ch21 Leasing

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McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

Corporate Finance Ross Westerfield Jaffe Sixth Edition

21Chapter Twenty One

Leasing

Prepared by

Gady JacobyUniversity of Manitobaand Sebouh AintablianAmerican University of Beirut

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Chapter Outline21.1 Types of Leases21.2 Accounting and Leasing21.3 Taxes and Leases21.4 The Cash Flows of Leasing21.5 A Detour on Discounting and Debt Capacity with

Corporate Taxes21.6 NPV Analysis of the Lease-versus-Buy Decision21.7 Debt Displacement and Lease Valuation21.8 Does Leasing Ever Pay: The Base Case21.9 Reasons for Leasing21.10 Some Unanswered Questions

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21.1 Types of Leases

• The Basics– A lease is a contractual agreement between a lessee and

lessor. – The agreement establishes that the lessee has the right to

use an asset and in return must make periodic payments to the lessor.

– The lessor is either the asset’s manufacturer or an independent leasing company.

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Operating Leases

• Usually not fully amortized. This means that the payments required under the terms of the lease are not enough to recover the full cost of the asset for the lessor.

• Usually require the lessor to maintain and insure the asset.

• Lessee enjoys a cancellation option. This option gives the lessee the right to cancel the lease contract before the expiration date.

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Financial Leases

The exact opposite of an operating lease.1. Do not provide for maintenance or service by the lessor.2. Financial leases are fully amortized.3. The lessee usually has a right to renew the lease at

expiry.4. Generally, financial leases cannot be cancelled, i.e., the

lessee must make all payments or face the risk of bankruptcy.

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Sale and Lease-Back

• A particular type of financial lease.• Occurs when a company sells an asset it already

owns to another firm and immediately leases it from them.

• Two sets of cash flows occur:– The lessee receives cash today from the sale.– The lessee agrees to make periodic lease payments,

thereby retaining the use of the asset.

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Leveraged Leases

• A leveraged lease is another type of financial lease.• A three-sided arrangement between the lessee, the

lessor, and lenders.– The lessor owns the asset and for a fee allows the lessee

to use the asset.– The lessor borrows to partially finance the asset.– The lenders typically use a nonrecourse loan. This means

that the lessor is not obligated to the lender in case of a default by the lessee.

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21.2 Accounting and Leasing

• In the old days, leases led to off-balance-sheet financing.

• In 1979, the Canadian Institute of Chartered Accountants implemented new rules for lease accounting according to which financial leases must be “capitalized.”

• Capital leases appear on the balance sheet—the present value of the lease payments appears on both sides.

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Accounting and Leasing

Balance SheetTruck is purchased with debtTruck $100,000 Debt $100,000Land $100,000 Equity $100,000Total Assets $200,000 Total Debt & Equity $200,000

Operating LeaseTruck DebtLand $100,000 Equity $100,000Total Assets $100,000 Total Debt & Equity $100,000

Capital LeaseAssets leased $100,000 Obligations under capital lease $100,000Land $100,000 Equity $100,000Total Assets $200,000 Total Debt & Equity $200,000

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Capital Lease

• A lease must be capitalized if any one of the following is met:– The present value of the lease payments is at least 90-

percent of the fair market value of the asset at the start of the lease.

– The lease transfers ownership of the property to the lessee by the end of the term of the lease.

– The lease term is 75-percent or more of the estimated economic life of the asset.

– The lessee can buy the asset at a bargain price at expiry.

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21.3 Taxes and Leases

• The principal benefit of long-term leasing is tax reduction.• Leasing allows the transfer of tax benefits from those who

need equipment but cannot take full advantage of the tax benefits of ownership to a party who can.

• If the CCRA (Canada Customs and Revenue Agency) detects one or more of the following, the lease will be disallowed.

1. The lessee automatically acquires title to the property after payment of a specified amount in the form of rentals.

2. The lessee is required to buy the property from the lessor.3. The lessee has the right during the lease to acquire the

property at a price less than fair market value.

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21.4 The Cash Flows of Leasing

Consider a firm, ClumZee Movers, that wishes to acquire a delivery truck.

The truck is expected to reduce costs by $4,500 per year.

The truck costs $25,000 and has a useful life of five years.

If the firm buys the truck, they will depreciate it straight-line to zero.

They can lease it for five years from Tiger Leasing with an annual lease payment of $6,250.

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• Cash Flows: BuyYear 0 Years 1-5

Cost of truck –$25,000After-tax savings 4,500×(1-.34) = $2,970Depreciation Tax Shield 5,000×(.34) = $1,700

–$25,000 $4,670

• Cash Flows: LeaseYear 0 Years 1-5

Lease Payments –6,250×(1-.34) = –$4,125After-tax savings 4,500×(1-.34) = $2,970

–$1,155

• Cash Flows: Leasing Instead of BuyingYear 0 Years 1-5$25,000 –$1,155 – $4,670 = –

$5,825

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• Cash Flows: Leasing Instead of BuyingYear 0 Years 1-5$25,000 –$1,155 – $4,670 = –$5,825

• Cash Flows: Buying Instead of Leasing Year 0 Years 1-5–$25,000 $4,670 –$1,155 = $5,825

• However we wish to conceptualize this, we need to have an interest rate at which to discount the future cash flows.

