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Leasing
INTRODUCTION

The central focus of this chapter is the valuation of a lease to determine whether, and to what
extent, it tends to enhance the value of the firm. Financial leases are leases that cover most of an
asset's estimated economic life. These leases are non-cancelable by the lessee or cancelable only
if the lessor is reimbursed for expected 1osses arising from forgone income. Financial leases are
essentially considered as substitutes for buying the asset and financing the same by borrowing
the money required. A continuing comparison between leasing and borrowing is made as
financing alternatives. The decision rule that emerges is: a financial lease is superior to buying
and borrowing if the financing provided by the lease exceeds the present value of the liability it
creates.

KEY CONCEPTS IN THE CHAPTER

Terms to Know: Before you embark on an analysis of leases, you must know a variety of terms.
The more important ones are summarized below:

Lessee is the renter or the user of the asset. Lessee contracts to make a series of payments to the
lessor, and in return, gets to use the asset for the lease term.

Lessor is the legal owner and normally is entitled to the tax privileges of ownership like
depreciation deductions or investment tax credits, if they are available. At the end of the lease
period, the equipment reverts to the lessor.

Operating lease is a short-term lease, cancelable at the option of the lessee. These are usually
engaged into for convenience and flexibility. Generally, this is not considered a substitute for
ownership and long-term use of the asset.

Financial or full-payout leases are non-cancelable, long-term leases for most of the asset’s
useful life. Failure to make the lease payments can get the lessee into serious trouble, and in
that sense, lease obligations are like debt obligations. This form of leasing is considered a
source of financing and a substitute for debt.

Full-service or rental lease is one where the lessor maintains, insures, and pays taxes on the
equipment. On the other hand, in a net lease the lessee maintains, insures, and pays taxes on the
property. Sale and leaseback is an arrangement where a firm sells an asset to the lessor and then
leases it back from the buyer. Leveraged leases are financial leases where the lessor borrows
part of the purchase price using the leased equipment as collateral.

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Significance of Financial Leases: Financial leases are studied in depth because they are a
source of financing; they displace debt. With financial leases, the lessee (the user) assumes the
risks and rewards of ownership. Leasing displaces debt. The ownership of the asset makes a
difference as to who gets the salvage value at the end of the lease period and who gets the tax
privileges. When bankruptcy and reorganization occur, the lessee loses the asset's use, whereas
the lessor does not. Financial leases will, normally, have to be reported in the balance sheet as
equivalent ownership of the asset with the lease obligations capitalized and shown on the
liability side.

Why Lease: Some motivations for leasing can make a lot of sense, while others appear dubious
and imply market myopia and inefficiency. Those, which are rational and make sense include:

- Convenience,
- Cancellation options are valuable,
- Maintenance is provided,
- Tax shields may be advantageous, and
- Could help avoid alternative minimum tax.

Some dubious reasons for leasing include:

- Avoid capital expenditure controls,

- Preserves capital,
- Off-balance sheet financing; this may no longer be possible as leases must be capitalized
and their estimated present values called as an asset and a liability, if they fall under
certain guidelines, and
- Affects book income positively

The dubious reasons imply that markets and the investor could be fooled by appearances.

Operating Leases: Operating leases may make sense when an asset is required over an extended
period and the lessor can buy and manage the asset cheaper than the lessee; for example, a truck-
leasing company. The option to cancel the lease is sufficiently important to the lessee.

Valuing Financial Leases: Valuing financial leases are similar to valuing any set of cash flows.
Essentially, you identify all the cash flows involved and then calculate the present values at the
appropriate discount rates. Add up the present values to find the NPV; accept if the NPV is
positive. For convenience, we will adopt the usual practice of analyzing a lease from the lessee’s
perspective. If you are interested in the lessor’s perspective, all you need to do it is just reverse
the signs – a positive cash flow to the lessee is negative for the lessor. The main cash flows
resulting from a lease transaction are:

- At the start (time 0), the lessee saves the cost of purchasing the asset. This is the main
positive cash flow for the lessee.

