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Leasing and Other
Asset-Based
Financing
Corporate Financial Management 3e
Emery Finnerty StoweModified for course use by Arnold R. Cowan
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Lease Financing
A lease is a rental agreement that extends for one
year or longer.
The owner of the asset (the lessor) grantsexclusive use of the asset to the lessee for a fixed
period of time.
In return, the lessee makes fixed periodic payments to
the lessor.
At termination, the lessee may have the option to
either renew the lease or purchase the asset.
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Types of Leases
Full-service lease
Lessor responsible for maintenance, insurance,
and property taxes.Net lease
Lessee responsible for maintenance, insurance,
and property taxes.
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Types of Leases
Operating lease
short-term
may be cancelable
Financial lease
long-term
similar to a loan agreement
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Types of Lease Financing
Direct leases
Sale-and-lease-back agreements
Leveraged leases
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Direct Lease
LesseeManufacturer
/ LessorLease
Lessee LessorLease Sale of AssetManufacturer
/ Lessor
or
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Sale-and-Lease-Back
Sale of Asset
Lease
Lessee Lessor
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Leveraged Lease
LenderLien
Equity
Investor
LesseeLease
Single
Purpose
Leasing
Company
ManufacturerSaleofA
sset
Equity
Loan
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Synthetic Leases
Firms have used synthetic leases to get theuse of assets but keep debt off their balance
sheets.An unrelated financial institution investssome equity and sets up a special-purpose-entity that buys the assets and leases it to
the firm under an operating lease.Since the Enron bankruptcy, firms havebeen reluctant to use synthetic leases.
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Enrons Murky Deals
Lending
Group
Equity
Investor
Enron
Partnership
or Special
PurposeEntity
Enron used outside
partnerships to move assets
off its balance sheet and
monetize assets. But the
company was deeplyinvolved with funding
those partnerships.
Enron sells assets, gets
debt off the balance
sheet and recognizes a
gain on the sale.
Outside investors inject
at least 3% of the
funding so that Enron
doesnt have to claim it
as a subsidiary.
1
3Enron provided some or
all of the 3%.
Banks provided the
other 97% of thefinancing.
45Enron guarantees the loan.
Sometimes with now-
worthless Enron shares.
2
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Enrons Partnerships
As a result, any debt incurred by thepartnership could be kept off the company's
balance sheet.As an added bonus, Enron often recognizeda gain on the sale of the assets.
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Why did Enron want debt off their
balance sheet?
The simple answer is that Enron feared that
too much debt would damage its credit
rating.
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Why did Enron want debt off their
balance sheet?
A more complex answer lies with agency costs.
Enron executives headed and partly owned
some of the partnerships, which provided a hugesource of outside income for those involved.
Enrons former CFO, Andrew Fastow, made more
than $30 million from two partnerships that he ran.
If you were a shareholder in a SPE buying an
asset from your employer, where would your
loyalties lie?
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How Widespread Was This at Enron?
There were hundreds, and perhaps even
thousands, of these partnerships.
The exact number isn't known.In all, Enron had about 3,500 subsidiaries
and affiliates, many of them limited
partnerships and limited-liabilitycompanies, which are a sort of hybrid
between corporations and partnerships.
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How Did They Get Away With It?
The company and its board of directors
claimed that allowing executives to be
involved with the outside partnerships gaveit the advantage of speed.
Enron claimed that it set up safeguards to
protect itself, but in retrospect they wereclearly inadequate.
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Advantages of Leases
Efficient use of tax deductions and tax credits ofownership
Reduced risk
Reduced cost of borrowing
Bankruptcy considerations
Tapping new sources of funds
Circumventing restrictions debt covenants
off-balance sheet financing
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Disadvantages of Leasing
Lessee forfeits tax deductions associated
with asset ownership.
Lessee usually forgoes residual asset value.
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Valuing Financial Leases
Basic approach is similar to debt refunding.
Lease displaces debt.
Missed lease payments can result in the lessor claiming the asset.
filing lawsuits.
forcing firm into bankruptcy.
Risk of a firms lease payments are similar to
those of its interest and principal payments.
