Principles of Corporate Finance Brealey and Myers Sixth Edition Leasing Slides by Matthew Will Irwin/McGraw Hill Chapter 25 ©The McGraw-Hill Companies, Inc., 200 25- Topics Covered What is a Lease? Why Lease? Operating Leases Valuing Financial Leases When Do Financial Leases Pay? Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 25- Lease Terms Operating Leases Financial Leases Rental Lease Net lease Direct lease Leveraged lease Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 25- Why Lease? Sensible Reasons for Leasing Short-term leases are convenient Cancellation options are valuable Maintenance is provided Standardization leads to low costs Tax shields can be used Avoiding the alternative minimum tax Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 25- Why Lease? Dubious Reasons for Leasing Leasing avoids capital expenditure controls Leasing preserves capital Leases may be off balance sheet financing Leasing effects book income Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 25- Operating Lease Example Acme Limo has a client who will sign a lease for years, with lease payments due at the start of each year The following table shows the NPV of the limo if Acme purchases the new limo for $75,000 and leases it our for years Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 25- Operating Lease Example - cont Acme Limo has a client who will sign a lease for years, with lease payments due at the start of each year The following table shows the NPV of the limo if Acme purchases the new limo for $75,000 and leases it our for years Initial cost Maintenance, insurance, selling, and administrative costs Tax shield on costs Depreciation tax shield Total NPV @ 7% = - $98.15 Break even rent(level) Tax Break even rent after-tax NPV @ 7% = - $98.15 Irwin/McGraw Hill Year -75 -12 -12 -12 -12 -12 -12 -12 4.2 -82.8 4.2 5.25 -2.55 4.2 8.4 0.6 4.2 5.04 -2.76 4.2 3.02 -4.78 4.2 3.02 -4.78 4.2 1.51 -6.29 26.18 -9.16 17.02 26.18 -9.16 17.02 26.18 -9.16 17.02 26.18 -9.16 17.02 26.18 -9.16 17.02 26.18 -9.16 17.02 26.18 -9.16 17.02 ©The McGraw-Hill Companies, Inc., 200 25- Financial Leases Example Greymore Bus Lines is considering a lease Your operating manager wants to buy a new bus for $100,000 The bus has an year life The bus saleswoman says she will lease Greymore the bus for years at $16,900 per year, but Greymore assumes all operating and maintenance costs Should Greymore buy or lease the bus? Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 25- Financial Leases Example - cont Greymore Bus Lines is considering a lease Your operating manager wants to buy a new bus for $100,000 The bus has an year life The bus saleswoman says she will lease Greymore the bus for years at $16,900 per year, but Greymore assumes all operating and maintenance costs Should Greymore buy or lease the bus? Cash flow consequences of the lease contract to Greymore Cost of new bus Lost Depr tax shield Lease payment Tax shield of lease Cash flow of lease Irwin/McGraw Hill (7.00) (16.90) 5.92 (17.98) (11.20) (16.90) 5.92 (22.18) Year (4.03) (16.90) 5.92 (15.01) (4.03) (16.90) 5.92 (15.01) (2.02) (16.90) 5.92 (13.00) (16.90) 5.92 (10.98) 100.00 (16.90) 5.92 89.02 (6.72) (16.90) 5.92 (17.70) ©The McGraw-Hill Companies, Inc., 200 25- 10 Financial Leases Example - cont Greymore Bus Lines is considering a lease Your operating manager wants to buy a new bus for $100,000 The bus has an year life The bus saleswoman says she will lease Greymore the bus for years at $16,900 per year, but Greymore assumes all operating and maintenance costs Should Greymore buy or lease the bus? Cash flow consequences of the lease contract to Greymore: •Greymore saves the $100,000 cost of the bus •Loss of depreciation benefit of owning the bus •$16,900 lease payment is due at the start of each year •Lease payments are tax deductible Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 25- 11 Financial Leases Example - cont Greymore Bus Lines Balance Sheet without lease Equivalent lease balance sheet Greymore Bus Lines (figures in $1,000s) Bus 10 100 Loan secured by bus All other assets 1000 450 Other loans 550 Equity Toital Assets 1100 1100 Total liabilities Greymore Bus Lines (figures in $1,000s) Bus 10 100 Financial lease All other assets 1000 450 Other loans 550 Equity Toital Assets 1100 1100 Total liabilities Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 25- 12 Financial Leases Example - cont Greymore Bus Lines can borrow at 10%, thus the value of the lease should be discounted at 6.5% or 10 x (1-.35) The result will tell us if Greymore should lease or buy the bus Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 25- 13 Financial Leases Example - cont Greymore Bus Lines can borrow at 10%, thus the value of the lease should be discounted at 6.5% or 10 x (1-.35) The result will tell us if Greymore should lease or buy the bus 17.99 22.19 17.71 15.02 NPV lease = 89.02 1.065 (1.065) (1.065) (1.065) 15.02 13.00 10.98 (1.065) (1.065) (1.065) = −.70 or - $700 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 25- 14 Financial Leases Example - cont Greymore Bus Lines lease cash flows can also be thought of as loan equivalent cash flows Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 25- 15 Financial Leases Example - cont Greymore Bus Lines lease cash flows can also be thought of as loan equivalent cash flows Amount borrowed at year end Interest paid @ 10% Tax shield @ 35% Interest paid after tax Principal repaid Net cash flow of equivalent loan Irwin/McGraw Hill Year 89.72 77.56 -8.97 3.14 -5.83 -12.15 60.42 -7.76 2.71 -5.04 -17.14 46.64 -6.04 2.11 -3.93 -13.78 34.66 -4.66 1.63 -3.03 -11.99 21.89 -3.47 1.21 -2.25 -12.76 10.31 -2.19 0.77 -1.42 -11.58 0.00 -1.03 0.36 -0.67 -10.31 89.72 -17.99 -22.19 -17.71 -15.02 -15.02 -13.00 -10.98 ©The McGraw-Hill Companies, Inc., 200 25- 16 Financial Leases Example - cont The Greymore Bus Lines lease cash flows can also be treated as a favorable financing alternative and valued using APV APV = NPV of project NPV of lease APV = -5,000 + 8,000 = $3,000 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 ... consequences of the lease contract to Greymore: •Greymore saves the $100,000 cost of the bus •Loss of depreciation benefit of owning the bus •$16,900 lease payment is due at the start of each year... lease the bus? Cash flow consequences of the lease contract to Greymore Cost of new bus Lost Depr tax shield Lease payment Tax shield of lease Cash flow of lease Irwin/McGraw Hill (7.00) (16.90)... Companies, Inc., 200 25- Operating Lease Example Acme Limo has a client who will sign a lease for years, with lease payments due at the start of each year The following table shows the NPV of the limo