Chapter 26 Leasing


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Chapter 26 Leasing


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Title: Chapter 26 Leasing

Chapter 26 - Leasing
  • What is a Lease?
  • Why Lease?
  • Operating versus Financial Leases
  • Valuing Leases
  • When Do Leases Pay?

  • The Basics
  • A lease is a contractual agreement between a
    lessee and lessor.
  • The agreement establishes that the lessee has the
    right to use an asset and in return must make
    periodic payments to the lessor.
  • The lessor is either the assets manufacturer or
    an independent leasing company.

Buying versus Leasing
Firm U buys asset and uses asset financed by
debt and equity.
Lessor buys asset, Firm U leases it.
Reasons for Leasing
  • Good Reasons
  • Taxes may be reduced by leasing.
  • The lease contract may reduce certain types of
  • Transactions costs can be higher for buying an
    asset and financing it with debt or equity than
    for leasing the asset.
  • Bad Reasons
  • Leasing and accounting income
  • 100 financing

Operating Leases
  • Usually not fully amortized. This means that the
    payments required under the terms of the lease
    are not enough to recover the full cost of the
    asset for the lessor.
  • Usually require the lessor to maintain and insure
    the asset.
  • Lessee enjoys a cancellation option. This option
    gives the lessee the right to cancel the lease
    contract before the expiration date.

Financial (Capital) Leases
  • The exact opposite of an operating lease.
  • Do not provide for maintenance or service by the
  • Financial leases are fully amortized.
  • The lessee usually has a right to renew the lease
    at expiry.
  • Generally, financial leases cannot be cancelled,
    i.e., the lessee must make all payments or face
    the risk of bankruptcy.

Sale and Lease-Back
  • 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.

Leveraged Leases
  • A leveraged lease is another type of financial
  • 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
  • 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.

Leveraged Leases
Lessor buys asset, Firm U leases it.
Manufacturer of asset
Lessor borrows from lender to partially finance
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
Lessee (Firm U)
  • Owns asset
  • Uses asset

2. Does not use asset
2. Does not own asset
In the event of a default by the lessor, the
lender has a first lien on the asset. Also the
lease payments are made directly to the lender
after a default.
Equity shareholders
Accounting and Leasing
  • In the old days, leases led to off-balance-sheet
  • In 1979, the Canadian Institute of Chartered
    Accountants implemented new rules for lease
    accounting according to which financial leases
    must be capitalized.
  • Capital leases appear on the balance sheetthe
    present value of the lease payments appears on
    both sides.

Accounting and Leasing
  • Balance Sheet
  • Truck is purchased with debt
  • Truck 100,000 Debt 100,000
  • Land 100,000 Equity 100,000
  • Total Assets 200,000 Total Debt Equity
  • Operating Lease
  • Truck Debt
  • Land 100,000 Equity 100,000
  • Total Assets 100,000 Total Debt Equity
  • 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

Financial (Capital) 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 bargain price
    at expiry.

Taxes and Leases
  • The principal benefit of long-term leasing is tax
  • Leasing allows the transfer of tax benefits from
    those who need equipment but cannot take full
    advantage of the tax benefits of ownership to a
    party who can.
  • If the CRA (Canada Revenue Agency) detects one or
    more of the following, the lease will be
  • The lessee automatically acquires title to the
    property after payment of a specified amount in
    the form of rentals.
  • The lessee is required to buy the property from
    the lessor.
  • The lessee has the right during the lease to
    acquire the property at a price less than fair
    market value.

Operating Lease
  • Example Acme Limo has a client who will sign a
    lease for 7 years, with lease payments due at the
    start of each year. The following table shows
    the NPV of the limo if Acme purchases the new
    limo for 75,000 and leases it for 7 years.

