Chapter 27 Leasing McGraw Hill Irwin Copyright 2013 by The McGraw Hill Companies Inc All rights reserved Key Concepts and Skills Understand basic lease terminology Understand the criteria for a capital lease vs an operating lease Understand the typical incremental cash flows to leasing Be able to compute the net advantage to leasing Understand the good reasons for leasing and the dubious reasons for leasing 27 2 Chapter Outline Leases and Lease Types Accounting and Leasing Taxes the IRS and Leases The Cash Flows from Leasing Lease or Buy A Leasing Paradox Reasons for Leasing 27 3 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 4 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 5 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 27 6 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 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 27 7 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 a below market price 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 8 Incremental Cash Flows Cash flows from the lessee s 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 9 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 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 10 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 company s debt 27 11 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 3 116 Should the firm buy or lease 27 12 Work the Web Example Many people must choose between buying and leasing a car Click on the web surfer to go to Kiplinger s Go to Tools Calculators Cars Do the calculations for a 30 000 car 5 year loan at 7 with monthly payments and a 3 000 down payment The available lease is for 3 years and requires a 550 per month payment with a 1 000 security deposit and 1 000 other upfront costs 27 13 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 14 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 15 Quick Quiz What is the difference between a lessee and a