Financial Management-II

Leasing

K K Ray

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Lease Terminology

• Lease – contractual agreement for use of an asset in return for a series of payments

• Lessee – user of an asset; makes payments

• Lessor – owner of the asset; receives payments

• Direct lease – lessor is the manufacturer

• Captive finance company – subsidiaries that lease products for the manufacturer

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Types of Leases • Operating lease

– Shorter-term lease

– Lessor is responsible for insurance, taxes, and maintenance

– Often cancelable

• Financial lease (capital lease)

– Longer-term lease

– Lessee is responsible for insurance, taxes, and maintenance

– Generally not cancelable

– Specific capital leases

• Tax-oriented

• Leveraged

• Sale and leaseback

• 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.

• The lease expense is treated as an operating expense in the income statement and the lease does not affect the balance sheet.

Operating Lease

• In a capital lease, the lessee assumes some of the risks of ownership and enjoys some of the benefits.

• It is recognized both as an asset and as a liability (for the lease payments) on the balance sheet.

• The firm gets to claim depreciation each year on the asset and also deducts the interest expense component of the lease payment each year.

Capital Lease

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Lease Accounting

• Leases are governed primarily by Ind AS17/FASB 13

• Financial leases are essentially treated as debt financing – Present value of lease payments must be included on the

balance sheet as a liability

– Same amount shown on the asset as the “capitalized value of leased assets”

• Operating leases are still “off-balance-sheet” and do not have any impact on the balance sheet itself

Capital Leases - Effects On:

Balance sheet -At the inception of a capital lease, the company leasing the equipment will record the equipment as an asset, and the company will also recognize a liability on the balance sheet, by an amount equal to the present value of the minimum lease payments. The discount rate used will be the lower of the following two rates: • The lessor's (the rental company's) implied rate

The lessee incremental borrowing rate. The leased asset is depreciated in a manner consistent with the lessee's usual policy for depreciating its operational assets. It can be over the term of the lease (most common) or over the asset's useful life, if ownership transfers or a bargain purchase option is present.

Capital Leases on Income statement –

A capital-lease payment includes two components: 1. Interest expense - which is included in the income

statement but is not part of operating income (earnings before taxes from continuing operations)

2. Depreciation expenses

Cash flow statement – cash flow from operations will include only the interest portion of the capital-lease expense. The principal payment will be included as a cash outflow from cash flow from financing activities. As a result, capital leases will overstate CFO and understate CFF.

Operating Leases - Effects On: • Balance sheet - No assets or liabilities are recorded. • Income statement - The operating-lease payment will be

treated as an operating expense. • Cash flow statement - Cash flow from operations will

include the total lease payment for the specified accounting period.

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Criteria for a Capital Lease

• If one of the following criteria is met, then the lease is considered a capital lease and must be shown on the balance sheet – Lease transfers ownership by the end of the lease term

– Lessee can purchase asset at below market price

– Lease term is for 75 percent or more of the life of the asset

– Present value of lease payments is at least 90 percent of the fair market value at the start of the lease

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Taxes

• Lessee can deduct lease payments for income tax purposes

– Must be used for business purposes and not to avoid taxes

– Term of lease is less than 80 percent of the economic life of the asset

– Should not include an option to acquire the asset at the end of the lease at a below market price

– Lease payments should not start high and then drop dramatically

– Must survive a profits test – lessor should earn a fair return

– Renewal options must be reasonable and consider fair market value at the time of the renewal

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Incremental Cash Flows

• Cash Flows from the Lessee’s point of view

– After-tax lease payment (outflow)

• Lease payment*(1 – T)

– Lost depreciation tax shield (outflow)

• Depreciation * tax rate for each year

– Initial cost of machine (inflow)

• Inflow because we save the cost of purchasing the asset now

– May have incremental maintenance, taxes, or insurance

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Example: Lease Cash Flows

• ABC, Inc. needs some new equipment. The equipment would cost $100,000 if purchased, and would be depreciated straight-line over 5 years. No salvage is expected. Alternatively, the company can lease the equipment for $25,000 per year. The marginal tax rate is 40%.

– What are the incremental cash flows?

• After-tax lease payment = 25,000(1 - .4) = 15,000 (outflow years 1 - 5)

• Lost depreciation tax shield = (100,000/5)*.4 = 8,000 (outflow years 1 – 5)

• Cost of machine = 100,000 (inflow year 0)

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Lease or Buy?

• The company needs to determine whether it is better off borrowing the money and buying the asset, or leasing

• Compute the NPV of the incremental cash flows

• Appropriate discount rate is the after-tax cost of debt since a lease is essentially the same risk as a company’s debt

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Net Advantage to Leasing

• The net advantage to leasing (NAL) is the same thing as the NPV of the incremental cash flows – If NAL > 0, the firm should lease

– If NAL < 0, the firm should buy

• Consider the previous example. Assume the firm’s cost of debt is 10%. – After-tax cost of debt = 10(1 - .4) = 6%

– NAL = 3,116

• Should the firm buy or lease?