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7/28/2019 Leasing ACF Present
1/22
Leasing
Marini 807899Wang Fei 808652
7/28/2019 Leasing ACF Present
2/22
Key Concepts and Skills
Understand the different types of leases.
Understand how to apply NPV to the lease
vs. buy decision.
Understand the importance of tax rates in
determining the benefit of leasing.
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Types of Leases
The BasicsA 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.
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Buying versus LeasingBuy Lease
Firm U buys asset and uses asset;financed by debt and equity. Lessor buys asset, FirmUleases it.
Manufacturer
of asset
Equity
shareholders
Firm U1. Uses asset
2. Owns asset
Creditors
Manufacturer
of asset
Lessor1. Owns asset
2. Does not use asset
Equity
shareholders Creditors
Lessee (Firm U)1. Uses asset
2. Does not own asset
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Operating Leases
Usually not fully amortized
Usually require the lessor to maintain and
insure the asset
Lessee enjoys a cancellation option
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Financial Leases
The exact opposite of an operating
lease.1.
Do not provide for maintenance or serviceby the lessor.
2. Financial leases are fully amortized.
3. The lessee usually has a right to renew the
lease at expiry.
4. Generally, financial leases cannot be
cancelled.
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Sale and Lease-Back
A particular type of financial lease
Occurs when a company sells an
asset it already owns to another firmand 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 leasepayments, thereby retaining the use of theasset.
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Leveraged Leases
A leveraged lease is another type offinancial 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 thelender in case of a default by the lessee.
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Leveraged Leases
Lessor buys asset, Firm Uleases it.
Manufacturer
of asset
Lessor1. Owns asset
2. Does not use asset
Equity
shareholders Creditors
Lessee (Firm U)1. Uses asset
2. Does not own asset
The lenders typically use a
nonrecourse loan. This
means that the lessor is notobligated to the lender in
case of a default by the
lessee.
Lessor borrows from lender to
partially finance purchase
In the event of a default by
the lessor, the lender has afirst lien on the asset. Also,
the lease payments are
made directly to the lender
after a default.
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Leveraged Leases
In the old days, leases led to off-balance-sheet financing.
Today, leases are either classified ascapital leases or operating leases.
Operating leases do not appear on thebalance sheet.
Capital leases appear on the balancesheetthe present value of the leasepayments appears on both sides.
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Taxes, the IRS, and Leases
The principal benefit of long-term leasing
is tax reduction.
Leasing allows the transfer of tax benefits
from those who need equipment but
cannot take full advantage of the tax
benefits of ownership to a party who can.
Naturally, the IRS seeks to limit this,
especially if the lease appears to be set up
solely to avoid taxes.
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Taxes, the IRS, and Leases
The lessee can deduct lease payments if thelease is qualifiedby the IRS.
1. The term must be less than 30 years.
2. There can be no bargain purchase option.
3. The lease should not have a schedule of paymentsthat is very high at the start of the lease and lowthereafter.
4. The lease payments must provide the lessor with a
fair market rate of return.5. The lease should not limit the lessees right to issue
debt or pay dividends.
6. Renewal options must be reasonable and reflect fair
market value of the asset.
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A Detour on Discounting and Debt
Capacity with Corporate Taxes
Present Value of Riskless Cash Flows In a world with corporate taxes, firms should
discount riskless cash flows at the after tax
riskless rate of interest.
Optimal Debt Level and Riskless Cash
Flows In a world with corporate taxes, one determines
the increase in the firms optimal debt level by
discounting a future guaranteed after tax inflow at
the after tax riskless interest rate.
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Operating and Capital Leases
Firms often choose to lease long-term assets rather
than buy them for a variety of reasons - the tax
benefits are greater to the lessor than the lessees,
leases offer more flexibility in terms of adjusting tochanges in technology and capacity needs.
If a firm is allowed to lease a significant portion of its
assets and keep it off its financial statements, a
perusal of the statements will give a very misleadingview of the company's financial strength
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Operating and Capital Leases
Two ways of accounting for leases:
In an operating lease, the lessor (or owner) transfers
only the right to use the property to the lessee. At the
end of the lease period, the lessee returns the property
to the lessor.
Since the lessee does not assume the risk of
ownership, the lease expense is treated as anoperating expense in the income
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Operating and Capital Leases
Financial Accounting Standards Board has ruled that a
lease should be treated as an capital lease if it meets
any one of the following four conditions:
(a) if the lease life exceeds 75% of the life of the asset
(b) if there is a transfer of ownership to the lessee at
the end of the lease term
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CONT
(c) if there is an option to purchase the asset at a
"bargain price" at the end of the lease term.
(d) if the present value of the lease payments,
discounted at an appropriate discount rate, exceeds
90% of the fair market value of the asset.
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Operating versus Capital Leases
The lessor uses the same criteria for determining
whether the lease is a capital or operating lease and
accounts for it accordingly:
If it is a capital lease, the lessor records thepresent value of future cash flows as revenue
and recognizes expenses. The lease receivable
is also shown as an asset on the balance sheet,
and the interest revenue is recognized over theterm of the lease,
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CONT.
In practical terms, however, reclassifying operating
leases as capital leases can increase the debt shown
on the balance sheet substantially especially for firms
in sectors which have significant operating leases;airlines and retailing come to mind
The fact that the lessee may not take ownership of the
asset at the end of the lease period, which seems to be
the crux on which the operating/capital lease choice ismade, should not be a significant factor in whether
the commitments are treated as the equivalent of debt.
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Conclusion
As an approximation, using the firms current pre-tax
cost of debt as the discount rate yields a good
estimate of the value of operating leases. Note that
capital leases are accounted for similarly in financialstatements, but the significant difference is that the
present value of capital lease payments is computed
using the cost of debt at the time of the capital lease
commitment, and is not adjusted as market rateschange.
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