Financial Leases
Example 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
Financial Leases
Example - cont Greymare Bus Lines can borrow at
10, thus the value of the lease should be
discounted at 6.5 or .10 x (1-.35). The result
will tell us if Greymare should lease or buy the
Financial Leases
Example A loan with same cash flows as lease
Financial Leases
Example - cont The Greymare Bus Lines lease cash
flows can also be treated as a favorable
financing alternative and valued using APV.
Financial Lease Benefits
Value of lease to lessor
Value of lease
  • Consider a firm, ClumZee Movers, that wishes to
    acquire a delivery truck.
  • The truck is expected to reduce costs by 4,500
    per year.
  • The truck costs 25,000 and has a useful life of
    five years.
  • If the firm buys the truck, they will depreciate
    it straight-line to zero.
  • They can lease it for five years from Tiger
    Leasing with an annual lease payment of 6,250
    paid at the end of the year.
  • The firms borrowing rate is 7.70 and its
    marginal tax rate is 34.

Example Q1 continue
  • Suppose ClumZee movers is actually in the 25
    tax bracket and Tiger Leasing is in the 35 tax
    bracket and a before tax borrowing rate of 7. If
    Tiger reduces the lease payment to 6,200, can
    both firms have a positive NPV?

  • There are three ways to value a lease.
  • Use the real-world convention of discounting the
    incremental after-tax cash flows at the lessors
    after-tax rate on secured debt.
  • Calculate the increase in debt capacity by
    discounting the difference between the cash flows
    of the purchase and the cash flows of the lease
    by the after-tax interest rate. The increase in
    debt capacity from a purchase is compared to the
    extra outflow at year 0 from a purchase.
  • Use APV (APV All-Equity Value Financing NPV)
  • They all yield the same answer.

Practice Question 1
  • Calculate NPV for lessee and lessor
  • Cost of machine 85,000
  • CCA rate 30
  • Operating costs 10,000 per year maintenance
  • Lease payments 53,600 per year
  • Lessor provides maintenance as a part of the
    lease contract.
  • Cost of debt (rD) 15
  • After-tax cost of debt, rD(1 -TC) 9
  • TC 40 (for both the lessee and the lessor)

Practice Question 2
  • A noncancellable lease contract lasts for 4 years
    with payments of 37,000 at the end of each year.
    The lessee pays maintenance expense under either
    the lease or buy alternatives. If purchased, the
    100,000 asset has a CCA rate of 30. The
    before-tax cost of debt is 10 and the corporate
    tax rate is 40. What is the value of the lease
    to the lessee?
  • If the lease in problem were cancelable, how much
    must the cancellation option be worth to make the
    lease alternative better than the purchase

Chapter 26 - Hedging
  • Why Manage Risk?
  • Insurance
  • Forward and Futures Contracts
  • How to Set Up A Hedge

Risk Reduction
  • Why risk reduction does not add value
  • 1. Hedging is a zero sum game
  • 2. Investors do-it-yourself alternative

Risk Reduction
  • Risks to a business
  • Cash shortfalls
  • Financial distress
  • Agency costs

  • Most businesses face the possibility of a hazard
    that can bankrupt the company in an instant.
  • Insurance companies have some advantages in
    bearing risk.
  • The cost and risk of a loss due to a hazard,
    however, can be shared by others who share the
    same risk.

  • Example
  • An offshore oil platform is valued at 1
    billion. Expert meteorologist reports indicate
    that a 1 in 10,000 chance exists that the
    platform may be destroyed by a storm over the
    course of the next year.
  • How can the cost of this hazard be shared?

  • What do you expect the premium of an insurance
    contract on this oil platform to be?
  • Think of the following
  • Administrative costs
  • Adverse selection
  • Moral hazard

Insurance Catastrophe Risk
  • The loss of an oil platform by a storm may be 1
    in 10,000. The risk, however, is larger for an
    insurance company since all the platforms in the
    same area may be insured, thus if a storm damages
    one it may damage all in the same area. The
    result is a much larger risk to the insurer
  • Catastrophe Bonds - (CAT Bonds) Allow insurers
    to transfer their risk to bond holders by selling
    bonds whose cash flow payments depend on the
    level of insurable losses NOT occurring.

