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									                                                                                                                    11/14/2003

                                     Chapter 20. Tool Kit for Lease Financing

LEASING

Leasing provides firms with a flexible alternative when it comes to acquiring productive assets. Instead of buying fixed
assets and having them on the balance sheet, companies may opt to lease. About 30% of all new capital equipment
acquired by businesses is leased. Leasing generally takes one of three forms: (1) sale-and-leaseback arrangements, (2)
operating leases, and (3) straight financial, or capital, leases. A sale-and-leaseback arrangement is one whereby a firm
sells land, buildings, or equipment and simultaneously leases the property back for a specified period under specific
terms. An operating lease is one in which the lessor maintains and finances the property. A financial lease does not
provide for maintenance services and is not cancelable. This kind of lease is fully amortized over its life (and therefore is
also called a capital lease).

Financial Statement Effects

Lease payments are shown as operating expenses on a firm's income statement. Under certain conditions, neither the
leased assets nor the liabilities under the lease contract appears on the firm's balance sheet. For these reasons, leasing is
often called "off balance sheet financing". This can be illustrated by looking at the hypothetical firms, B and L. These
two firms are identical in every way, except Firm B has decided to buy its new assets, while Firm L has chosen to lease.

                     Before the increase in assets
                           Firms B and L
Curr. Assets            50                  Debt                      50                 Debt Ratio
Fixed Assets            50                  Equity                    50                   50%
Total Assets           100                  Total D&E                100

                      After the increase in assets
                                Firm B
Curr. Assets             50                 Debt                     150                 Debt Ratio
Fixed Assets            150                 Equity                    50                   75%
Total Assets            200                 Total D&E                200

                                Firm L
Curr. Assets             50                 Debt                      50                 Debt Ratio
Fixed Assets             50                 Equity                    50                   50%
Total Assets            100                 Total D&E                100

From this simple example, we see that by leasing the assets Firm L did not change its capital structure at all. Whereas,
Firm B would be increasing their debt ratio from 50% to 75%. Recall from Chapter 16, increased debt, amongst other
effects, increases the risk of the firm, its assets, and its equity. In fact, this example typifies the use of operating and
financial leverage. Firm is increasing its fixed costs, and its debt in one action.
EVALUATION BY THE LESSEE

Any prospective lease must be evaluated by both the lessee and the lessor. The lessee must determine whether leasing the
asset will be less costly than buying the asset, and the lessor must determine if the lease provides an adequate return.
Much like the capital budgeting decisions we have seen previously, we must be concerned with incremental cash flows.

PROBLEM
Thompson-Grammatikos Compnay (TGC) requires the use of a two-year aset that costs $100. TGC can borrow $100 at
an interest rate of 10%, with payments of $10 each year and a principle payment of $100 at Year-2. For simplicity,
assume straight-line depreciation of $50 per year. The tax rate is 40%. If TGC leases the asset the lease payment is $55
due at the end of each year.

Input Data
(all dollar figures in thousands)

New Equipment cost                      $100                 KEY OUTPUT
New Equipment life                          2
Equip. Salvage Value                      $0                    LEASE
Tax Rate                                 40%                 because of the net advantage of leasing is            $2.83
Loan interest rate                       10%
Annual rental charge                     $55
Depreciation                             $50
After-tax cost of debt                    6%


NPV LEASE ANALYSIS

                    Year =          0            1                 2
  Cost of Owning
Equipment cost                          ($100)
Loan amount                              $100
Interest expense                                     ($10)           ($10)
Tax savings from interest                                4               4
Principal repayment                                                 ($100)
Tax savings from depr.                               $20              $20
Net cash flow                            $0          $14             ($86)
PV ownership cost @ 6%              ($63.33)

 Cost of Leasing
Lease payment                                        ($55)             ($55)
Tax savings from lease                                $22               $22
Net cash flow                            $0          ($33)             ($33)
PV of leasing @ 6%                  ($60.50)

 Cost Comparison
PV ownership cost @ 6%              ($63.33)
PV of leasing @ 6%                  ($60.50)
Net Advantage to Leasing              $2.83