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 - During the lease term, the lessee promises to pay regular lease payments. These could be
annual, or more frequent, and in some cases start, at time 0. The lease payments are tax-
deductible.
- The lessee loses the tax privileges associated with ownership. This means that the tax
deductions from depreciation are not available.
- At the end of the lease period, the lessee does not own the asset and thus, loses the
remaining value of the asset.
- There may be other cash flows such as maintenance costs. These will have to be
accounted for.

The basic approach to valuing the lease is to find the present value of all the above cash flows
and sum them up. The only issue, which remains, is the discount rate to be used. The accepted
practice is to use the after-tax borrowing rate to discount all the cash flows, except the salvage
value. The salvage value may be discounted at the company cost of capital.

An alternate approach involves calculating the equivalent loan. The equivalent loan is the loan
that exactly matches the lease liability at each point in time, i.e., commits the firm to exactly the
same cash outflows as the lease would. Compare the financing by the lease with the financing
provided by the equivalent loan and accept the lease if the value of the lease is positive.

Value of lease = cash flows from leasing - cash flows from equivalent loan

The main cash flow from leasing, in most cases, is simply the purchase price of the asset. The
two approaches would give exactly the same answer. In general, a financial lease is superior to
buying and borrowing if the financing provided by the lease exceeds the present value.

Financial leasing decisions are an example of the interaction between financing and investing
decisions. Therefore, where subsidies arise, the adjusted net present value of the investment
decision should be determined before a decision is made.

APV = NPV of the project + NPV of lease

What this suggests is that if the equipment for a project is available under lease financing, the
project NPV should be adjusted to reflect any positive NPV coming out of the lease transaction.
This could, in some cases, result in turning a negative NPV project into an acceptable project
because of the benefits of the lease.

The evaluation methods discussed above will show that if all the factors are identical for the
lessee and the lessor, then the values of the lease to the lessor and lessee would be equal (but of
opposite signs). This would mean that it is not possible to have a mutually beneficial lease
transaction if the lessee and the lessor have the same tax rates, the same cost of the asset, and the
same discount rate. Thus, a lease would make sense only if the lessee and the lessor have
different tax rates. Of course, it might also make sense if the cost of the asset or the discount
rate is different; but then this is not a reason for leasing. Any such difference would qualify the

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lessor to be a seller (lower cost of asset) of the asset or a lender (lower discount rate). In short,
it is generally agreed that tax differentials drive financial leases in many cases.

WORKED EXAMPLES

1. Lean and Mean, Inc., is evaluating the lease of a minicomputer which, if purchased, would
cost $150,000. Its estimated useful life is 5 years, at the end of which time it will be
obsolete. The annual lease payments are $35,000, payable in six installments, the first being
payable when the contract is signed. The company is in the 35 percent marginal income tax
bracket. Set up a statement of cash-flow consequences of the lease contract. If Lean and
Mean, Inc.'s before-tax borrowing rate on long-term debt is 12 percent, estimate the net
present value (NPV) of the lease.

SOLUTION

The table below gives the cash flows and present values. Note that the depreciation schedule is
contained in that portion of the table (from Chapter 6 of the text). Leasing displaces debt and
the risk of the cash flows from leasing approximates the risk of the cash flows that would have
been incurred had the firm borrowed. The current after-tax borrowing rate is the appropriate
rate at which to evaluate the lease. That is 12(1 - 0.35) = 7.80 percent. This is the rate used to
calculate the present values. Discounting at this rate, we obtain a NPV of -$10,210.

Cash-Flows from the Lease Contract (Value of Lease to Lessee - $ 1,000)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cost of computer 150.00
Lost depreciation tax shield -10.50 -16.80 -10.08 -6.05 -6.05 -3.02
Lease payment -35.00 -35.00 -35.00 -35.00 -35.00 -35.00
Tax shield of payment 12.25 12.25 12.25 12.25 12.25 12.25
Cash flow 116.75 -39.55 -32.83 -28.80 -28.80 -25.77
NPV at 7.80% -10.21

