Corporate Finance Thirteenth Edition

Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe /

Bradford D. Jordan

Chapter 21

Leasing
Dr. Le Anh Tuan

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 Key Concepts and Skills
• Understand the different types of leases.
• Understand how to apply NPV to the lease-versus-buy
decision.
• Understand the importance of tax rates in determining the
benefit of leasing.

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 Chapter Outline
• Types of Leases
• Accounting and Leasing
• Taxes, the IRS, and Leases
• Lease or Buy Example
• Reasons for Leasing

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 Leases
• A lease is a contractual agreement between a lessor (the
owner of the asset) and a lessee (another party).

• The lessor owns the asset and for a fee allows the lessee
to use the asset.

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 Figure 21.1 Buying versus Leasing

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 1. Type of Leases
• Operating Leases
• Financial (Capital) Leases
• Sale and Leaseback
• Leveraged Leases

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 Operating Leases
• Usually not fully amortized
• Have a life that is less than the economic life of the asset
• The leasing company is responsible for maintenance and
insurance
• Can be cancelled by the lessee
• The leasing company will take the asset back at the end of
the lease
• Don't have to show the asset on your balance sheet

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 Financial (Capital) Leases
Essentially opposite of an operating lease.

• Long-term lease over the expected life of the equipment.

• The user (lessee) is resonsiple for maintenance or
insurance.
• Financial leases are fully amortized.
• The lessee usually has a right to renew the lease at expiry.
• Financial leases cannot be canceled.
• Must show the leased asset on your balance sheet as a
capital item

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 Sale and Leaseback
• Occurs when a company sells an asset it already owns to
another firm and immediately leases it from them.
• Two sets of cash flows occur:
• The lessee receives cash today from the sale of the asset.
• The lessee makes periodic lease payments, thereby retaining
the use of the asset.

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 Leveraged Leases
• A three-sided arrangement among the lessee, the lessor, and the
lenders:
• The lessee uses the assets and makes periodic lease payments.
• The lessor borrows to partially finance the asset (the lessor puts up
no more than 40 to 50% of the purchase price).
• The lenders supply the remaining financing and receive interest
payments from the lessor.

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 2. Accounting and Leasing
In the old days, leases led to off-balance sheet financing.
Today, leases are either classified as capital leases or
operating leases.
• Historically, only capital leases appeared on the balance
sheet; operating leases were only disclosed in the
footnotes.
• As of 2019, operating leases are required to be shown on
the balance sheet, too.

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Examples of Balance Sheets under FAS 13

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 Capital (Financial) Lease
A lease must be capitalized if any one of the following is met:
• The present value of the lease payments is at least 90
percent of the fair market value of the asset at the start of
the lease.
• The lease transfers ownership of the property to the lessee
by the end of the term of the lease.
• The lease term is 75 percent or more of the estimated
economic life of the asset.
• The lessee can buy the asset at a price below fair market
value when the lease expires. This is frequently called a
bargain purchase price option.

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 Taxes, the IRS, and Leases
The lessee can deduct lease payments for income tax
purposes if the lease is qualified by the International
Revenue Service (IRS).
1. The term of the lease must be less than 30 years.
2. There can be no bargain purchase option.
3. The lease should not have a schedule of payments that is
very high at the start of the lease and low thereafter.
4. The lease payments must provide the lessor with a fair
market rate of return.
5. The lease should not limit the lessee’s 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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 Taxes, the IRS, and Leases
The reason the IRS is concerned about lease contracts is
that many times they appear to be set up solely to avoid
taxes.
Suppose a firm plans to purchase a $1 million bus that has a
five-year class life. Depreciation expense would be $200,000
per year, assuming straight-line depreciation.
Now suppose the firm can lease the bus for $500,000 per
year for two years and buy the bus for $1 at the end of the
two-year term.
The present value of the tax benefits from acquiring the bus
would clearly be less than if the bus were leased.

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 3. Lease or Buy Example
Company A is considering acquiring a delivery truck, which is
expected to reduce annual operating costs by $4,500.
• Buy option: The truck costs $25,000 and has a useful life
of five years. If the firm buys the truck, it will be
depreciated on a straight-line basis to zero over its useful
life.
• Lease option: Alternatively, the firm can lease the truck
for five years from a leasing company, with annual lease
payments of $6,250.
The firm's corporate tax rate is 21%. Should the firm buy or
lease the truck?