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Equivalent Ways to Analyze
Net Advantage to Leasing (NAL) approach:
Lease if
NAL > 0.The Internal Rate of Return (IRR) approach:
Lease if
IRR of leasing < after-tax cost of debtfinancing.
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Leases Analysis Example
The Emerson Co. needs the use of a special
purpose stamping machine for the next 10
years.The machine costs $6 million, has a life of
10 years, and a salvage value of $300,000.
Emerson can lease this machine from theGeneral Supply Co. for 10 years, with annual
year-end lease payments of $1.05 million.
Emersons tax rate is 40%.
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Leases Analysis Example
If Emerson were to buy the machine, it
would finance 80% of the purchase price with
a 11.5% secured installment loan, with theremainder being borrowed as unsecured
installment debt at 14% interest.
The after-tax required return on the asset is15%.
Evaluate this leasing opportunity.
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Leasing Displaces Borrowing
Suppose initially that the Emerson Co. has net
assets worth $50 million, and a debt ratio of
50%. Compute the debt ratio if Emerson uses:
Conventional financing for the stamping
machine.
Leases the stamping machine. How
would the target debt ratio be restored?
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Leasing Displaces Borrowing
InitialCapitalization
Conventional Debt
Financial LeaseObligation
Total Debt
EquityTotal
$ 25 M
$ 0 M$25 M
$25 M$50 M
Debt Ratio 50%
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Leasing Displaces Borrowing
ConventionalFinancing
Conventional Debt
Financial LeaseObligation
Total Debt
EquityTotal
$ 28 M
$ 0 M$25 M
$28 M$56 M
Debt Ratio 50%
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Leasing Displaces Borrowing
LeaseFinancing
Conventional Debt
Financial LeaseObligation
Total Debt
EquityTotal
$ 2 5 M
$ 6 M$ 31 M
$25 M$56 M
Debt Ratio 5 5.36%
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Leasing Displaces Borrowing
Debt RatioRestored
Conventional Debt
Financial LeaseObligation
Total Debt
EquityTotal
$ 22 M
$ 6 M$28 M
$28 M$56 M
Debt Ratio 50%
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Analyzing Leases
TheNet Advantage to Leasing(NAL)
equals the purchase price (P) minus the
present value of the incremental after-taxcash flows (CFAT) associated with the
lease.
NAL =PPV(CFATs)
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Analyzing Leases - the Discount
Rate
The discount rate should be the lessees after-taxcost of similarly secured debt.
Since the lease obligation is not overcollateralized,
the secured debt rate should reflect this.
Fully secured means the asset is worth more than25% of the loan.
$80M loan on $100M asset: $20/$80 = 25%
Use weighted average of secured and unsecureddebt rates if necessary.
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Analyzing Leases - the Cash Flows
Cost of asset (saving)
Lease payments (cost)
Incremental differences in operating andother expenses (cost or savings)
Depreciation tax shelter (foregone benefit)
Expected net residual value (foregone
benefit)
Investment tax credits (foregone benefit)
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Net Advantage to LeasingD
t = yeartdepreciation deduction
DEt= yeartcash expense savings from leasing
ITC = investment tax credit, if available
CFt= lease payment in yeart
N = life of lease (in years)P = purchase price of asset
r = assets after-tax required return
r = cost of debt (secured & unsecured)Salvage = net salvage valueT = lessees marginal income tax rate
'1
(1 )( )
(1 (1 ) ) (1 )
Nt t t
t Nt
T CF E TD SalvageNAL P ITC
T r r
D
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Net Advantage to Leasing
We save paying the purchase priceP.We lose the ITC and salvage value.
We pay the lease payment CF; this may be partlyoffset by savings on operating and other cash
expenses (E) and by tax deductibility.We lose the depreciation tax shield TD.
Discount main cash flows at the after-tax cost ofdebt.
