FINANCE IN A

CANADIAN SETTING
Sixth Canadian Edition
Lusztig, Cleary,
Schwab

CHAPTER
TWENTY-FIVE
Leasing

Learning Objectives
1. Discuss the advantages for the lessor and the lessee
under a lease agreement.
2. Compare the differences between operating and
financial (or capital) leases.
3. Discuss the three most important cash flows under a
lease.
4. Compare the internal rate of return (IRR) and net
present value (NPV) methods of evaluating leasing
costs. State why one is preferable to the other.
5. Identify three major reasons for the popularity of
leasing.

Introduction

Most leases fall into the class of

intermediate-term financing
Under a lease two parties are involved:
1. lessor owns the asset
2. lessee has full use of the asset and
makes periodic lease payments to the
lessor

Leasing has become a popular

alternative to buying assets

Introduction

Introduction

Operating leases
contract covers a period that is shorter than the
life of the asset
usually longer than a year
operating leases are advantageous for lessee
when:
the assessment of risk of obsolescence for an
asset is higher than that of the lessor
managers want the flexibility to exchange
assets on short notice without penalties

Introduction

Financial leases
also called full payout leases
a long-term contract that allows the lessor to
recover the full cost of the asset plus a return
during the period of the lease
financial leases can take two forms:

direct lease lessee gets the use of an asset not

previously owned
sales and leaseback lessee sells an asset to a
financial institution which than leases the asset
back to the lessee

Introduction

Tax-leveraged leases
developed to meet the financing of milliondollar capital equipment projects with
economic lives between 10 to 25 years
lessor provides 20 to 40 percent of the capital
needed to purchase the equipment while the
remainder is provided by a financial institution
lessor as the owner of the asset is permitted
to deduct CCA on the leased asset for income
purposes

Evaluation of
Financial Leases

Relevant cash flow must be estimated to determine the

economic desirability of leasing versus purchasing an
asset
The lessee avoids the initial outlay of capital required in
purchasing the asset but subsequent costs are incurred
including:
1. direct cash outflows associated with the lease contract
periodic lease payments minus taxes
2. opportunity costs associated with not owning the asset
tax shields from CCA

Evaluation of
Financial Leases

Leasing as a form of debt financing

lease and debt financing affects a firms financial

position in the way they are committed to fixed
payments before any earning are accrued to
shareholders

Framework for discounted cash flow analysis

both NPV and IRR can be used to analyse leases
if IRR > than after-tax borrowing cost, borrowing is
preferred and vice versa
if NPV of the leasing cost is > than the asset value,
borrowing is preferred and vice versa

Evaluation of
Financial Leases

Residual value
when evaluating whether to lease or purchase
an asset, we have to charge a lease with the
loss of any residual value
The present value of net benefit from salvage is
equal to:

S n S n dT
1

(1values

(difficult
n to estimate
residual
are
often

k
)
(
d

r
)
1

k
)

because a judgmental risk-adjusted discount

rate needs to be applied

Reasons For Leasing

Leasing and taxes

Many firms find it advantageous to lease

rather than borrow because of the differential
tax treatments between lessors and lessees

Leases and accounting

to overcome the effects of leasing on

companies balance sheets, the CICA provides
guidelines on distinguishing between
operating and financial leases and how to
treat financial leases

Reasons For Leasing

Other reasons for leasing include:
1. ready availability

companies with poor credit ratings can sometimes

obtain 100 percent financing through a lease
compared to only partial loan financing on the
same asset

2. payment provisions

If payments on a loan are variable while lease

payments are fixed, the borrowing option contains
an additional element of risk, giving incentive to
lease

Reasons For Leasing

Organizational considerations
some leases are written simply to circumvent
organizational restrictions on capital expenditures
Lease financing through manufacturers
terms under a manufacturers lease may be more
attractive than those that a customer could get
under a comparable loan
Flexibility and obsolescence
leases provide the lessee with flexibility and
insurance against obsolescence

Summary
1. The lessor retains title to the asset and
makes it available to a lessee in return for
periodic lease payments. The lessor takes
capital cost allowance (CCA) and any residual
value on the asset at the end of the lease
agreement.
2. Operating leases provide for a contractual
commitment that is short relative to the life
of the asset. The risk of obsolescence rests
with the lessor.

Summary
3. Financial (or capital leases) call for a
contractual arrangement of sufficient length
to allow the lessor to recover the full costs of
the asset plus a return. From the viewpoint
of the lessee, reliance on a financial lease is
very similar to raising funds through debt.
Financial leases may take the form of direct
leases or sale-and-leaseback arrangements,
and they may be two-party leases or thirdparty, tax-leveraged leases.

Summary
4. The quantitative analysis of leasing versus borrowing is
carried out within the framework of discounted cash flow
analysis. The relevant cash flows under a lease consist of:
the initial financing obtained in the amount of the purchase
price of the asset (an inflow or saving)
subsequent direct cash outflows in the amount of the aftertax lease payments
subsequent indirect costs that consist of the tax savings
lost by being unable to claim CCA on the asset, and net
benefits lost through foregoing any residual value that the
assets may have at the end of the lease period

Summary
5. The effective cost of a lease is given by its internal
rate of return (IRR). The IRR is compared to the aftertax interest cost of a term loan, and the alternative
with the lower cost is preferred.
6. The leases net present value (NPV) is given by:

NPV leasing = + purchase price of asset

- present value of after-tax lease payments
present value of tax savings from
lost capital
cost allowance
- present value of lost net
benefits
from residual value

Summary
7. The discount rate employed in
calculating the NPV is the after-tax
interest cost on a comparable term
loan. A higher, risk-adjusted
discount rate, however, may be
appropriate for the residual value.

Summary

Major reasons that have contributed

to the popularity of leasing include:
differences in tax rates and regulations
applicable to lessor and lessee
different accounting treatments of
lease and debt financing
different provisions governing lessors
and creditors in case of default

Summary
9. Other considerations that may play
a role in evaluations of leasing and
borrowing include differences in
payment provisions (fixed versus
variable payments), organizational
restrictions regarding capital
acquisitions, and differences in the
flexibility afforded.