Leasing - Leasing - Lecture Notes, Study notes of Finance

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LEASING

548 APPENDIX B

(^1) In addition to arranging financing for asset users, captive finance companies (or subsidiaries) may purchase their parent company’s accounts receivable. General Motors Acceptance Corporation (GMAC) and General Electric (GE) Capital are examples of captive finance companies.

LEASING VERSUS BUYING

As far as the lessee is concerned, it is the use of the asset that is important, not neces- sarily who has title to it. One way to obtain the use of an asset is to lease it. Another way is to obtain outside financing and buy it. Thus, the decision to lease or buy amounts to a comparison of alternative financing arrangements for the use of an asset. Figure B.1 compares leasing and buying. The lessee, Sass Company, might be a hos- pital, a law firm, or any other firm that uses computers. The lessor is an independent leasing company that purchased the computer from a manufacturer such as Hewlett- Packard (HP). Leases of this type, in which the leasing company purchases the asset from the manufacturer, are called direct leases. Of course, HP might choose to lease its own computers, and many companies, including HP and some of the other companies mentioned previously, have set up wholly owned subsidiaries called captive finance companies to lease out their products.^1 As shown in Figure B.1, whether it leases or buys, Sass Company ends up using the asset. The key difference is that in one case (buy), Sass arranges the financing, purchases the asset, and holds title to the asset. In the other case (lease), the leasing company arranges the financing, purchases the asset, and holds title to the asset.

OPERATING LEASES

Years ago, a lease in which the lessee received an equipment operator along with the equipment was called an operating lease. Today, an operating lease (or service lease ) is difficult to define precisely, but this form of leasing has several important character- istics. First of all, with an operating lease, the payments received by the lessor are usually not enough to allow the lessor to fully recover the cost of the asset. A primary reason is that operating leases are often relatively short-term. Therefore, the life of the lease may be much shorter than the economic life of the asset. For example, if you lease a car for two years, the car will have a substantial residual value at the end of the lease, and the lease payments you make will pay off only a fraction of the original cost of the car. The lessor in an operating lease expects to either lease the asset again or sell it when the lease terminates. A second characteristic of an operating lease is that it frequently requires that the les- sor maintain the asset. The lessor may also be responsible for any taxes or insurance. Of course, these costs will be passed on, at least in part, to the lessee in the form of higher lease payments. The third, and perhaps most interesting, feature of an operating lease is the cancela- tion option. This option can give the lessee the right to cancel the lease before the ex- piration date. If the option to cancel is exercised, the lessee returns the equipment to the lessor and ceases to make payments. The value of a cancelation clause depends on whether technological and/or economic conditions are likely to make the value of the asset to the lessee less than the present value of the future lease payments under the lease. To leasing practitioners, these three characteristics define an operating lease. How- ever, as we will see shortly, accountants use the term in a somewhat different way.

OPERATING LEASE

Usually a shorter-term lease under which the lessor is responsible for insurance, taxes, and upkeep. May be cancelable by the lessee on short notice.

550 APPENDIX B

efit because the lessor may return a portion of the tax benefits to the lessee in the form of lower lease costs.

Leveraged Leases A leveraged lease is a tax-oriented lease in which the lessor borrows a substantial por- tion of the purchase price of the leased asset on a nonrecourse basis, meaning that if the lessee stops making the lease payments, the lessor does not have to keep making the loan payments. Instead, the lender must proceed against the lessee to recover its invest- ment. In contrast, with a single-investor lease , if the lessor borrows to purchase the asset, the lessor remains responsible for the loan payments regardless of whether or not the lessee makes the lease payments.

Sale and Leaseback Agreements A sale and leaseback occurs when a company sells an asset it owns to another party and immediately leases it back. In a sale and leaseback, two things happen:

1. The lessee receives cash from the sale of the asset.
2. The lessee continues to use the asset. Often, with a sale and leaseback, the lessee may have the option to repurchase the leased asset at the end of the lease. An example of a sale and leaseback occurred in July 1985 when the city of Oakland, California, used the proceeds from the sale of its city hall and 23 other buildings to help meet the liabilities of its $150 million Police and Retirement System, which was un- derfunded by about $60 million. As part of the same transaction, Oakland leased back the buildings to provide for their continued use. A little more recently, in March 1998, cash-strapped Korean Airlines announced plans to sell 14 of its aircraft and then lease them back from the purchaser. Although the purchaser was not revealed, it was widely understood that KAL was working with General Electric Capital Aviation Services, one of the largest lessors specializing in air- craft. Under terms of the deal, KAL would raise about $386 million in badly needed cash without giving up control of its planes.

