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Chapter 27 Leasing McGraw-Hill/Irwin Copyright © 2010 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 [...]... comparable 27- 15 Quick Quiz • What is the difference between a lessee and a lessor? • What is the difference between an operating lease and a capital lease? • What are the requirements for a lease to be tax deductible? • What are typical incremental cash flows, and how do you determine the net advantage to leasing? • What are some good reasons for leasing? • What are some dubious reasons for leasing? 27- 16... $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... 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,... 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... Ethics Issues • Suppose a manager chooses to lease an asset (operating lease) rather than buy, simply to keep the asset off-balance sheet and thereby avoid reporting the liability? – Although this may be legal, is there any ethical implication? – Are investors able to effectively monitor and analyze such activity? 27- 17 Comprehensive Problem • What is the net advantage to leasing for the following project,... purchased – It would be depreciated straight-line to zero salvage over 5 years – Alternatively, it may be leased for $65,000/yr – The firm’s after-tax cost of debt is 6%, and its tax rate is 40% 27- 18 End of Chapter 27- 19 . 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. and how do you determine the net advantage to leasing? • What are some good reasons for leasing? • What are some dubious reasons for leasing? 27- 16 Ethics Issues • Suppose a manager chooses
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