21-1 CHAPTER 21 Introduction to Corporate Finance McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 21-2 Chapter Outline 21.1 21.2 21.3 21.4 21.5 21.6 21.7 21.8 21.9 21.10 21.11 Types of Leases Accounting and Leasing Taxes, the IRS, and Leases The Cash Flows of Leasing A Detour on Discounting and Debt Capacity with Corporate Taxes NPV Analysis of the Lease-versus-Buy Decision Debt Displacement and Lease Valuation Does Leasing Ever Pay: The Base Case Reasons for Leasing Some Unanswered Questions Summary and Conclusions McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 21-3 21.1 Types of Leases The Basics A lease is a contractual agreement between a lessee and lessor The lessor owns the asset and for a fee allows the lessee to use the asset McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 21-4 Buying versus Leasing Buy Lease Firm U buys asset and uses asset; financed by debt and equity Lessor buys asset, Firm U leases it Manufacturer of asset Manufacturer of asset Firm U Lessor Uses asset Owns asset Equity shareholders McGraw-Hill/Irwin Corporate Finance, 7/e Creditors Owns asset Lessee (Firm U) Uses asset Does not use asset Does not own asset Equity shareholders Creditors © 2005 The McGraw-Hill Companies, Inc All Rights 21-5 Operating Leases Usually not fully amortized Usually require the lessor to maintain and insure the asset Lessee enjoys a cancellation option McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 21-6 Financial Leases The exact opposite of an operating lease Do not provide for maintenance or service by the lessor Financial leases are fully amortized The lessee usually has a right to renew the lease at expiry Generally, financial leases cannot be cancelled McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 21-7 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 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 21-8 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 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 21-9 Leveraged Leases Lessor buys asset, Firm U leases it Manufacturer of asset Lessor Owns asset Does not use asset Equity shareholders McGraw-Hill/Irwin Corporate Finance, 7/e Lessor borrows from lender to partially finance purchase The lenders typically use a nonrecourse loan This means that the lessor is not Lessee (Firm U) obligated to the lender in case of a default by the Uses asset lessee Does not own asset In the event of a default by the lessor, the lender has a first lien on the asset Also the lease payments are Creditors made directly to the lender after a default © 2005 The McGraw-Hill Companies, Inc All Rights 10 21.2 Accounting and Leasing In the old days, leases led to off-balance-sheet financing Today, leases are either classified as capital leases or operating leases Operating leases not appear on the balance sheet Capital leases appear on the balance sheet—the present value of the lease payments appears on both sides McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 21 NPV Analysis of the Lease-vs.-Buy Decision 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 percent NPV Buying Instead of Leasing Year Years 1-5 – $25,000 $4,670 – $1,155 = $5,825 CF0 –$25,000 CF1 $5,825 F1 McGraw-Hill/Irwin Corporate Finance, 7/e I NPV $219.20 © 2005 The McGraw-Hill Companies, Inc All Rights 22 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 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 23 21.7 Debt Displacement and Lease Valuation 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 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 24 21.7 Debt Displacement and Lease Valuation Suppose ClumZee agrees to a lease payment of $6,250 before tax This payment would support a loan of $25,219.20 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 After-Tax Lease Payments –6,250×(1 –.34) = –$4,125 Forgone Depreciation Tax Shield –5,000×(.34) = –$1,700 –$5,825 N I/Yr 5 McGraw-Hill/Irwin Corporate Finance, 7/e PV PMT FV $25,219.20 –$5,825 © 2005 The McGraw-Hill Companies, Inc All Rights 25 21.7 Debt Displacement and Lease Valuation Suppose ClumZee agrees to a lease payment of $6,250 before tax This payment would support a loan of $25,219.20 $25,219 $20,655 $15,862 $10,831 $5,547 $0.00 $1,910 $1,565 $1,202 $821 $420 Tax Deduction on interest $650 $532 $409 $279 $143 After-tax Interest Expense $1,261 $1,033 $793 $542 $277 Year Outstanding Loan Balance Interest Extra Cash that purchasing firm generates over leasing firm $5,825 $5,825 $5,825 $5,825 $5,825 $1,260.96 $25,219.20 0.05 $20,655.16 $25,219.20 $5,825 $1,260.96 After-Tax Lease Payments Forgone Depreciation Tax Shield McGraw-Hill/Irwin Corporate Finance, 7/e –6,250×(1 –.34) = $4,125 5,000ì(.34) = $1,700 $5,825 â 2005 The McGraw-Hill Companies, Inc All Rights 26 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: Cash Flows: Tiger Leasing Year Cost of truck Depreciation Tax Shield Lease Payments Years 1–5 –$25,000 –$25,000 CF0 –$25,000 CF1 $5,825 McGraw-Hill/Irwin Corporate Finance, 7/e 5,000×(.34) = $1,700 6,250×(1-.34) = $4,125 $5,825 I F1 NPV $219.20 © 2005 The McGraw-Hill Companies, Inc All Rights 27 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 Accounting McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 28 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? Cash Flows: Tiger Leasing Year Years 1-5 Cost of truck –$25,000 Depreciation Tax Shield 5,000×(.34) = Lease Payments 6,200×(1 –.34) = $4,092 –$25,000 $5,792 $1,700 NPV = 76.33 Cash Flows ClumZee Movers: Leasing Instead of Buying Year Years 1-5 Cost of truck we didn’t buy Lost Depreciation Tax Shield After-Tax Lease Payments $25,000 –$5,900 NPV = -$543.91 McGraw-Hill/Irwin Corporate Finance, 7/e $25,000 5,000ì(.25) = 6,200ì(1 .25) = $1,250 $4,650 â 2005 The McGraw-Hill Companies, Inc All Rights 29 Tiger Leasing’s Break-even Payment What is the smallest lease payment that Tiger Leasing will accept? Set their NPV to zero and solve for $Lmin: Cash Flows: Tiger Leasing Cost of truck Depreciation Tax Shield Lease Payments Year -$25,000 Years 1-5 5,000×(.34) = $1,700 $Lmin $Lmin × (1 –.34) = × (1 –.34) $1,700 + $Lmin × (1 –.34) -$25,000 NPV 0 $25,000 66 Lmin $1,700 (1.05)t t 1 $1 $1,700 $25,000 .66 Lmin t t ( 05 ) t t 1 (1.05) McGraw-Hill/Irwin Corporate Finance, 7/e $25,000 Lmin 700 $(11.,05 ) t 1 t $1 66 t t 1 (1.05) Lmin $6,173.29 © 2005 The McGraw-Hill Companies, Inc All Rights 30 Tiger Leasing’s Break-even Payment Step one is to find the after-tax cost of the truck Step two is to find the after-tax payment required Step One Step Two CF0 −25,000 N CF1 $1,700 I/Yr F1 PV − $17,639.89 I PMT $4,074.37 NPV McGraw-Hill/Irwin Corporate Finance, 7/e −$17,639.89 FV This is $6,173.29 on a pre-tax basis © 2005 The McGraw-Hill Companies, Inc All Rights 31 ClumZee Mover’s Break-even Payment 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 Buying Year Cost of truck we didn’t buy $25,000 Lost Depreciation Tax Shield After-Tax Lease Payments Years 1-5 5,000×(.25) = – $1,250 – $Lmax ×( –.25) = 75× Lmax – 1,250 – 75× Lmax $25,000 5 75Lmax $1,250 NPV 0 $25,000 t (1.05) t 1 5 75Lmax $1,250 $25,000 t t (1.05) t 1 t 1 (1.05) No lease is possible: Lmin > Lmax McGraw-Hill/Irwin Corporate Finance, 7/e $25,000 Lmax 250 $(11.,05 ) t t 1 (1 75 05) t 1 t Lmax $6,032.49 © 2005 The McGraw-Hill Companies, Inc All Rights 32 ClumZee Mover’s Break-even Payment Step one is to find the after-tax cost of the truck Step two is to find the after-tax payment required Step One Step Two CF0 −25,000 N CF1 $1,250 I/Yr F1 PV − $19,588.15 I PMT $4,524.37 NPV McGraw-Hill/Irwin Corporate Finance, 7/e −$19,588.15 FV This is $6,032.49 on a pre-tax basis © 2005 The McGraw-Hill Companies, Inc All Rights 33 The most that ClumZee movers can afford to pay is $6,032.49 The least that Tiger Leasing can accept is $6,173.29 So there won’t be a lease in this case McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 34 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? Why are Some Assets Leased More than Others? McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 35 21.11 Summary and Conclusions There are three ways to value a lease Use the real-world convention of discounting the incremental after-tax cash flows at the lessors after-tax rate on secured debt 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 from a purchase Use APV (presented in the appendix to this chapter) They all yield the same answer The easiest way is the least intuitive McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights ... asset McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 21-4 Buying versus Leasing Buy Lease Firm U buys asset and uses asset; financed by debt and equity... 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 McGraw-Hill/Irwin Corporate Finance, ... Owns asset Does not use asset Equity shareholders McGraw-Hill/Irwin Corporate Finance, 7/e Lessor borrows from lender to partially finance purchase The lenders typically use a nonrecourse loan This