Insurance What to Insure
  • Two Possibilities
  • Most Common - buy insurance only for large
    potential losses.
  • BP case buy insurance for small risks only.

Hedging with Forwards and Futures
  • Business has risk
  • Business Risk - variable costs
  • Financial Risk - Interest rate changes
  • Goal - Eliminate risk
  • HOW?
  • Hedging Forward Contracts

Hedging with Forwards and Futures
  • Ex - Kellogg produces cereal. A major component
    and cost factor is sugar.
  • Forecasted income sales volume is set by using
    a fixed selling price.
  • Changes in cost can impact these forecasts.
  • To fix your sugar costs, you would ideally like
    to purchase all your sugar today, since you like
    todays price, and made your forecasts based on
    it. But, you can not.
  • You can, however, sign a contract to purchase
    sugar at various points in the future for a price
    negotiated today.
  • This contract is called a Futures Contract.
  • This technique of managing your sugar costs is
    called Hedging.

Hedging with Forwards and Futures
1- Spot Contract - A contract for immediate sale
delivery of an asset. 2- Forward Contract - A
contract between two people for the delivery of
an asset at a negotiated price on a set date in
the future. 3- Futures Contract - A contract
similar to a forward contract, except there is an
intermediary that creates a standardized
contract. Thus, the two parties do not have to
negotiate the terms of the contract. The
intermediary is the Commodity Clearing Corp
(CCC). The CCC guarantees all trades provides
a secondary market for the speculation of
Types of Futures
Commodity Futures -Sugar -Corn -OJ -Wheat -Soy
beans -Pork bellies Financial Futures -Tbills -Y
en -GNMA -Stocks -Eurodollars Index Futures
-SP 500 -Value Line Index -Vanguard Index
Futures Contract Concepts
  • Not an actual sale
  • Always a winner a loser (unlike stocks)
  • Settled every day. (Marked to Market)
  • Hedge - used to eliminate risk by locking in
  • Speculation - used to gamble
  • Margin - not a sale - post partial amount

Futures and Spot Contracts
The basic relationship between futures prices and
spot prices for equity securities.
Futures and Spot Contracts
  • Example
  • The DAX spot price is 3,970.22. The interest
    rate is 3.5 and the dividend yield on the DAX
    index is 2.0. What is the expected price of the
    6 month DAX futures contract?

Futures and Spot Contracts
The basic relationship between futures prices and
spot prices for commodities.
Futures and Spot Contracts
  • Example
  • In July the spot price for coffee was .7310 per
    pound. The interest rate was 1.5 per (1.3 per
    10 months). The 10 month futures price was
    0.8285? What is the net convenience yield?

Homemade Forward Rate Contracts
Suppose you know that you will receive 100m in
one year. You are worried that interest rates
might go down? You can enter a FRA (forward rate
agreement) with a bank.
Friendly Bancorp invested 50 M in debt carrying
8 fixed interest rate and maturing in 5 years.
Annual payments are 4m. However, friendly
Bancorp is predicting increases in interest
rates, so it wants a floating rate. Here is what
it can do.
  • Birth 1981
  • Definition - An agreement between two firms, in
    which each firm agrees to exchange the interest
    rate characteristics of two different financial
    instruments of identical principal

How to Set a Hedge?
  • In practice, the commodity that a firm sells is
    likely not identical to the one traded on the
  • Delta measures the sensitivity of A to changes in
    the value of B.
  • Duration is also used in setting hedge. (if two
    assets have the exact duration, they will be
    equally affected by change in interest rates).

Ex - Settlement Speculate
  • Example - You are speculating in Hog Futures.
    You think that the Spot Price of hogs will rise
    in the future. Thus, you go Long on 10 Hog
    Futures (1K is of 30,000 pound). If the price
    drops .17 cents per pound (.0017) what is total
    change in your position?