CONCEPT QUESTIONS

• What are the differences between an operating lease and a financial lease?
• What is a tax-oriented lease?
• What is a sale and leaseback agreement?

Accounting and Leasing

Before November 1976, leasing was frequently called off–balance sheet financing. As the name implies, a firm could arrange to use an asset through a lease and not neces- sarily disclose the existence of the lease contract on the balance sheet. Lessees had to report information on leasing activity only in the footnotes to their financial statements. In November 1976, the Financial Accounting Standards Board (FASB) issued its Statement of Financial Accounting Standards No. 13 (FASB 13), “Accounting for Leases.” The basic idea of FASB 13 is that certain financial leases must be “capital-

LEVERAGED LEASE A

financial lease in which the lessor borrows a substantial fraction of the cost of the leased asset on a nonrecourse basis.

SALE AND LEASEBACK

A financial lease in which the lessee sells an asset to the lessor and then leases it back.

Leasing 551

ized.” Essentially, this requirement means that the present value of the lease payments must be calculated and reported along with debt and other liabilities on the right-hand side of the lessee’s balance sheet. The same amount must be shown as the capitalized value of leased assets on the left-hand side of the balance sheet. Operating leases are not disclosed on the balance sheet. Exactly what constitutes a financial or operating lease for accounting purposes will be discussed in just a moment. The accounting implications of FASB 13 are illustrated in Table B.1. Imagine a firm that has $100,000 in assets and no debt, which implies that the equity is also $100,000. The firm needs a truck costing $100,000 (it’s a big truck) that it can lease or buy. The top of the table shows the balance sheet assuming that the firm borrows the money and buys the truck. If the firm leases the truck, then one of two things will happen. If the lease is an op- erating lease, then the balance sheet will look like the one in Part B of the table. In this case, neither the asset (the truck) nor the liability (the present value of the lease pay- ments) appears. If the lease is a capital lease, then the balance sheet will look more like the one in Part C of the table, where the truck is shown as an asset and the present value of the lease payments is shown as a liability. As we discussed earlier, it is difficult, if not impossible, to give a precise definition of what constitutes a financial lease or an operating lease. For accounting purposes, a lease is declared to be a capital lease, and must therefore be disclosed on the balance sheet, if at least one of the following criteria is met:

1. The lease transfers ownership of the property to the lessee by the end of the term of the lease.

(^2) We have made the simplifying assumption that the present value of the lease payments under the capital lease is equal to the cost of the truck. In general, it is the present value of the payments that must be reported, not the cost of the asset.

A. Balance Sheet with Purchase (the company finances a $100,000 truck with debt) Truck $100,000 Debt $100, Other assets $100,000 Equity $100, Total assets $200,000 Total debt plus $200, equity B. Balance Sheet with Operating Lease (the company finances the truck with an operating lease) Truck $000,000 Debt $000, Other assets $100,000 Equity $100, Total assets $100,000 Total debt plus $100, equity C. Balance Sheet with Capital Lease (the company finances the truck with a capital lease) Assets under $100,000 Obligations under $100, capital lease capital lease Other assets $100,000 Equity $100, Total assets $200,000 Total debt plus $200,

TABLE B.

Leasing and the balance sheet

In the first case, a $100,000 truck is purchased with debt. In the second case, an operating lease is used; no balance sheet entries are created. In the third case, a capital (financial) lease is used; the lease payments are capitalized as a liability, and the leased truck appears as an asset.

Leasing 553

the lease term and thereafter very low. If the lease requires early “balloon” pay- ments, this will be considered evidence that the lease is being used to avoid taxes and not for a legitimate business purpose. The IRS may require an adjustment in the payments for tax purposes in such cases.

4. The lease payments must provide the lessor with a fair market rate of return. The profit potential of the lease to the lessor should be apart from the deal’s tax benefits.
5. Renewal options must be reasonable and reflect the fair market value of the asset at the time of renewal. This requirement can be met by, for example, granting the les- see the first option to meet a competing outside offer.