• That rate is the after-tax rate on the firm’s secured debt.

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21.5 A Detour on Discounting and Debt Capacity with Corporate Taxes• Present Value of Riskless Cash Flows

– In a world with corporate taxes, firms should discount riskless cash flows at the after-tax riskless rate of interest.

• Optimal Debt Level and Riskless Cash Flows– In a world with corporate taxes, one determines the

increase in the firm’s optimal debt level by discounting a future guaranteed after-tax inflow at the after-tax riskless interest rate.

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21.6 NPV Analysis of the Lease-vs.-Buy Decision• A lease payment is like the debt service on a secured bond

issued by the lessee.• In the real world, many companies discount both the

depreciation tax shields and the lease payments at the after-tax interest rate on secured debt issued by the lessee.

• The various tax shields could be riskier than lease payments for two reasons:

1. The value of the CCA tax benefits depends on the firm’s ability to generate enough taxable income.

2. The corporate tax rate may change.

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NPV Analysis of the Lease-vs.-Buy Decision

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NPV Buying Instead of Leasing Year 0 Years 1-5

-$25,000 $4,670 – $1,155 = $5,825

• There is a simple method for evaluating leases: discount all cash flows at the after-tax interest rate on secured debt issued by the lessee. Suppose that rate is 5-percent.

NPV Leasing Instead of BuyingYear 0 Years 1-5$25,000 –$1,155 – $4,670 = -$5,825

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21.7 Debt Displacement and Lease Valuation

• Considering the issues of debt displacement allows for a more intuitive understanding of the lease versus buy decision.

• Leases displace debt—this is a hidden cost of leasing. If a firm leases, it will not use as much regular debt as it would otherwise. – The interest tax shield will be lost.

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• The debt displaced by leasing results in forgone interest tax shields on the debt that ClumZee movers didn’t go into when they leased instead of bought the truck.

• Suppose ClumZee agrees to a lease payment of $6,250 before tax. This payment would support a loan of $25,219.20 (see the next slide)

• In exchange for this, they get the use of a truck worth $25,000.

• Clearly the NPV is a negative $219.20, which agrees with our earlier calculations.

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Suppose ClumZee agrees to a lease payment of $6,250 before tax. This payment would support a loan of $25,219.20

0 1 2 3 4 5Outstanding Balance of the Loan $25,219.20 $20,655.16 $15,862.92 $10,831.07 $5,547.62 $0.00Interest $1,910.55 $1,564.78 $1,201.74 $820.54 $420.27Tax Deduction on interest $649.59 $532.03 $408.59 $278.98 $142.89After-tax Interest Expense $1,260.96 $1,032.76 $793.15 $541.55 $277.38Extra Cash that purchasing firm genereates over leasing firm 5,825.00$ 5,825.00$ 5,825.00$ 5,825.00$ 5,825.00$

05.020.219,25$96.260,1$

After-Tax Lease Payments –6,250×(1-.34) = –$4,125Forgone Depreciation Tax Shield – 5,000×(.34) = –$1,700

-$5,825 Calculate the increase in debt capacity by discounting the

difference between the cash flows of the purchase and the cash flows of the lease by the after-tax interest rate.

96.260,1$.825,5$20.219,25$16.655,20$

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21.8 Does Leasing Ever Pay: The Base Case

• In the above example, ClumZee Movers chose to buy, because the NPV of leasing was a negative $219.20

• Note that this is the opposite of the NPV that Tiger Leasing would have:

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• Cash Flows: Tiger LeasingYear 0 Years 1-5

Cost of truck –$25,000

Depreciation Tax Shield 5,000×(.34) = $1,700

Lease Payments 6,250×(1-.34) = $4,125

–$25,000 $5,825

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21.9 Reasons for Leasing

• Good Reasons– Taxes may be reduced by leasing.– The lease contract may reduce certain types of

uncertainty.– Transactions costs can be higher for buying an asset and

financing it with debt or equity than for leasing the asset.• Bad Reasons

– Leasing and accounting income– 100% financing

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A Tax Arbitrage

• Suppose ClumZee movers is actually in the 25% tax bracket and Tiger Leasing is in the 34% tax bracket. If Tiger reduces the lease payment to $6,200, can both firms have a positive NPV?