Commodity Hedge
  • In June, farmer John Smith expects to harvest
    10,000 bushels of corn during the month of
    August. In June, the September corn futures are
    selling for 2.94 per bushel (1K 5,000
    bushels). Farmer Smith wishes to lock in this
    price (hedge).
  • Show the transactions if the Sept spot price
    drops to 2.80.
  • Show the transactions if the Sept spot price
    rises to 3.05.

Commodity Speculation
You have lived in NYC your whole life and are
independently wealthy. You think you know
everything there is to know about pork bellies
(uncured bacon) because your butler fixes it for
you every morning. Because you have decided to
go on a diet, you think the price will drop over
the next few months. On the CME, each PB K is
38,000 lbs. Today, you decide to short three May
Ks _at_ 44.00 cents per lbs. In Feb, the price
rises to 48.5 cents and you decide to close your
position. What is your gain/loss? If In Feb the
price drops to 40.0 cents, what is your
  • The amount (percentage) of a Futures Contract
    Value that must be on deposit with a broker.
  • Since a Futures Contract is not an actual sale,
    you need only pay a fraction of the asset value
    to open a position margin.
  • CME margin requirements are 15
  • Thus, you can control 100,000 of assets with
    only 15,000.

Chapter 32 - Mergers
  • Sensible Motives for Mergers
  • Some Dubious Reasons for Mergers
  • Estimating Merger Gains and Costs
  • The Mechanics of a Merger
  • Takeover Battles and Tactics
  • Mergers and the Economy

The Basic Forms of Acquisitions
  • There are three basic legal procedures that one
    firm can use to acquire another firm
  • Merger (or consolidation)
  • Acquisition of Stock
  • Acquisition of Assets
  • Although these forms are different from a legal
    standpoint, the financial press frequently does
    not distinguish among them.
  • In our discussions, we use the term merger
    regardless of the actual form of the acquisition.

Merger or Consolidation
  • A merger refers to the absorption of one firm by
    another. The acquiring firm retains its name and
    identity, and acquires all the assets and
    liabilities of the acquired firm. After the
    merger, the acquired firm ceases to exist as a
    separate entity.
  • A consolidation is the same as a merger except
    that an entirely new firm is created. In a
    consolidation, both the acquiring firm and the
    acquired firm terminate their previous legal

Acquisition of Stock
  • A firm can acquire another firm by purchasing
    target firms voting stock in exchange for cash,
    shares of stock, or other securities.
  • A tender offer is a public offer to buy shares
    made by one firm directly to the shareholders of
    another firm.
  • If the shareholders choose to accept the offer,
    they tender their shares by exchanging them for
    cash or securities.
  • A tender offer is frequently contingent on the
    bidders obtaining some percentage of the total
    voting shares.
  • If not enough shares are tendered, then the offer
    might be withdrawn or reformulated.

Acquisition of Assets
  • One firm can acquire another by buying all of its
  • A formal vote of the shareholders of the selling
    firm is required.
  • Advantage of this approach it avoids the
    potential problem of having minority shareholders
    that may occur in an acquisition of stock.
  • Disadvantage of this approach it involves a
    costly legal process of transferring title.

A Classification Scheme
  • Financial analysts typically classify
    acquisitions into three types
  • Horizontal acquisition when the acquirer and the
    target are in the same industry.
  • Vertical acquisition when the acquirer and the
    target are at different stages of the production
    process example an airline company acquiring a
    travel agency.
  • Conglomerate acquisition the acquirer and the
    target are not related to each other.

Recent Mergers in Canada
Date Amount (M) Target Acquiring June
2002 6,320 Bell Canada BCE Inc. Jan
2002 8,000 Canada Trust TD Bank Jan
2002 9,203 PanCanadian Energy Alberta Energy
Sensible Reasons for Mergers
  • Economies of Scale
  • A larger firm may be able to reduce its per unit
    cost by using excess capacity or spreading fixed
    costs across more units.