'1
(1 )( )(1 (1 ) ) (1 )
N t t t
t Nt
T CF E TD SalvageNAL P ITCT r r
D
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Net Advantage to Leasing
For the Emerson Co.,
P= $6 million
CFt= $1.05 million per year for 10 yearsD
t= ($6,000,000 - $300,000) / 10 = $570,000
per year for 10 years
DEt= 0,ITC= 0 r= 15%
r = 80%(11.5%) + 20%(14%) = 12.0%
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Net Advantage to Leasing
'1
(1 )( )
(1 (1 ) ) (1 )
Nt t t
t Nt
T CF E TD SalvageNAL P ITC
T r r
D
10
10
1 )15.1(
000,300$
)12.0)40.01(1(
000,570$4.0)05.1)($40.1(6$
tt
mmNAL
068,45$NAL
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The IRR Approach
For Emersons leasing opportunity, the IRR
is 7.58%.
The after-tax cost of debt financing is12%(10.40) = 7.20%.
Since the IRR (the cost of lease financing)
is greater than the after-tax cost of debtfinancing, Emerson should not lease the
machine.
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Break-Even Lease Payments
The break-even lease payments can be
computed by setting the NAL to zero.
In the case of Emersons lease, the annualbreak-even payments are $1,039,206.
Since the lease contract calls for payments of
$1,050,000; the leasing alternative is notpreferred.
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NPV of Lease to the Lessor
In a perfect market with no tax, leasing is a
zero-sum game.
The NPV of the lease to the lessor will be- (NAL to the lessee).
If lessee and lessor have the same marginal
income tax rates, leasing is still a zero sumgame in an otherwise perfect market.
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NPV of Lease to the Lessor
where T= lessors marginal income tax rate.
' '
Lessor ' '
1
(1 )( )
(1 (1 ) ) (1 )
Nt t t
t N
t
T CF E T D SalvageNAL P ITC
T r r
D
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NPV of Lease to the Lessor
10
10
1
Lessor)15.1(
000,300$
)12.0)40.01(1(
000,570$4.0)05.1)($40.1(6$
tt
mmNAL
068,45$Lessor NAL
' '
Lessor ' '1
(1 )( )
(1 (1 ) ) (1 )
Nt t t
t Nt
T CF E T D SalvageNAL P ITC
T r r
D
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Effect of Tax Asymmetries
Suppose lessees (Emersons) tax rate is
zero. Also assume that the before-tax
required return on the asset for the lessee is17.50%.
The NAL to Emerson is then $7,460.
The NPV to the lessor is still $45,068.Thus, both parties gain from the leasing
arrangement.
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Tax Treatment of Financial Leases
IRS has guidelines for distinguishing
between true leases and
installment sales agreements. secured loans.
If lessor meets these guidelines:
lessor can claim tax deductions and credits ofasset ownership.
lessee can deduct full amount of lease payment
for tax purposes.
id li f i i l
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IRS Guidelines for Financial
Leases
Term of lease < 80% of assets useful life.
Lessor must maintain an equity investment ofat least 10% of assets original cost.
Exercise price of the purchase option mustequal the assets fair market value at the timethe option is exercised.
Lessee does not pay any portion of the assetspurchase price.
Lessor must hold title to the property.
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Accounting Treatment of Financial
Leases
SFAS 13 requires lessees to capitalize all leases
that meet any one of the following:
Lease transfers ownership of asset to lessee beforethe lease expires.
Lessee has option to purchase asset at a bargain
price.
Term of lease is greater than or equal to 75% of
assets useful economic life.
PV of lease payments is 90% of asset value.
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Project Financing
Desirable when
Project can stand alone as an economic unit.
Project will generate enough revenue (net ofoperating costs) to service project debt.
Examples:
Mines & mineral processing facilities Pipelines
Oil refineries
Paper mills
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Project Financing Arrangements
Completion undertaking
Purchase, throughput, or tolling agreements
Cash deficiency agreements
Ad d Di d f
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Advantages and Disadvantages of
Project Financing
Advantages
Risk sharing
Expanded debt capacity Lower cost of debt
Disadvantages
Significant transaction costs and legal fees
Complex contractual agreements
Lenders require a higher yield premium
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Limited Partnership Financing
Another form of tax-oriented financing.
Allows the firm to sell the tax deductions
and credits associated with asset ownershipto the limited partners.
Income (or loss) for tax purposes flowsthrough to the partners.
Limited partners are passive investors.
General partner operates the limitedpartnership and has unlimited liability.