Cost of truck –$25,000Depreciation Tax Shield 5,000×(.34) = $1,700Lease Payments 6,200×(1 –.34) = $4,092

–$25,000 $5,792NPV = 76.33• Cash Flows ClumZee Movers: Leasing Instead of Buying

Year 0 Years 1-5Cost of truck we didn’t buy $25,000Lost Depreciation Tax Shield 5,000×(.25) = –$1,250After-Tax Lease Payments 6,200×(1 –.25) = –$4,650

$25,000 –$5,900NPV = -$543.91

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Reservations and Negotiations

• What is the smallest lease payment that Tiger Leasing will accept? Set their NPV to zero and solve for $Lmin:


Cost of truck -$25,000Depreciation Tax Shield 5,000×(.34) = $1,700Lease Payments $Lmin ×(1 –.34) = $Lmin × .66

-$25,000 $1,700 + $Lmin × .66

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Reservations and Negotiations

• What is the highest lease payment that ClumZee Movers can pay? Set their NPV to zero and solve for $Lmax:

• Cash Flows ClumZee Movers: Leasing Instead of BuyingYear 0 Years 1-5

Cost of truck we didn’t buy $25,000Lost Depreciation Tax Shield 5,000×(.25) = – $1,250After-Tax Lease Payments – $Lmax×( 1 –.25) = .75× Lmax

$25,000 – 1,250 – .75× Lmax

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49.032,6$max LNo lease is possible: Lmin > Lmax

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21.10 Some Unanswered Questions

• Are the Uses of Leases and of Debt Complementary?• Why are Leases offered by Both Manufacturers and Third

Party Lessors?– For manufacturer lessors, the basis for determining

capital cost allowance is the manufacturer’s cost.– For third party lessors, the basis is the sale price that the

lessor paid to the manufacturer.• Why are Some Assets Leased More than Others?

– The more sensitive is the value of an asset to use and maintenance decisions, the more likely it is that the asset will be purchased instead of leased.

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21.11 Summary and Conclusions

• There are three ways to value a lease.1. Use the real-world convention of discounting the

incremental after-tax cash flows at the lessor’s after-tax rate on secured debt.

2. Calculate the increase in debt capacity by discounting the difference between the cash flows of the purchase and the cash flows of the lease by the after-tax interest rate. The increase in debt capacity from a purchase is compared to the extra outflow at year 0 from a purchase.

3. Use APV (presented in the appendix to this chapter).• They all yield the same answer.• The easiest way is the least intuitive.

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Appendix 21A: APV Approach to Leasing

APV = All-Equity Value + Financing NPV

Calculations shown on the following slides will show that for the latest Clumzee Movers example (tax rate is 25%)

APV = $591.38 – $1,135.30

APV = –$543.91

Which is the same value as the easier NPV analysis.

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APV = All-Equity Value + Financing NPV• To find the all-equity value, discount the cash flows at the

pre-tax interest rate. The after-tax rate was 5% which implies a pretax rate of

6.66% = 5%/(1-.25).

38.591$)06667.1(

900,5$000,25$ueequity val-All5

1

t

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Cash Flows ClumZee Movers: Leasing Instead of BuyingYear 0 Years 1-5

Cost of truck we didn’t buy $25,000

Lost Depreciation Tax Shield 5,000×(.25) = –$1,250

After-Tax Lease Payments 6,200×(1 –.25) = –$4,650

$25,000 –$5,900

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APV = All-Equity Value + Financing NPV• The NPV of the financing is the forgone interest tax shields

on the debt that ClumZee movers didn’t go into when they leased instead of bought the truck.

• ClumZee agreed to a lease payment of $5,900.• This payment would support a loan of $25,543.91

5

1 )05.1(900,5$91.543,25$capacitydebt Increased

tt

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5432 )06667.1(65.93$

)06667.1(84.182$

)06667.1(79.267$

)06667.1(69.348$

)06667.1(73.425$30.135,1$

91.543$30.135,1$38.591$ APV

The lost interest tax shield associated with this additional debt capacity of $25,543.91 has a present value of $1,135.30

0 1 2 3 4 5Outstanding Balance of the Loan $25,543.91 $20,921.11 $16,067.16 $10,970.52 $5,619.05 $0.00Interest $1,702.93 $1,394.74 $1,071.14 $731.37 $374.60Tax Deduction on interest $425.73 $348.69 $267.79 $182.84 $93.65After-tax Interest Expense $1,277.20 $1,046.06 $803.36 $548.53 $280.95

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5432 )06667.1(65.93$

)06667.1(84.182$

)06667.1(79.267$

)06667.1(69.348$

)06667.1(73.425$30.135,1$

91.543$30.135,1$38.591$ APV

The lost interest tax shield associated with this additional debt capacity of $25,219.20 has a present value of $

0 1 2 3 4 5Outstanding Balance of the Loan $25,219.20 $20,655.16 $15,862.92 $10,831.07 $5,547.62 $0.00Interest $1,910.55 $1,564.78 $1,201.74 $820.54 $420.27Tax Deduction on interest $649.59 $532.03 $408.59 $278.98 $142.89After-tax Interest Expense $1,260.96 $1,032.76 $793.15 $541.55 $277.38Extra Cash that purchasing firm genereates over leasing firm 5,825.00$ 5,825.00$ 5,825.00$ 5,825.00$ 5,825.00$

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