corporate finance
Rust99
Week5Slides.pdf
Prof. Julia Sokolova
BCO315 CORPORATE FINANCE
Session 5:
LEASING
19-1
What is a Lease? Why Lease? Types of Leases: ◦ Operating Leases ◦ Financial Leases Sale and Leaseback Leveraged Leases
19-2
Lease – contractual agreement for use of an asset in return for a series of payments
Lessor – owner of the asset; receives payments The lessor is either the asset’s manufacturer or an
independent leasing company
Lessee – user of an asset; makes payments ◦ For the lessee the most important is the use of the
asset, not who owns the asset ◦ Buying versus Leasing: The decision involves a
comparison of the alternative financing methods employed to secure the use of the asset. In both cases, the company ends up using the asset.
19-3
19-4
Sensible Reasons for Leasing ◦ Short-term leases are convenient ◦ Cancellation options are valuable ◦ Maintenance is provided ◦ Standardization leads to low costs ◦ Tax shields can be used
Dubious Reasons for Leasing ◦ Leasing avoids capital expenditure controls ◦ Leasing preserves capital ◦ Leases may be off balance sheet financing
19-5
Operating Leases
Financial Leases
19-6
Also called a service lease. 1. Payments are not high enough for the
lessor to recover the full cost of the asset (i.e., not fully amortized).
2. Life of the lease is often less than the economic life of the asset.
3. The lessor often provides the routine maintenance for the asset.
4. It is often cancelable.
19-7
Also called capital leases. 1. Do not provide for maintenance or service
by 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.
19-8
Two special types of Financial Leases:
◦ Sale and leaseback – lessee sells the asset to the lessor and then leases it back
◦ Leveraged leases – lessor borrows a substantial portion of the purchase price of the leased asset
19-9
A particular type of financial lease 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. ◦ The lessee agrees to make periodic lease
payments, thereby retaining the use of the asset.
19-10
A leveraged lease is another type of financial 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 the lender in case of a default by the lessee.
19-11
In the old days, leases led to off-balance- sheet financing.
Today, leases are either classified as capital leases or operating leases. ◦ Operating leases – not disclosed on the balance
sheet, but discussed in the footnotes. ◦ Financial (capital) leases – capitalized and
reported on the balance sheet (a debit to the asset for the present value of the lease payments and a credit recognizing the financial obligation of the lease).
19-12
Truck is purchased with debt Truck $100,000 Debt $100,000 Land $100,000 Equity $100,000 Total Assets $200,000 Total Debt & Equity $200,000
Operating Lease Truck Debt Land $100,000 Equity $100,000 Total Assets $100,000 Total Debt & Equity $100,000
Capital Lease Assets leased $100,000 Obligations under capital lease $100,000 Land $100,000 Equity $100,000 Total Assets $200,000 Total Debt & Equity $200,000
19-13
A lease is declared a capital lease if one or more of the following criteria is met:
1. Property ownership is transferred to the lessee by the end of the lease term.
2. Lessee can purchase the asset for below market value at the lease’s expiration.
3. Lease term is 75 percent of the asset’s economic life.
4. Present value of payments is at least 90 percent of the market value of the asset at inception.
19-14
Cash flows from the lessee’s point of view Tax deductible lease payment (outflow) Lease payment × (1 – T)
Lost depreciation tax shield from lack of ownership (outflow) Depreciation × T
Initial cost of machine (inflow) Inflow because we save the cost of purchasing the asset now.
May have incremental maintenance, taxes, or insurance
19-15
ABC, Inc. needs 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 21%. What are the incremental cash flows? After-tax lease payment = 25,000(1 - 0.21) =
19,750 (outflow years 1 to 5) Lost depreciation tax shield = (100,000 / 5) ×
0.21 = 4,200 (outflow years 1 to 5) Cost of machine = 100,000 (inflow year 0)
19-16
Assume the firm’s cost of debt is 7.1%. Aftertax cost of debt = 7.1(1 - 0.21) = 5.609%
CF0 = $100,000
CF1 to CF5 = (-$19,750) + (-$4,200) = -$23,950
NPV at 5.609% = -$1,968
Should the firm buy or lease? ◦ Negative NPV of -$1,968 implies the firm should NOT
lease. We can also see this because the aftertax cost of leasing embedded in the cash flows is calculated to be 6.325%, which is higher than the aftertax cost of debt.