Tax depreciation rate 0.20 0.32 0.192 0.1152 0.1152 0.0576

Borrowing cost 12%
Tax rate 0.35
After-tax rate 7.80%

Note that:
Lost depreciation tax shield = cost X depreciation rate X marginal tax rate
For year 1- Lost depreciation tax shield = 150 X 0.32 X 0.35 = 16.80

2. Calculate the equivalent loan of the lease given in problem 1.

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SOLUTION

The equivalent loan is simply the present value of the lease cash outflows discounted at the after-
tax borrowing rate. From the table above, present value of the cash out flows (exclude the cost
of the computer) = $126.96. What this means is that for the same cash flows you are committing
to the lease, you can actually get a loan of $126,960. As this is more than the cost of the
computer, you are better off rejecting the lease.

NPV of lease = 116.75 - 126.96 = -10.21

3. What is the value of the above lease to the lessor?

SOLUTION

The cash flows to the lessor are the same as those to the lessee except the signs are reversed.
Thus, the NPV to the lessor is a positive $10,210.

4. Assume the lessee's tax rate is zero. What is the value of the lease now?

SOLUTION

The table below shows the results. It is still a negative NPV deal, actually a little worse.

Year
0 1 2 3 4 5
Cost of computer 150.00
Lost depreciation tax shield 0.00 0.00 0.00 0.00 0.00 0.00
Lease payment -35.00 -35.00 -35.00 -35.00 -35.00 -35.00
Tax shield of lease payment 0.00 0.00 0.00 0.00 0.00 0.00
Cash flow of lease 115.00 -35.00 -35.00 -35.00 -35.00 -35.00
NPV -11.17

Tax depreciation rate on cost 0.2000 0.3200 0.1920 0.1152 0.1152 0.0576
Required return 12.00%
Marginal tax rate 0.00%
After-tax discount rate 12.00%

SUMMARY

This chapter provides an overview of the different types of leases. It then focuses on the
evaluation of financial leases, which are considered a source of financing. Financial leasing can
be considered as an alternative to buying the asset and borrowing the cost of the asset. Two
equivalent approaches to evaluating financial leases were presented.

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The evaluation of financial leases assumes the same format as the evaluation of any other cash
flows. The direct cash flows are discounted at a tax-adjusted rate appropriate to the level of risk,
which is typically and conveniently assumed to be the firm's present borrowing rate. The
present borrowing rate is used because the lease displaces debt in the company's financial
structure but has no effect on the required amount of equity financing.

The first approach to evaluating leases is to discount all the cash flows at the after-tax interest
rate of the firm. The sum of these present values gives you the NPV of the lease transaction.
The alternate approach computes the equivalent loan that would be supported by the cash
outflows produced by the lease payments. If the equivalent loan is less than the financing
required to purchase the asset, the lease would be a good deal.

LIST OF TERMS

Capital leases Lessor (owner)

Direct lease Leveraged leases
Equivalent loan Net lease
Financial lease Off-balance-sheet financing
Full-service lease Operating lease
Lease Sale and lease-back
Lessee

EXERCISES

Fill-in Questions

1. The user of a leased asset is called the ______________________, whereas the owner of a
leased asset is called the ____________________.

2. Leases which are short-term and cancelable during the contract period at the option of the
_____________ are called ___________________ leases.

3. Leases which are long-term or extend over the economic life of the asset and which cannot
be canceled or can be canceled only if the _______________________ is reimbursed for
losses are called __________________ leases.

4. When the lessor promises to maintain and insure the leased assets and pay property taxes on
it, they have taken out a(n) _________________ lease.

5. When the __________________ agrees to maintain the leased asset, insure it, and pay
properly taxes due on it, the lease is known as a net lease.

6. When the lessee identifies the equipment to be used and arranges for the leasing company to
buy it from the manufacturer, the signed contract is called a(n) ___________________ lease.

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7. When a firm sells an asset it owns and leases it back to the buyer, the arrangement is known
as _______________.

8. When lessors borrow part of the purchase price of a leased asset and use the lease contract as
security for the loan, the entire financing scheme is known as a(n) ____________________
lease.

