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PowerPoint Presentationprepared by
Traven ReedCanadore College
chapter 15Lease Financing
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Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-3
Corporate Valuation and Lease Financing
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Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-4
Topics in Chapter
• Types of leases• Tax treatment of leases• Effects on financial statements• Lessee’s analysis• Lessor’s analysis• Other issues in lease analysis
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Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-5
Who are the two parties to a lease transaction?
• The lessee, who uses the asset and makes the lease, or rental, payments.
• The lessor, who owns the asset and receives the rental payments.
• Note that the lease decision is a financing decision for the lessee and an investment decision for the lessor.
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Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-6
What are the five primary lease types?
• Operating lease– Short-term and normally cancelable– Maintenance usually included
• Financial lease– Long-term and normally noncancelable– Maintenance usually not included
• Sale and leaseback• Combination lease• "Synthetic" lease
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How are leases treated for tax purposes?
• Leases are reviewed by CRA to determine if they are an actual lease or conditional sale.
• For an actual lease the full lease payment is deductible.
• If the lease did not meet the CRA guidelines then the lessee would treat the asset as a purchase and only deduct CCA and the interest portion of the lease payments.
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Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-8
How does leasing affect afirm’s balance sheet?
• For accounting purposes, leases are classified as either capital or operating.
• Capital leases must be shown directly on the lessee’s balance sheet.
• Operating leases, sometimes referred to as off-balance sheet financing, must be disclosed in the footnotes.
• Why are these rules in place?
CH15
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
CICA Section 3065
• Firms entering a financial lease contract are obligated to make lease payments as if they had signed a loan agreement
• Fail to make lease payments is taken as a default on interest/principal can bankrupt a firm
• To capitalize a lease, the present value of the lease payments is shown as debt.
• The same amount is shown as a fixed asset.
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Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-10
Impact on a firm’s capital structure
• Leasing is a substitute for debt.• As such, leasing uses up a firm’s
debt capacity.• Assume a firm has a 50/50 target
capital structure. Half of its assets are leased. This has the effect of raising its true debt ratio, and thus its true capital structure is changed.
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Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-11
Lessee’s Evaluation
• 2-year-life equipment cost: $100.• Loan rate on equipment = 10%• Marginal tax rate = 40%• Class 12, 100% CCA rate• If borrow and buy, a 2-year simple loan
requires $10 interest at ending of each year and $100 repayment at = 2
• Residual value at t = 2: $0• Maintenance cost: $0
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Other Information for Lease
• If the equipment is leased:– Lease contract runs for 2 years– Lease meets CRA guidelines to
deduct lease payments for tax purposes
– Lease payment will be $55 at the end of each year
CH15
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
CCA Schedule for Owning
• Owner is entitled to the CCA and the interest deductions
• Note the CCA tax shield for Year 1, is: $100 x 1 x ½ = $ 50
$ 50 x 0.40 = $ 60
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Year UCC before CCA
CCA@100%
UCC after CCA
Tax Saving from CCA
1 $100 $50 $50 $20
2 50 50 0 20
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Cash Flow Time Line: Borrow-to-buy
0 1 2Equipment cost ($100)Inflow from loan 100
Interest expense ($10) ($10)
Interest tax savings 4 4Principal repayment ($100)CCA tax savings 20 20NCF 0 $14 ($86)
PV@6% cost of buying= $63.33
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Why use 6% as the discount rate?
• Leasing is similar to debt financing.– The cash flows have relatively low risk; most
are fixed by contract.– Therefore, the firm’s 10% cost of debt is a
good candidate.
• The tax shield of interest payments must be recognized, so the discount rate is:
10%(1 - T) = 10%(1 - 0.4) = 6.0%
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Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-16
Cash Flow Time Line: Leasing
PV cost of leasing @ 6% = $60.50
0 1 2
Lease pmt ($55) ($55)
Tax savings frompayment
22 22
NCF 0 ($33) ($33)
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What is the net advantage to leasing (NAL)?