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 The Cash Flows of Leasing
Cash Flows: Buy
Year 0 Years 1-5
Cost of truck −$25,000
Aftertax savings $4,500 × (1 − .21) = $3,555
Depreciation tax benefit _______ 5,000 × .21 = 1,050
−$25,000 $4,605

Cash Flows: Lease

Year 0 Years 1-5
Lease payments −$6,250 × (1−.21) = −$4,937.50
Aftertax savings 4,500 × (1−.21) = 3,555.00
−$1,382.50

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 The Cash Flows of Leasing
Incremental cash flow consequences from leasing instead of
buying (lease minus buy):

Year 0 Years 1–5

$25,000 −$1,382.50 − 4,605 = −$5,987.50

• A lease payment is like the debt service on a secured

bond issued by the lessee. The discount rate is the after-
tax rate on the firm’s secured debt.

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 NPV Analysis
There is a simple method for evaluating leases: discount all cash flows at
the after-tax interest rate on secured debt issued by the lessee. Suppose
that rate is 5 percent.
NPV Leasing Minus Buying
Year 0 1 2 3 4 5
CF 25000 -5987.5 -5987.5 -5987.5 -5987.5 -5987.5

Discount rate 5%

NPV -922.74
Because the net present value of the incremental cash flows from
leasing relative to purchasing is negative, the firm prefers to purchase.
The NPV we have computed here is often called the net advantage to
leasing (NAL).

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 Impact of Taxes Example
Now suppose a world without a flat corporate tax rate where
Company A is in the 21 percent tax bracket and Leasing Company
is in a 34 percent tax bracket. If Leasing Company reduces the
lease payment to $6,200, can both firms have positive NPV?
Cash Flows: Leasing Company
Year 0 Years 1-5
Cost of truck −$25,000
Depreciation tax Shield $5,000 × .34 = $1,700
Lease payments _______ 6,200 × (1 − .34) = 4,092
−$25,000 $5,792

NPV = $76.33

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 Impact of Taxes Example
Company A’ Cash Flows: Leasing Instead of Buying

Year 0 Years 1 to 5
Cost of truck we didn’t buy $25,000
Lost depreciation tax –$5,000 × .21 = −$1,050
shield
Aftertax lease payments _______ 6,200 × (1 − .21) = −4,898
$25,000 −$5,948

NPV = −$751.73

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 Leasing’s Reservation Payment
What is the smallest lease payment that Leasing Company will
accept? Set their NPV to zero and solve for $Lmin

Year 0 Years 1 to 5
Cost of truck −$25,000
Depreciation tax shield $5,000 × .34 = $1,700
Lease payments _______ $Lmin × (1 − .34) = $Lmin × (1 − .34)
−$25,000 $1,700 + $Lmin × (1 − .34)

This is $6,173.29 on a pretax basis.

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 Company A’s Reservation Payment
What is the highest lease payment that ClumZee Movers can pay?
Set their NPV to zero and solve for $Lmax:

Year 0 Years 1 to 5
Cost of truck $25,000
Depreciation tax shield -$5,000 × .21 =-$1,050
Lease payments _______ -$Lmax × (1 − .21) = -$Lmax × (1 − .21)
$25,000 -$1,050 - $Lmax × (1 − .21)

This is $5,980.22 on a pretax basis.

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 Is a Lease Possible?
The most that ClumZee Movers can afford to pay is
$5,980.22
The least that Tiger Leasing can accept is $6,173.29
So, there will not be a lease in this case.

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 4. Reasons for Leasing
Good Reasons

• Short-Term Leases Are Convenient

• Tax Shields Can Be Used

• The lease contract may reduce certain types of uncertainty.

• Transactions costs can be higher for buying an asset and

financing it with debt or equity than for leasing the asset.

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 Suggested Exercises
9, 10, 11, 14, 18

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 Exercises (Problem 14 in textbook)
Wolfson Corporation has decided to purchase a new machine that costs
$2.1 million. The machine will be depreciated on a straight-line basis and
will be worthless after four years. The corporate tax rate is 24 percent. The
Sur Bank has offered Wolfson a four-year loan for $2.1 million. The
repayment schedule is four yearly principal repayments of $525,000 and
an interest charge of 9 percent on the outstanding balance of the loan at
the beginning of each year. Both principal repayments and interest are due
at the end of each year. Cal Leasing Corporation offers to lease the same
machine to Wolfson. Lease payments of $640,000 per year are due at the
beginning of each of the four years of the lease.
• Should Wolfson lease the machine or buy it with bank financing?
• What is the annual lease payment that will make Wolfson indifferent to
whether it leases the machine or purchases it?

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