AFM 371 Winter 2008 Chapter 22 - Leasing

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1 AFM 371 Winter 2008 Chapter 22 - Leasing 1 / 15

2 Outline Background Incremental Cash Flows NPV Analysis Reasons for Leasing 2 / 15

3 Types of Leases a lease is a contract between two parties: the lessee receives the right to use an asset in exchange for making a series of payments to the owner of the asset (the lessor) two basic types of leases: operating leases: not fully amortized (i.e. lease payments do not cover the entire cost of the asset to the lessor, e.g. because of a short term) lessor normally provides insurance and maintenance lessee has a cancellation option financial leases (a.k.a. capital leases): fully amortized no provision for maintenance and insurance by lessor lessee usually does not have a cancellation option, but does have a renewal option at the expiration of the lease financial leases are very similar to secured loans, except that: lessor retains ownership at expiry, but once a secured loan is paid the user owns the asset if lessee fails to make a payment, the lessor can recover the asset but if the value of the asset is less than the PV of promised future payments, the lessor is an unsecured creditor (in a similar situation with a secured loan the lender is a secured creditor) ackground 3 / 15

4 Two Special Types of Financial Leases sale and lease-back: occurs when a firm sells an asset that it owns to another firm and immediately leases it back lessee receives cash from selling the asset today, makes payments to the lessor so as to retain the use of the asset sometimes the lessee has an option to repurchase the asset when the lease expires leveraged lease: a three party deal involving the lessee, the lessor, and an outside lender lessor borrows to partially finance the asset lender usually uses a non-recourse loan the lessor is not obligated to the lender if the lessee defaults lender has first claim on the asset if lessor defaults (and lease payments go directly to the lender if the lessor defaults) Background 4 / 15

5 Accounting and Taxes the accounting treatment of leases follows CICA 3065 balance sheet disclosure is required if any one of the following holds: ownership is transferred to lessee by the end of the contract there is a bargain purchase price option at expiry the lease term is at least 75% of the expected economic life of the asset the PV of lease payments is at least 90% of the asset s fair market value at the start of the lease there are also qualification rules for tax purposes, basically any contract which results in or is very likely to result in an ownership transfer means that the lease is treated as a loan the idea is that lease payments are fully tax deductible, but in a conditional sale, only the interest portion of payments is deductible ackground 5 / 15

6 Incremental Cash Flows of Leasing vs. Buying example: a firm is considering leasing or buying a CCA Class 8 (25%) machine. The machine costs $150,000. This will be the firm s only Class 8 asset. The machine is expected to be used for 5 years, after which time it will be worthless. The machine can be leased for 5 years for annual payments of $36,750, starting immediately. The firm faces a corporate tax rate of 40% and will consistently be in a tax-paying position. It can borrow at an interest rate of 10%. since the firm will be using the asset regardless of whether it leases or buys, revenues associated with the use of the asset are not incremental cash flows the relevant cash flows for the lease vs. buy decision are the lease payments and any cash flows resulting from ownership with the lease, the cash flows are the (after-tax) lease payments of $36,750(1.40) = $22,050 per year ncremental Cash Flows 6 / 15

7 Incremental Cash Flows of Leasing vs. Buying (Cont d) with the purchase, the firm incurs the cost of $150,000 now but is entitled to CCA tax deductions: Year UCC $75, $131, $98, $73, $55, CCA $18, $32, $24, $18, $13, Tax shield $7, $13, $9, $7, $5, note that this assumes that the first CCA deduction is one year from today. In the text, it is assumed in Chapter 22 that the first CCA deduction is today (which is inconsistent with the way it is done in Chapter 8) this means that if you want to reproduce the PV of CCA tax shields in the text, you will have to bring forward the calculated values by one year also note that in this case the firm would have a terminal loss UCC after CCA is taken in year 5 is $55, $13, = $41, X = $41, min($150,000,$0) = $41, > 0, no other assets the firm will have a tax saving of.40($41,528.32) = $16, in year 5 ncremental Cash Flows 7 / 15

8 Incremental Cash Flows of Leasing vs. Buying (Cont d) summarizing: Year After-tax cash flows from leasing Lease payment -$22, $22, $22, $22, $22, After-tax cash flows from buying Asset cost -$150, CCA tax shield $7, $13, $9, $7, $5, Terminal loss $16, Total -$150, $7, $13, $9, $7, $22, Incremental after-tax cash flows from leasing instead of buying $127, $29, $35, $31, $29, $22, ncremental Cash Flows 8 / 15

9 The Discount Rate the lease payment is very much like an interest payment because the cash flows are a known obligation once the lease contract is entered into more specifically, a lease payment is like the debt service on a secured bond issued by the lessee the lessee incurs a liability equal to the present value of all future lease payments (the lease is sometimes said to displace debt ) in practice, many firms discount both the depreciation tax shields and the lease payments at the after-tax interest rate on secured debt issued by the lessee since in our example the firm can borrow at 10% and the corporate tax rate is 40%, we will use the discount rate of.10(1.4) =.06 PV Analysis 9 / 15

10 NPV Calculations we can calculate the NPV of leasing instead of buying as: NPV = $127, $29, $29, $22, = $2, alternatively: $35, $31, PV Analysis 10 / 15

11 Does Leasing Pay? in the example above, we calculated that the NPV to the lessee is $2, now consider the lessor s perspective. Suppose the lessor can borrow at the same interest rate and also faces a corporate tax rate of 40%. in this case, the lessor s cash flows would be: the cost of buying the asset the CCA tax shields and terminal loss the after tax lease payments received in PV terms, we would have: $150,000 + $98, $37, $12, = $2, we have a zero-sum game: the lessor s cash flows are just the opposite in sign of the lessee s we could find a lease payment such that the NPV is zero for both parties, but that is the best they can do (you can check that the lease payment in this example which makes NPV zero is $37,542.91) NPV Analysis 11 / 15

12 Reasons for Leasing we saw above that if the lessor and lessee faced the same corporate tax rate (and had the same borrowing cost), then leasing is a zero-sum game however, it is possible for both parties to gain if the lessee has a lower corporate tax rate (the lessor can take full advantage of the tax benefits of ownership and compensate the lessee by charging a lower lease payment) the principal benefit of long term leasing is tax reduction other good reasons for leasing: reduced uncertainty (the residual value risk at the end of the contract is borne by the lessor since it retains ownership, and it may be in a better position to bear this risk) transactions costs can be higher for buying an asset and financing it rather than leasing it Reasons for Leasing 12 / 15

13 Illustration of Benefits of Tax Reduction consider the same example as before, but instead assume that the lessee is exempt from corporate taxes and also that the lease payments will be made for 10 years (and the machine will last for 10 years) the cash flows to the lessee are now just the saved purchase price and the lease payments (CCA doesn t matter since taxes are zero) calculate the maximum payment that the lessee will be willing to make: easons for Leasing 13 / 15

14 Illustration of Benefits of Tax Reduction (Cont d) now calculate the minimum payment that the lessor will be willing to charge: easons for Leasing 14 / 15

15 Illustration of Benefits of Tax Reduction (Cont d) since the most the lessee will pay ($22,192.55) is more than the least that the lessor will charge ($21,908.99), both parties can gain with a lease payment in between these two values note that this will not always be the case, but it does work out here (it would not have if we had stayed with the 5 year lease) suppose that the gains are to be split equally: easons for Leasing 15 / 15