• NAL = PV cost of owning - PV cost of leasing
= $63.33 - $60.50 = $2.83 > 0
• Should the firm lease or buy the equipment? Why?
• Lease because NAL > 0 implying leasing is cheaper than buying.
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• Note that we have assumed the company will not continue to use the asset after the lease expires; that is, project life is the same as the term of the lease.
• What changes to the analysis would be required if the lessee planned to continue using the equipment after the lease expired?
What is the net advantage to leasing (NAL)? (cont’d)
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Residual Value Consideration
• In leasing, the asset’s value at the end of the lease is called residual value.
• Assume the RV could be $0 or $400,000, with an expected value of $200,000. How could this risk be reflected?
• The discount rate applied to the residual value inflow (a positive CF) should be increased to account for the increased risk.
• All other cash flows should be discounted at the original 6% rate.
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• If the residual value were included as an outflow (a negative CF) in the cost of leasing cash flows, the increased risk would be reflected by applying a lower discount rate to the residual value cash flow.
• Again, all other cash flows have relatively low risk, and hence would be discounted at the 6% rate.
Residual Value Consideration (cont’d)
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Effect of Increased Residual Value Uncertainty
• The lessor owns the equipment when the lease expires.
• Therefore, residual value risk is passed from the lessee to the lessor.
• Increased residual value risk makes the lease more attractive to the lessee.
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Lessor’s analysison the lease transaction
• To the lessor, writing the lease is an investment.
• Therefore, the lessor must compare the return on the lease investment with the return available on alternative investments of similar risk.
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Copyright © 2011 by Nelson Education Ltd. All rights reserved. 15-23
Lessor Evaluation
• Lease payment = $320,000 at the beginning of each year
• Cost of equipment = $1,000,000• Loan rate on equipment = 10%• Marginal tax rate = 40%• Class 43, 30% CCA rate• 4- year maintenance contract costs
$20,000 at the beginning of each year• Residual value at t = 4: $200,000
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Time Line: Lessor’s Analysis (In Thousands)
0 1 2 3 4
Cost -1,000
CCA tax shield 60 102 71.4 49.98
Maint -20 -20 -20 -20
Tax sav 8 8 8 8
Lse pmt 320 320 320 320
Tax -128 -128 -128 -128
RV 200
RV tax -80
NCF -804 240 282 251.4 169.98
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• The NPV of the net cash flows, when discounted at 6%, is $19,114
• Should the lessor write the lease? Why?
• Yes! If the lease’s NPV is greater than zero, then the lease should be written.
Time Line: Lessor’s Analysis (In Thousands – cont’d)
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Remarks
• If all inputs for leasing analysis are symmetrical between lessee and lessor, leasing is a zero-sum game.
• The lessor’s cash flows would be equal, but opposite in sign, to the lessee’s NAL.
• What are the implications?• Differences between lessees and
lessors must exist to support a lease
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Issues of Cancellation Clause
• A cancellation clause would lower the risk of the lease to the lessee but raise the lessor’s risk.
• To account for this, the lessor would increase the annual lease payment or else impose a penalty for early cancellation.
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Other Issues in Lease Analysis
• Do higher residual values make leasing less attractive to the lessee?
• Is lease financing more available or “better” than debt financing?
• Is the lease analysis presented here applicable to real estate leases? To auto leases?
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• Would spreadsheet models be useful in lease analyses?
• What impact do tax laws have on the attractiveness of leasing?
Other Issues in Lease Analysis (cont’d)
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Numerical analyses often indicate that owning is less costly than leasing. Why,
then, is leasing so popular?
• Provision of maintenance services.• Risk reduction for the lessee.
– Project life– Residual value– Operating risk
• Portfolio risk reduction enables lessor to better bear these risks.
CH15
Copyright © 2011 by Nelson Education Ltd. All rights reserved.
Reasons for Leasing
• Leasing is driven by various differences between lessees and lessors. Top three motivations:– Tax rate differentials– Lessors are often better to bear the
residual value risk than lessees– Lessors can maintain the leased asset
more efficiently than lessees
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