McGraw-Hill/Irwin

Copyright 2012 by McGraw-Hill Education (Asia). All rights reserved.

Lease Terminology
Lease contractual agreement for use of an
asset in return for a series of payments
Lessee user of an asset; makes payments
Lessor owner of the asset; receives payments
Direct lease lessor is the manufacturer
Captive finance company subsidiaries that
lease products for the manufacturer
27-1
Types of Leases
Operating lease
Shorter-term lease
Lessor is responsible for insurance, taxes, and
maintenance
Often cancelable
Financial lease (capital lease)
Longer-term lease
Lessee is responsible for insurance, taxes, and
maintenance
Generally not cancelable
Specific capital leases
Tax-oriented
Leveraged
Sale and leaseback
27-2
Lease Accounting
Leases are governed primarily by FASB 13
and IAS 17
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
27-3
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
price at the leases expiration
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 market value of the asset at the
start of the lease
27-4
Taxes
Lessee can deduct lease payments for income tax
purposes
Must be used for business purposes and not to
avoid taxes
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 below fair
market value
Lease payments should not start high and then
drop dramatically
Must survive a profits test lessor should earn
a fair return
Renewal options must be reasonable and
consider fair market value at the time of the
renewal
27-5
Incremental Cash Flows
Cash flows from the lessees point of view
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
27-6
Example: Lease Cash Flows
ABC, Inc. needs some new equipment. The
equipment costs $100,000 if purchased and can be
depreciated straight-line over 5 years. No salvage
is expected. Alternatively, the company can lease
the equipment for $25,000 per year. The marginal
tax rate is 40%.
What are the incremental cash flows?
After-tax lease payment = 25,000(1 - .4) =
15,000 (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)
27-7
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 flows
Appropriate discount rate is the after-tax cost of
debt since a lease is essentially the same risk as
a companys debt
27-8
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
firms cost of debt is 10%.
After-tax cost of debt = 10(1 - .4) = 6%
NAL = $3,116
Should the firm buy or lease?
27-9
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
borrowing
27-10
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
27-11
Comprehensive Problem
What is the net advantage to leasing for the
following project, and what decision should be
made?
Equipment costs $250,000 if purchased
It will be depreciated straight-line to zero
salvage over 5 years.
Alternatively, it may be leased for $65,000/yr.
The firms after-tax cost of debt is 6%, and its
tax rate is 40%

27-12
Problem
The Wildcat Oil Comp. Is trying to decide whether
to lease or buy a new computer assisted drilling
system. Management has decided that it must
use the system, it will provide $1.75 million in
annual pretax cost saving. The system costs $8
million and will be depreciated straight line to zero
over five years. Tax rate 34 percent, and the firm
can borrow at 9 percent. Lambert Leasing Comp.
has offered to lease the drilling equipment to
Wildcat for payment of $1,9 million per year.
Lambert policy is to require its lessees to make
payments at the start of the year.

Question
Lease or buy? What is the maximum lease
payment that would be acceptable to the
company?
If the equipment will have an aftertax residual
value of $500.000 at the end of the lease, what is
the maximum lease payment acceptable to
Wildcat now?
Suppose Lambert requires Wildcat to pay
$200.000 security deposit at the inception of the
lease and if the lease payment still $1,9 million, is
it advantageous for Wildcat to lease the
equipment now?