The IRS is concerned about lease contracts because leases sometimes appear to be set up solely to defer taxes. To see how this could happen, suppose that a firm plans to purchase a $1 million bus that has a five-year life for depreciation purposes. Assume that straight-line depreciation to a zero salvage value is used. The depreciation expense would be $200,000 per year. Now suppose the firm can lease the bus for $500,000 per year for two years and buy the bus for $1 at the end of the two-year term. The present value of the tax benefits is clearly less if the bus is bought than if the bus is leased. The speedup of lease payments greatly benefits the firm and basically gives it a form of ac- celerated depreciation. In this case, the IRS might decide that the primary purpose of the lease was to defer taxes.

CONCEPT QUESTIONS

• Why is the IRS concerned about leasing?
• What are some of the standards the IRS uses in evaluating a lease?

The Cash Flows from Leasing

To begin our analysis of the leasing decision, we need to identify the relevant cash flows. The first part of this section illustrates how this is done. A key point, and one to watch for, is that taxes are a very important consideration in a lease analysis.

THE INCREMENTAL CASH FLOWS

Consider the decision confronting the Tasha Corporation, which manufactures pipe. Business has been expanding, and Tasha currently has a five-year backlog of pipe or- ders for the Trans-Missouri Pipeline. The International Boring Machine Corporation (IBMC) makes a pipe-boring ma- chine that can be purchased for $10,000. Tasha has determined that it needs a new ma- chine, and the IBMC model will save Tasha $6,000 per year in reduced electricity bills for the next five years. Tasha has a corporate tax rate of 34 percent. For simplicity, we assume that five-year straight-line depreciation will be used for the pipe-boring machine, and, after five years, the machine will be worthless. Johnson Leasing Corporation has offered to lease the same pipe-boring machine to Tasha for lease payments of $2,500 paid at the end of each of the next five years. With the lease, Tasha would remain responsible for maintenance, insurance, and operating expenses.^3 (^3) We have assumed that all lease payments are made in arrears, that is, at the end of the year. Actually, many leases require payments to be made at the beginning of the year.

554 APPENDIX B

Susan Smart has been asked to compare the direct incremental cash flows from leas- ing the IBMC machine to the cash flows associated with buying it. The first thing she realizes is that, because Tasha will get the machine either way, the $6,000 savings will be realized whether the machine is leased or purchased. Thus, this cost savings, and any other operating costs or revenues, can be ignored in the analysis. Upon reflection, Ms. Smart concludes that there are only three important cash flow differences between leasing and buying: 4

1. If the machine is leased, Tasha must make a lease payment of $2,500 each year. However, lease payments are fully tax deductible, so the aftertax lease payment would be $2,500  (1  .34)  $1,650. This is a cost of leasing instead of buying.
2. If the machine is leased, Tasha does not own it and cannot depreciate it for tax pur- poses. The depreciation would be $10,000/5  $2,000 per year. A $2,000 deprecia- tion deduction generates a tax shield of $2,000  .34  $680 per year. Tasha loses this valuable tax shield if it leases, so this is a cost of leasing.
3. If the machine is leased, Tasha does not have to spend $10,000 today to buy it. This is a benefit from leasing.

The cash flows from leasing instead of buying are summarized in Table B.2. Notice that the cost of the machine shows up with a positive sign in Year 0. This is a reflection of the fact that Tasha saves the initial $10,000 equipment cost by leasing instead of buying.

A NOTE ON TAXES

Susan Smart has assumed that Tasha can use the tax benefits of the depreciation al- lowances and the lease payments. This may not always be the case. If Tasha were los- ing money, it would not pay taxes and the tax shelters would be worthless (unless they could be shifted to someone else). As we mentioned before, this is one circumstance under which leasing may make a great deal of sense. If this were the case, the relevant lines in Table B.2 would have to be changed to reflect a zero tax rate.

CONCEPT QUESTIONS

• What are the cash flow consequences of leasing instead of buying?
• Explain why the $10,000 in Table B.2 has a positive sign.

(^4) There is a fourth consequence of leasing that we do not discuss here. If the machine has a nontrivial resid- ual value, then, if we lease, we give up that residual value. This is another cost of leasing instead of buying.