PROBLEM
Anderson Company plans to acquire equipment, with a 5-year MACRS life (but a 10-year useful life), at a cost of $10
million (delivery and installation included). Anderson can borrow the $10 million at 10%, interest only until the
repayment in 5 years. Alternatively, Anderson can lease the equipment for five years at a rental charge of $2.65 million
per year, at the beginning of the year. The equipment, when used, will have an estimated net salvage value of $2 million.
If Anderson buys, it will own the equipment at the end of five years. If Anderson leases, it will not exercise the option to
buy the equipment. The lease includes maintenance service, whereas if bought, the equipment would require maintenance
provided by a service contract for $500,000 per year, at the end of the year. The equipment falls into the MACRS five-
year class life, and the depreciable basis is the original cost. Anderson's tax rate is 35%.
Input Data
(all dollar figures in thousands)

New Equipment cost                $10,000                      KEY OUTPUT
New Equipment MACRS life                 5
                                   $2,000
Equip. Salvage Value at end of MACRS                              LEASE
Annual Maintenance                   $500                      because of the net advantage of leasing is               $53.93
Tax Rate                              35%
Loan interest rate                    10%
Annual rental charge               $2,600
Useful life                             10
Scrap Value at end of useful life     $50

After-tax cost of debt                    6.5%

Now, we will use the MACRS 5-year depreciation schedule to calculate the annual depreciation charges.

MACRS 5-year Depreciation Schedule
    Year          1            2                      3              4              5             6
 Depr. Rate     20%          32%                    19%            12%            11%            6%
 Depr. Exp.   $2,000        $3,200                 $1,900         $1,200         $1,100         $600
Starting book
    value     $10,000       $8,000                 $4,800         $2,900         $1,700         $600
 Remaining
 book value   $8,000        $4,800                 $2,900         $1,700          $600           $0


NPV LEASE ANALYSIS

                    Year =            0              1               2              3             4           5
 Cost of Owning
After-tax loan payments                               ($650)          ($650)         ($650)       ($650)    ($10,650)
Maintenance Cost                          ($500)      ($500)          ($500)         ($500)       ($500)
Tax savings from main.                     $175        $175            $175           $175         $175
Tax savings from depr.                                 $700          $1,120           $665         $420         $385
Residual value                                                                                                $2,000
Tax on residual value                                                                                          ($490)
Net cash flow                           ($325)        ($275)             $145        ($310)       ($555)     ($8,755)
PV ownership cost @ 6.5%            ($7,533.5)

 Cost of Leasing
Lease payment                         ($2,600)      ($2,600)        ($2,600)       ($2,600)     ($2,600)
Tax savings from lease                   $910          $910            $910           $910         $910
Net cash flow                         ($1,690)      ($1,690)        ($1,690)       ($1,690)     ($1,690)          $0
PV of leasing @ 6.5%                ($7,479.6)

 Cost Comparison
PV ownership cost @ 6%              ($7,533.5)
PV of leasing @ 6%                  ($7,479.6)
Net Advantage to Leasing                $53.9
EVALUATION BY THE LESSOR
PROBLEM

The lessor for Anderson Equipment company is a wealthy individual whose marginal federal plus state tax rate is 40%.
The investor can buy 5-year bonds with a 9% yield to maturity. All other terms of the lease are the same as above.

Input Data
(all dollar figures in thousands)

New Equipment cost                  $10,000
New Equipment life                        5
Equip. Salvage Value                 $2,000
Annual Maintenance                     $500
Tax Rate                                40%
Loan interest rate                       9%
Annual rental charge                 $2,600

After-tax cost of debt                   5.4%


NPV LEASE ANALYSIS

                    Year =           0           1          2              3            4           5
 Cost of Owning
Net purchase price                  ($10,000)
Maintenance cost                       ($500)     ($500)      ($500)        ($500)      ($500)
Tax savings from main.                  $200       $200        $200          $200        $200
Tax savings from depr.                             $800      $1,280          $760        $480        $440
Lease payment                         $2,600     $2,600      $2,600        $2,600      $2,600
Tax on lease payment                 ($1,040)   ($1,040)    ($1,040)      ($1,040)    ($1,040)
Residual value                                                                                     $2,000
Tax on residual value                                                                               ($560)
Net cash flow                        ($8,740)   $2,060       $2,540        $2,020      $1,740      $1,880
NPV @ 5.4%                             $81.2

IRR                                    5.8%
MIRR=                                 5.60%
a221da50-96aa-4129-a826-176eb9cf0b38.xls                                                                      Extension




