Leasing

1
CHAPTER 20Lease Analysis, pp. 877 - 885

• Leasing
• Types of Leases
• Financial Statement Effects
• Evaluation by the Lessee
• Factors that Affect Leasing Decisions

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Leasing

• Leasing is sometimes referred to as off balance
  sheet financing if a lease is not capitalized.
  In other words, it is not shown on the balance
  sheet.
• Leasing is a substitute for debt financing and,
  thus, uses up a firms debt capacity.

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• Capital leases are different from operating
  leases
• Capital leases do not provide for maintenance
  service.
• Capital leases are not cancelable.
• Capital leases are fully amortized.

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Analysis Lease vs. Borrow-and-Buy

• Data
• New machine costs 1,200,000.
• 3-year MACRS class life 4-year economic life.
• Tax rate of 40.
• kd 10.

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• Maintenance of 25,000/year, payable at beginning
  of each year.
• Residual value in Year 4 of 125,000.
• 4-year lease includes maintenance.
• Lease payment is 340,000/year, payable at
  beginning of each year.

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Depreciation Schedule
Depreciable basis 1,200,000
MACRS Depreciation End-of-Year Year Rate
Expense Book Value 1 0.33 396,000
804,000 2 0.45 540,000 264,000
3 0.15 180,000 84,000 4 0.07
84,000 0 1.00 1,200,000
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In a lease analysis, what discount rate should
cash flows be discounted at?
Since cash flows in a lease analysis are
evaluated on an after-tax basis, we should use
the after-tax cost of borrowing. Previously, we
were told the cost of debt, kd, was 10.
Therefore, we should discount cash flows at 6.
A-T kd 10(1 T) 10(1 0.4) 6.
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Cost of Owning Analysis(In Thousands)
0
1
2
3
4
Cost of asset (1,200.0) Dep. tax savings1
158.4 216.0 72.0 33.6 Maint. (AT)2
(15.0) (15.0) (15.0) (15.0) Res. value
(AT)3 ______ _____ _____ _____ 75.0 Net
cash flow (1,215.0) 143.4 201.0
57.0 108.6 PV cost of owning (_at_ 6) -766,948.
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Notes 1 Depreciation is a tax deductible
expense, so it produces a tax savings of
T(Depreciation). Year 1 0.4(396)
158.4. 2 Each maintenance payment of 25 is
deductible so the after-tax cost of the lease is
(1 T)(25) 15. 3 The ending book value is 0
so the full 125 salvage (residual) value is
taxed.
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Cost of Leasing Analysis(In Thousands)
0
1
2
3
4
Lease pmt (AT)1 -204 -204 -204
-204 PV cost of leasing (_at_ 6)
-749,294. Note 1Each lease payment of 340 is
deductible, so the after-tax cost of the lease is
(1 T)(340) -204.
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Net Advantage of Leasing
Since the cost of owning outweighs the cost of
leasing, the firm should lease.
12
Suppose computers residual value could be as low
as 0 or as high as 250,000, but expected value
is 125,000. How could the riskiness of the SV
be incorporated in the analysis? What effect
would this have on lease decision?
To account for risk, the rate used to discount
the SV would be increased therefore, the cost of
owning would be even higher. Leasing becomes
even more attractive.
13
What effect would a cancellation clause have on
the riskiness of the lease?
A cancellation clause lowers the risk of the
lease to the lessee, but increases the risk to
the lessor.