19-17
Greymare Bus Lines is considering a lease. Your operating manager wants to buy a new bus for $100,000. The bus has an 8 year life. The Bus Saleswoman says she will lease Greymare the bus for 8 years at $16,900 per year, but Greymare assumes all operating and maintenance costs.
Should Greymare Buy or Lease the bus?
19-18
Greymare Bus Lines is considering a lease. Your operating manager wants to buy a new bus for $100,000. The bus has an 8 year life. The Bus Saleswoman says she will lease Greymare the bus for 8 years at $16,900 per year, but Greymare assumes all operating and maintenance costs.
Should Greymare Buy or Lease the bus?
Year 0 1 2 3 4 5 6 7
Cost of new bus 100.00 Lost Depr tax shield (7.00) (11.20) (6.72) (4.03) (4.03) (2.02) - Lease payment (16.90) (16.90) (16.90) (16.90) (16.90) (16.90) (16.90) (16.90) Tax shield of lease 5.92 5.92 5.92 5.92 5.92 5.92 5.92 5.92 Cash flow of lease 89.02 (17.98) (22.18) (17.70) (15.01) (15.01) (13.00) (10.98)
Cash flow consequences of the lease contract to Greymare:
Sheet1
| Acquirer | Target | Year | Price ($bil) |
| KKR | RJR Nabisco | 1989 | $ 24.72 |
| KKR | Beatrice | 1986 | $ 6.25 |
| KKR | Safeway | 1986 | $ 4.24 |
| Thompson Co. | Southland | 1987 | $ 4.00 |
| AV Holdings | Borg-Warner | 1987 | $ 3.76 |
| Wing Holdings | NWA, Inc. | 1989 | $ 3.69 |
| KKR | Owens-Illinois | 1987 | $ 3.69 |
| TF Investments | Hospital Corp of America | 1989 | $ 3.69 |
| FH Acquisitions | For Howard Corp. | 1988 | $ 3.59 |
| Macy Acquisition Corp. | RH Macy & Co | 1986 | $ 3.50 |
| Bain Capital | Sealy Corp. | 1997 | $ 811.20 |
| Citicorp Venture Capital | Neenah Corp. | 1997 | $ 250.00 |
| Cyprus Group (w/mgmt) | WESCO Distribution Inc. | 1998 | $ 1,100.00 |
| Clayton, Dublier & Rice | North Maerican Van Lines | 1998 | $ 200.00 |
| Clayton, Dublier & Rice (w/mgmt) | Dynatech Corp. | 1998 | $ 762.90 |
| Kohlberg & Co. (w.mgmt) | Helley Performance Products | 1998 | $ 100.00 |
Sheet2
| Amount Issued, | |||
| Country | Company and Date | $ millions | |
| France | St. Gobain (1986) | $ 2,091.40 | |
| France | Paribas (1987) | $ 2,742.00 | |
| Germany | Volkswagon (1961) | $ 315.00 | |
| Jamaica | Caribbean Cement (1987) | $ 45.60 | |
| Jpan | Japan Airlines (1987) | $ 2,600.00 | |
| Mexico | Telefonos de Mexico (1990) | $ 3,760.00 | |
| New Zealand | Air New Zealand (1989) | $ 99.10 | |
| Singapore | Neptune Orient Lines (1981-1988) | $ 308.50 | |
| United Kingdom | British Gas (1986) | $ 8,012.00 | |
| United Kingdom | BAA (Airports)(1987) | $ 2,028.00 | |
| United Kingdom | British Steel (1988) | $ 4,524.00 | |
| United States | Conrail (1987) | $ 1,650.00 |
Sheet3
| Sales Rank | Company | Numebr of Industries | ||||||||||||||||||||||
| 8 | ITT | 38 | ||||||||||||||||||||||
| 15 | Tenneco | 28 | Year | |||||||||||||||||||||
| 42 | Gulf & Western Industries | 41 | 0 | 1 | 2 | 3 | 4 | 5 | 6 | Year | ||||||||||||||
| 51 | Litton Industries | 19 | Initial cost | -75 | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | ||||||||||||
| 66 | LTV | 18 | Maintenance, insurance, selling, | -12 | -12 | -12 | -12 | -12 | -12 | -12 | ||||||||||||||