                                        Chapter 20 Extension. Tool Kit for Percentage Cost Analysis


    Anderson Company plans to acquire equipment, with a 5-year life, at a cost of $10 million (delivery and installation included).
    Anderson can borrow the $10 million at 10%, interest only until the repayment in 5 years. Alternatively, Anderson can lease th
    equipment for five years at a rental charge of $2.75 million per year, at the beginning of the year. The equipment, when used, w
    an estimated net salvage value of $1 million. If Anderson buys, it will own the equipment at the end of five years. If Anderson
    will not exercise the option to buy the equipment. The lease includes maintenance service, whereas if bought, the equipment wo
    require maintenance provided by a service contract for $500,000 per year, at the end of the year. The equipment falls into the M
    five-year class life, and the depreciable basis is the original cost. Anderson's tax rate is 40%.


    PERCENTAGE COST ANALYSIS

    We can analyze the proposed lease using the percentage cost approach, as shown in the table below.

    Input Data
    (all dollar figures in thousands)

    New Equipment cost                            $10,000
    New Equipment MACRS life                             5
    Equip. Salvage Value at end of MACRS           $2,000
    Annual Maintenance                               $500
    Tax Rate                                          35%
    Loan interest rate                                10%
    Annual rental charge                           $2,600
    Useful life                                         10
    Scrap Value at end of useful life                 $50

    After-tax cost of debt                             6.5%


                                     Year =        0               1          2             3             4
      Cost of Owning
    1. Avoided net puchase price                  $10,000
    2. After-tax lease payment                    ($1,690)        ($1,690)   ($1,690)     ($1,690)       ($1,690)
    3. Lost depreciation tax savings                                ($700)   ($1,120)       ($665)         ($420)
    4. Avoided after-tax maintenance                   $325          $325       $325         $325           $325
    5. Lost after-tax residual value
    Net cash flow                                  $8,635         ($2,065)   ($2,485)     ($2,030)       ($1,785)

    IRR                                                6.3%

    NPV                                           $53.930


    LEVERAGED LEASE ANALYSIS

    We can modify the situation above to be a leveraged lease with the lessor borrowing some of the purchase price, as shown
    in the table below.


Michael C. Ehrhardt                                      Page 7                                                3/7/2011
a221da50-96aa-4129-a826-176eb9cf0b38.xls                                                         Extension


    Input Data
    (all dollar figures in thousands)

    Amount borrowed                              $5,000
    Interest rate                                    9%            0%                  0%
    Tax rate                                        40%            0%                  0%
    After-tax cost of debt                         5.4%

                                      Year =      0            1         2         3         4
    1. Net cash flow for unlevered lessor
    (from Table 20-3, same as Row 186 of
    the Model worksheet                          ($8,740)      $2,060    $2,540    $2,020    $1,740
    2. Leveraging cash flows                      $5,000        ($270)    ($270)    ($270)    ($270)
    3. Net cash flow                             ($3,740)      $1,790    $2,270    $1,750    $1,470

    NPV=                                $81.21
    IRR=                                 9.09%
    MIRR=                                5.67%




Michael C. Ehrhardt                                   Page 8                                      3/7/2011
              a221da50-96aa-4129-a826-176eb9cf0b38.xls                                    Extension




 nsion. Tool Kit for Percentage Cost Analysis


 th a 5-year life, at a cost of $10 million (delivery and installation included).
 est only until the repayment in 5 years. Alternatively, Anderson can lease the
  million per year, at the beginning of the year. The equipment, when used, will have
derson buys, it will own the equipment at the end of five years. If Anderson leases, it
The lease includes maintenance service, whereas if bought, the equipment would
  for $500,000 per year, at the end of the year. The equipment falls into the MACRS
original cost. Anderson's tax rate is 40%.




                                                                   5




                                                                   ($385)

                                                                 ($1,510)
                                                                 ($1,895)




d lease with the lessor borrowing some of the purchase price, as shown



              Michael C. Ehrhardt                                      Page 9              3/7/2011
a221da50-96aa-4129-a826-176eb9cf0b38.xls                  Extension




                                            5


                                            $1,880
                                           ($5,270)
                                           ($3,390)




Michael C. Ehrhardt                             Page 10    3/7/2011

								
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