Reduces costs

Sensible Reasons for Mergers
  • Combining Complementary Resources
  • Merging may results in each firm filling in the
    missing pieces of their firm with pieces from
    the other firm.

Sensible Reasons for Mergers
  • Mergers as a Use for Surplus Funds
  • If your firm is in a mature industry with few,
    if any, positive NPV projects available,
    acquisition may be the best use of your funds.

Source of Synergy from Acquisitions
  • Revenue Enhancement
  • Cost Reduction
  • Including replacement of ineffective managers.
  • Tax Gains
  • Net Operating Losses
  • Unused Debt Capacity
  • Incremental new investment required in working
    capital and fixed assets

Dubious Reasons for Mergers
  • Diversification
  • Investors should not pay a premium for
    diversification since they can do it themselves.

Dubious Reasons for Mergers
  • The Bootstrap Game

Acquiring Firm has high P/E ratio
Dubious Reasons for Mergers
  • The Bootstrap Game

Dubious Reasons for Mergers
Earnings per dollar invested (log scale)
World Enterprises (after merger)
World Enterprises (before merger)
Muck Slurry
.10 .067 .05
Lower Financing Costs
The combined company can borrow at lower interest
rates than either firm could separately. That is
what we would expect in well functioning markets,
but it does not increase value for shareholders
Estimating Merger Gains
  • Questions
  • Is there an overall economic gain to the merger?
  • Do the terms of the merger make the company and
    its shareholders better off?

Estimating Merger Gains
Estimating Merger Gains
Example Two firms merge creating 25 million in
synergies. A pays B a sum of 65 million.
Estimating Merger Gains
  • Look at Incremental Economic Gain

Cash versus Common Stock Acquistion
  • Estimating Cost with Stock
  • Taxes
  • Cash acquisitions usually trigger taxes.
  • Stock acquisitions are usually tax-free.
  • Sharing Gains from the Merger
  • With a cash transaction, the target firm
    shareholders are not entitled to any downstream

The Tax Forms of Acquisitions
  • In a taxable acquisition (cash offer), the
    shareholders of the target firm are considered to
    have sold their shares, and they will have
    capital gain/losses that will be taxed.
  • In a tax-free acquisition, since the acquisition
    is considered an exchange instead of a sale, no
    capital gain or loss occurs.

Tax Consequences of a Merger
In 1995 Seacorp (fully owned by Captain B)
purchases a boat for 300,000. In 2005, the
boats book value is 150,000, but its market
value is 280,000. In 2005 Seacorp also holds
50,000 of marketable securities so its market
value is 330,000. Suppose Baycorp acquires
Seacorp for 330,000.
Defensive Tactics
  • Target-firm managers frequently resist takeover
  • It can start with press releases and mailings to
    shareholders that present managements viewpoint
    and escalate to legal action.
  • Management resistance may represent the pursuit
    of self interest at the expense of shareholders.
  • Resistance may benefit shareholders in the end if
    it results in a higher offer premium from the
    bidding firm or another bidder.

Takeover Defenses Terminology
  • White Knight - Friendly potential acquirer sought
    by the target companys management. The white
    knight promises to maintain the jobs of existing
    management and helps to threaten an unwelcome
  • Shark Repellent - Amendments to a company charter
    made to forestall takeover attempts.
  • Poison Pill - Measure taken by a target firm to
    avoid acquisition for example, the right for
    existing shareholders to buy additional shares at
    an attractive price if a bidder acquires a large
  • Golden parachutes - are compensation to outgoing
    target firm management.
  • Crown jewels - are the major assets of the
    target. If the target firm management is
    desperate enough, they will sell off the crown

The Control Block and Anti-Takeover Legislation
  • If one individual or group owns 51-percent of a
    companys stock, this control block makes a
    hostile takeover virtually impossible.
  • Control blocks are typical in Canada, although
    they are the exception in the United States.
  • In the US, however, anti-takeover legislation has
    received wide attention.