| 73 | Illinois Central Industries | 26 | and administrative costs | Cost of new bus | 100.00 | |||||||||||||||||||
| 103 | Textron | 16 | Tax shield on costs | 4.2 | 4.2 | 4.2 | 4.2 | 4.2 | 4.2 | 4.2 | Lost Depr tax shield | (7.00) | (11.20) | (6.72) | (4.03) | (4.03) | (2.02) | - 0 | ||||||
| 104 | Greyhound | 19 | Depreciation tax shield | 0 | 5.25 | 8.4 | 5.04 | 3.02 | 3.02 | 1.51 | Lease payment | (16.90) | (16.90) | (16.90) | (16.90) | (16.90) | (16.90) | (16.90) | (16.90) | |||||
| 128 | Marin Marietta | 14 | Total | -82.8 | -2.55 | 0.6 | -2.76 | -4.78 | -4.78 | -6.29 | Tax shield of lease | 5.92 | 5.92 | 5.92 | 5.92 | 5.92 | 5.92 | 5.92 | 5.92 | |||||
| 131 | Dart Industries | 18 | NPV @ 7% = - $98.15 | Cash flow of lease | 89.02 | (17.98) | (22.18) | (17.70) | (15.01) | (15.01) | (13.00) | (10.98) | ||||||||||||
| 132 | U.S. Industries | 24 | ||||||||||||||||||||||
| 143 | Northwest Industries | 18 | Break even rent(level) | 26.18 | 26.18 | 26.18 | 26.18 | 26.18 | 26.18 | 26.18 | ||||||||||||||
| 173 | Walter Kidde | 22 | Tax | -9.16 | -9.16 | -9.16 | -9.16 | -9.16 | -9.16 | -9.16 | ||||||||||||||
| 180 | Ogden Industries | 13 | Break even rent after-tax | 17.02 | 17.02 | 17.02 | 17.02 | 17.02 | 17.02 | 17.02 | ||||||||||||||
| 188 | Colt Industries | 9 | NPV @ 7% = - $98.15 |
19-19
Greymare Bus Lines is considering a lease. Your operating manager wants to buy a new bus for $100,000. The bus has an 8 year life. The Bus Saleswoman says she will lease Greymare the bus for 8 years at $16,900 per year, but Greymare assumes all operating and maintenance costs.
Should Greymare Buy or Lease the bus?
Cash flow consequences of the lease contract to Greymare :
•Greymare saves the $100,000 cost of the bus
•Loss of depreciation benefit of owning the bus
•$16,900 lease payment is due at the start of each year
•Lease payments are tax deductible
19-20
Greymare Bus Lines can borrow at 10%, thus the value of the lease should be discounted at 6.5% or 0.10 x (1-0.35). The result will tell us if Greymare should lease or buy the bus.
( ) ( ) ( )
( ) ( ) ( ) $700-or 70.
1.065 10.98
- 1.065 13.00
- 1.065 15.02
-
1.065 15.02
- 1.065 17.71
- 1.065 22.19
- 1.065 17.99
-89.02lease NPV
765
432
−=
=
Negative NPV implies the firm should NOT lease.
19-21
19-22
Fundamentals of Corporate Finance, Stephen Ross, 12th edition. Chapter 27 Leasing
Corporate Finance, David Hillier, 2nd European edition. Chapter 21 Leasing
www.investopedia.com www.chooseleasing.org www.elaonline.com
- Slide Number 1
- Topics Covered
- �What is a Lease?�
- Buying vs Leasing
- Why Lease?
- Types of Leases
- Operating Leases
- Financial Leases
- Financial Leases
- Sale and Leaseback
- Leveraged Leases
- Accounting and Leasing
- Accounting and Leasing (Balance Sheet)
- Capital Lease
- Incremental Cash Flows from Leasing
- Example 1: Lease Cash Flows (1 of 2)
- Example 1: Lease Cash Flows (2 of 2)
- Example 2: Lease Cash Flows (1 of 4)
- Example 2: Lease Cash Flows (2 of 4)
- Example 2: Lease Cash Flows (3 of 4)
- Example 2: Lease Cash Flows (4 of 4)
- Any Questions?
- Recommended Reading:
