Chapter 26 Leasing

1
Chapter 26 - Leasing

• What is a Lease?
• Why Lease?
• Operating versus Financial Leases
• Valuing Leases
• When Do Leases Pay?

2

• 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.

3
Buying versus Leasing
Buy
Lease
Firm U buys asset and uses asset financed by
debt and equity.
Lessor buys asset, Firm U leases it.
4
Reasons for Leasing

• Good Reasons
• Taxes may be reduced by leasing.
• 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.
• Bad Reasons
• Leasing and accounting income
• 100 financing

5
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.

6
Financial (Capital) Leases

• The exact opposite of an operating lease.
• Do not provide for maintenance or service by the
  lessor.
• 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.

7
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.

8
Leveraged Leases

• 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.

9
Leveraged Leases
Lessor buys asset, Firm U leases it.
Manufacturer of asset
Lessor borrows from lender to partially finance
purchase
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
Lessor
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
Creditors
10
Accounting and Leasing

• In the old days, leases led to off-balance-sheet
  financing.
• 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.

11
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
  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

12
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.

13
Taxes and Leases

• The principal benefit of long-term leasing is tax
  reduction.
• 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
  disallowed.
• 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.

14
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.

15
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
Greymare
16
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
bus.
17
Financial Leases
Example A loan with same cash flows as lease
18
Financial Leases
Example - cont The Greymare Bus Lines lease cash
flows can also be treated as a favorable
financing alternative and valued using APV.
19
Financial Lease Benefits
Value of lease to lessor
Value of lease
20
Example

• 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.

21
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?

22
Summary

• 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.

23
Practice Question 1

• Calculate NPV for lessee and lessor
• Cost of machine 85,000
• CCA rate 30
• Operating costs 10,000 per year maintenance
  expense
• 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)

24
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
  alternative?

25
Chapter 26 - Hedging

• Why Manage Risk?
• Insurance
• Forward and Futures Contracts
• SWAPS
• How to Set Up A Hedge

26
Risk Reduction

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

?
27
Risk Reduction

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

28
Insurance

• 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.

29
Insurance

• 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?

30
Insurance

• 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

31
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.

32
Insurance What to Insure

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

33
Hedging with Forwards and Futures

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

34
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.

35
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
Futures.
36
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
37
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
  prices
• Speculation - used to gamble
• Margin - not a sale - post partial amount

38
Futures and Spot Contracts
The basic relationship between futures prices and
spot prices for equity securities.
39
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?

40
Futures and Spot Contracts
The basic relationship between futures prices and
spot prices for commodities.
41
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?

42
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.
43
Swaps
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.
44
SWAPS

• 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

45
How to Set a Hedge?

• In practice, the commodity that a firm sells is
  likely not identical to the one traded on the
  exchange.
• 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).

46
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?

47
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.

48
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
gain/loss?
49
Margin

• 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.

50
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

51
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.

52
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
  existence.

53
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.

54
Acquisition of Assets

• One firm can acquire another by buying all of its
  assets.
• 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.

55
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.

56
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
57
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


58
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.

59
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.

60
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

61
Dubious Reasons for Mergers

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

62
Dubious Reasons for Mergers

• The Bootstrap Game

Acquiring Firm has high P/E ratio
63
Dubious Reasons for Mergers

• The Bootstrap Game

64
Dubious Reasons for Mergers
Earnings per dollar invested (log scale)
World Enterprises (after merger)
World Enterprises (before merger)
Muck Slurry
.10 .067 .05
Time
Now
65
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
66
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?

67
Estimating Merger Gains
68
Estimating Merger Gains
Example Two firms merge creating 25 million in
synergies. A pays B a sum of 65 million.
69
Estimating Merger Gains

• Look at Incremental Economic Gain

70
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
  synergies.

71
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.

72
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.
73
Defensive Tactics

• Target-firm managers frequently resist takeover
  attempts.
• 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.

74
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
  suitor.
• 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
  holding.
• 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
  jewels.

75
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.

76
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.

77
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.

78
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

79
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.

80
Divestitures

• 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.

81
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.

82
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.

83
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
  outstanding.
• 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?

84
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?