Machine Leasing Agreement by dsm45252


More Info
									         Lease Terminology
• 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
              Types of Leases
• Operating lease
   • Shorter-term lease
   • Lessor is responsible for insurance, taxes and
   • Often cancelable
• Financial lease (capital lease)
   • Longer-term lease
   • Lessee is responsible for insurance, taxes and
   • Generally not cancelable
   • Specific capital leases
      • Tax-oriented
      • Sale and leaseback
          Lease Accounting
• Leases are governed primarily by FASB 13
• 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 asset as the
    “capitalized value of leased assets”
• 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 term
  • Lessee can purchase asset at below market
  • 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 lease
• Lessee can deduct lease payments for income
  tax purposes
  • Must be used for business purposes and not to avoid
  • Term of lease is less than 80 percent of the economic
    life of the asset
  • Should not include an option to acquire the asset at
    the end of the lease at a below market price
  • Lease payments should not start high and then drop
  • Must survive a profits test – lessor should earn a fair
  • Renewal options must be reasonable and consider fair
    market value at the time of the renewal                 26-4
      Incremental Cash Flows
• Cash Flows from the Lessee’s point of
  • After-tax lease payment (outflow)
     • Lease payment*(1 – tC)
  • 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,
    insurance, or salvage value

  Example: Lease Cash Flows
• ABC, Inc. needs some new equipment. The
  equipment would cost $100,000 if purchased and
  would be depreciated straight-line over 5 years.
  No salvage is expected. Alternatively, the
  company can lease the equipment for $26,300
  per year. The marginal tax rate is 40%.
  • What are the incremental cash flows?
     • After-tax lease payment = 26,300(1 - .4) = 15,780 (outflow
       years 1 - 5)
     • Lost depreciation tax shield = (100,000/5)*.4 = 8,000 (outflow
       years 1 – 5)
     • Cost of machine = 100,000 (inflow year 0)

             Lease or Buy?
• 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 10%.
  • After-tax cost of debt = 10(1 - .4) = 6%

• NAL = $100,000 - $15,780(PVIFA6%,5)
•         - $8,000(PVIFA6%,5)
• NAL = -$170.01
• Do not lease the machine

• What is NAL to lessor?

            Differential taxes
•   Lessee pays no tax
•   Return = 10%
•   NAL = $100,000 - $26,300(PVIFA10%,5)
•   NAL = $302.31
•   Lease the machine

   Maximum Lease Payment
• NAL = $0

     Good Reasons for Leasing
•   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 – except that leases
  normally do require either a down-payment
  or security deposit
• Low cost – some may try to compare the
  “implied” rate of interest to other market
  rates, but this is not directly comparable

To top