reasons for Leasing 22.7
•   Taxes may be reduced
•   May reduce some uncertainty
•   May have lower transaction costs
•   May require fewer restrictive covenants
•   May encumber fewer assets than secured

 Dubious Reasons for Leasing
• Balance sheet, especially leverage ratios,
  may look better if the lease does not have
  to be accounted for on the balance sheet
• 100% financing – leases normally do not
  require either a down-payment or a
  security deposit
• Other reasons for leasing – circumvent
  capital expenditure control systems set up
  by bureaucratic firms
                Quick Quiz
• What is the difference between a lessee and a
• What is the difference between an operating
  lease and a capital lease?
• What are the requirements for a lease to be tax
• What are typical incremental cash flows and how
  do you determine the net advantage to leasing?
• What are some good reasons for leasing?
• What are some dubious reasons for leasing?
             Summary 22.8
• There are two types of leases: financial
  and operating
• There are accounting and tax
  consequences for both types of leases
• An NPV analysis is used to determine
  whether borrowing or leasing is most
  advantageous. The appropriate discount
  rate is the after-tax borrowing rate
• Differential tax rates can make leasing an
  attractive proposition to all parties      22-20

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