Lease versus Buy Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Aftertax $1,650 $1,650 $1,650 $1,650 $1, lease payment Lost $0,680 $0,680 $0,680 $0,680 $0, depreciation tax shield Cost of
$10, machine Total cash
$10,000 $2,330 $2,330 $2,330 $2,330 $2, flow

TABLE B.

Incremental cash flows for Tasha Corp. from leasing instead of buying

556 APPENDIX B

IRR from leasing is 5.317 percent, which is greater than Tasha’s aftertax borrowing cost of 5 percent. Normally, the higher the IRR, the better, but we decided that leasing was a bad idea here. The reason is that the cash flows are not conventional; the first cash flow is positive and the rest are negative, which is just the opposite of the conventional case. With this cash flow pattern, the IRR represents the rate we pay, not the rate we get, so the lower the IRR, the better. A second, and related, potential pitfall has to do with the fact that we calculated the advantage of leasing instead of buying. We could have done just the opposite and come up with the advantage of buying instead of leasing. If we did this, the cash flows would be the same, but the signs would be reversed. The IRR would be the same. Now, how- ever, the cash flows would be conventional, so we could interpret the 5.317 percent IRR as saying that borrowing and buying is better. The third potential problem is that our implicit rate is based on the net cash flows of leasing instead of buying. There is another rate that is sometimes calculated, which is based solely on the lease payments. If we wanted to, we could note that the lease pro- vides $10,000 in financing and requires five payments of $2,500 each. It would be tempting to then determine an implicit rate based on these numbers, but the resulting rate would not be meaningful for making lease versus buy decisions, and it should not be confused with the implicit return on leasing instead of borrowing and buying. Perhaps because of these potential sources of confusion, the IRR approach we have outlined thus far is not as widely used as the NPV-based approach that we describe next.

NPV ANALYSIS

Now that we know that the relevant rate for evaluating a lease versus buy decision is the firm’s aftertax borrowing cost, an NPV analysis is straightforward. We simply discount the cash flows back to the present at Tasha’s aftertax borrowing rate of 5 percent as fol- lows:

NPV  $10,000  2,330  (1  1/1.05^5 )/.

The NPV from leasing instead of buying is 2$87.68, verifying our earlier conclusion that leasing is a bad idea. Once again, notice the signs of the cash flows; the first is pos- itive, the rest are negative. The NPV we have computed here is often called the net ad- vantage to leasing (NAL). Surveys indicate that the NAL approach is the most popu- lar means of lease analysis in the real world.

A MISCONCEPTION

In our lease versus buy analysis, it looks as though we ignored the fact that if Tasha bor- rows the $10,000 to buy the machine, it will have to repay the money with interest. In fact, we reasoned that if Tasha leased the machine, it would be better off by $10, today because it wouldn’t have to pay for the machine. It is tempting to argue that if Tasha borrowed the money, it wouldn’t have to come up with the $10,000. Instead, Tasha would make a series of principal and interest payments over the next five years. This observation is true, but not particularly relevant. The reason is that if Tasha bor- rows $10,000 at an aftertax cost of 5 percent, the present value of the aftertax loan pay- ments is simply $10,000, no matter what the repayment schedule is (assuming that the

NET ADVANTAGE TO

LEASING (NAL) The NPV that is calculated when deciding whether to lease an asset or to buy it.

Leasing 557

loan is fully amortized). Thus, we could write down the aftertax loan repayments and work with these, but it would just be extra work for no gain.

LEASE EVALUATION

In our Tasha Corp. example, suppose Tasha is able to negotiate a lease payment of $2,000 per year. What would be the NPV of the lease in this case? With this new lease payment, the aftertax lease payment would be $2,000  (1  .34)  $1,320, which is $1,650  1,320  $330 less than before. Referring back to Table B.2, note that the aftertax cash flows would be $2,000 instead of $2,330. At 5 percent, the NPV would be:

NPV  $10,000  2,000  (1  1/1.05^5 )/.  $1341.

Thus, the lease is very attractive.

CONCEPT QUESTIONS

• What is the relevant discount rate for evaluating whether or not to lease an asset? Why?
• Explain how to go about a lease versus buy analysis.