9. Generally accepted accounting standards no longer allow _________________ financing;

rather, lease payments of _______________ leases must be ___________________, which is
to say that the present value of the lease payments must be estimated and shown as debt on
the right-hand side of the balance sheet.

10. A(n) ___________________ is one that exactly matches the lease liability, or to put it
another way, one which commits the firm to exactly the same cash outlays as a lease would.

Problems

1. H. L. Mean, Inc., decided to lease additional computer equipment for the next 5 years. The
deal requires annual lease payments of $66,000 commencing on the day the contract is
signed. Had the equipment been purchased, it would have cost $320,000. The company's
marginal tax bracket is 35 percent, and its long-term borrowing rate is 10 percent. Calculate
the net present value of the lease and its equivalent loan.

2. Provide an equivalent loan analysis for the situation of problem 1.

3. H. L. Mean, Inc.'s treasurer suddenly realizes that H. L. Mean, Inc. is unlikely to pay taxes in
the next five years. How does this affect the NPV of the lease?

Essay Questions

1. How can it be said that financial leases are a source of financing? Explain fully.

2. What is meant by off-balance-sheet financing?

3. In what sense may lease payments be viewed as the equivalent of interest payments?

4. Some people say that long-term lease obligations should be regarded as debt, even though
they may not appear on the balance sheet. What rationale can you give for this point of
view?

5. List and explain some of the reasons that make leasing dubious and offer an explanation for
each item.

6. Usually the direct cash flows from the lease are assumed to be safe and are discounted at
roughly the same rate of interest as obtainable on a secured bond issued by the lessee. Why?
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ANSWERS TO EXERCISES

Fill-in Questions

1. Lessee; lessor 6. Direct

2. Lessee; operating 7. Sale and lease-back
3. Lessor; financial 8. Leveraged
4. Full-service 9. Off-balance-sheet; financial; capitalized
5. Lessee 10. Equivalent loan

Problems

1. The analysis is provided in the table below. The NPV is negative (-$1,610). Reject the lease.

Cash Flow Analysis of the Lease (in $1,000s)

Year 0 Year l Year 2 Year 3 Year 4 Year 5

Cost of computer 320.00
Lost deprn tax shield -22.40 -35.84 -21.50 -12.90 -12.90 -6.45
Lease payment -66.00 -66.00 -66.00 -66.00 -66.00 -66.00
Tax shield of pmt 23.10 23.10 23.10 23.10 23.10 23.10
Cash flow 254.70 -78.74 -64.40 -55.80 -55.80 -49.35
NPV at 6.5% -1.60

Tax deprn rate 0.2 0.32 0.192 0.1152 0.1152 0.0576

Borrowing cost 10
Tax rate 0.35
After-tax rate 6.50

2. The equivalent loan is equal to the present value of the cash out flows produced by the lease.

Equivalent Loan Analysis (in $1,000s)

Year 0 Year l Year 2 Year 3 Year 4 Year 5

Lost deprn tax shield -22.40 -35.84 -21.50 -12.90 -12.90 -6.45
Lease payment -66.00 -66.00 -66.00 -66.00 -66.00 -66.00
Tax shield of pmt 23.10 23.10 23.10 23.10 23.10 23.10
Cash flow -65.30 -78.74 -64.40 -55.80 -55.80 -49.35
Present value at 6.5% $321,601

Equivalent Loan = $321,601. Reject the lease.

3. The analysis is given in the table below. The NPV of the lease is positive at $3,810. The
company's zero tax rate now makes the lease beneficial.
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 (in $ 1,000s)
Year 0 Year l Year 2 Year 3 Year 4 Year 5
Cost of computer 320.00
Lost deprn tax shield 0.00 0.00 0.00 0.00 0.00 0.00
Lease payment -66.00 -66.00 -66.00 -66.00 -66.00 46.00
Tax shield of pmt. 0.00 0.00 0.00 0.00 0.00 0.00
Cash flow 254.00 -66.00 -66.00 -66.00 -66.00 -66.00
NPV at 10% 3.81
Tax deprn rate 0.20 0.32 0.192 0.1152 0.1152 0.0576
Borrowing cost 10
Tax rate 0
After-tax rate 10.00

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