Exclusionary Offers and Nonvoting Stock
  • The target firm makes a tender offer for its own
    stock while excluding targeted shareholders.
  • An example
  • In 1986, the Canadian Tire Dealers Association
    offered to buy 49 of the companys voting shares
    from the founding Billes family.
  • The offer was voided by the OSC, since it was
    viewed as an illegal form of discrimination
    against one group of shareholders.

Going Private and LBOs
  • If the existing management buys the firm from the
    shareholders and takes it private.
  • If it is financed with a lot of debt, it is a
    leveraged buyout (LBO).
  • The extra debt provides a tax deduction for the
    new owners, while at the same time turning the
    previous managers into owners.
  • This reduces the agency costs of equity as
    managers are now also owners.

Abnormal Returns in Successful Canadian Mergers
  • Target Bidder
  • Mergers 1964--83 9 3
  • Going private
  • Transactions 1977--89 25 NA
  • - Minority buyouts 27 NA
  • - Non-controlling bidder 24 NA

Comparison of U.S. vs. Canadian Mergers
  • The evidence both in U.S. and Canada strongly
    suggests that shareholders of successful target
    firms achieve substantial gains from takeovers.
  • Shareholders of bidding firms earn significantly
    less from takeovers. The balance is more even for
    Canadian mergers than for U.S. ones.
  • One possible reason
  • There is less competition among bidders in Canada.

  • The basic idea is to increase corporate focus.
  • Divestiture can take three forms
  • Sale of assets usually for cash
  • Spinoff parent company distributes shares of a
    subsidiary to shareholders. Shareholders wind up
    owning shares in two firms. Sometimes this is
    done with a public IPO.
  • Issuance if tracking stock a class of common
    stock whose value is connected to the performance
    of a particular segment of the parent company.

Summary and Conclusions
  • The three legal forms of acquisition are
  • Merger and consolidation
  • Acquisition of stock
  • Acquisition of assets
  • MA requires an understanding of complicated tax
    and accounting rules.
  • The synergy from a merger is the value of the
    combined firm less the value of the two firms as
    separate entities.

Summary and Conclusions
  • The possible synergies of an acquisition come
    from the following
  • Revenue enhancement
  • Cost reduction
  • Lower taxes
  • Lower cost of capital
  • The reduction in risk may actually help existing
    bondholders at the expense of shareholders.

Practice Q1
  • Suppose Todd Trucking Company's stock is trading
    for 50 a share while Hamilton Company's stock
    goes for 25 a share. The EPS of Todd is 1 while
    the EPS of Hamilton is 2.50. Neither company has
    debt in its current capital structure. Both
    companies have one million shares of stock
  • a. If Todd can acquire Hamilton for stock in an
    exchange based on market value, what should be
    the post-merger EPS?
  • b. Suppose Todd pays a premium of 20 in excess
    of Hamilton's current market value. How many
    shares of Todd must be given to Hamilton's
    shareholders for each of their shares?
  • c. Based on your results in b, what will Todd's
    EPS be after it acquires Hamilton?
  • d. If Hamilton were to acquire Todd by offering a
    20 premium in excess of Todd's current market
    price, how many shares of stock would Hamilton
    have to offer, and what would be the effect on
    Hamilton's EPS?

Practice Q2
  • Susie's Pizza is analyzing the possible
    acquisition of Janet's Electric. The projected
    cash flows to debt and equity expected from the
    merger are as follows
  • Year(s) CF
  • 1 150,000
  • 2 170,000
  • 3 200,000
  • 4 200,000
  • 5 on 6 growth per year
  • The current market price of Janet's debt is
    800,000, the risk-free rate is 8, the required
    return on the market is 12, and the beta of the
    firm being acquired is 1.5.
  • a. Determine the maximum price (NPV) Susie can
    afford to pay.
  • b. If Janet's current equity value is 1,100,000
    and she demands a 30 premium, will the merger
    take place?