Week 3: Leasing
*How to find Lease-Equivalent loan* con't
Thus, by buying and borrowing using the lease-equivalent loan, Spafax saves an additional $39,622 − $38,000 = $1622 initially, and so leasing the equipment is unattractive relative to this alternative.
*LEASE PAYMENTS* How much should you pay to lease an asset? 23.1
It Depends on RESIDUAL VALUE PV(Lease Payments)= Purchase Price - PV(Residual Value)
Why lease rather than buy? What is a Lessee? Lessor?
It is an alternative to paying upfront Lessee: Liable to make payments each month Lessor: owns asset
Comparing Equation 23.2 with Equation 23.1, we see that while with a standard loan we are financing the entire cost of the asset, with a lease we are financing only the cost of the economic depreciation of the asset during the term of the lease. Because we are getting the entire asset when we purchase it with the loan, the loan payments are higher than the lease payments.
LOAN PAYMENTS IN A PERFECT MARKET (in pic)
*Valid Arguments for Leasing* *Efficiency Gains from Specialization.*
Lessors often have efficiency advantages over lessees in maintaining or operating certain types of assets. For example, a lessor of office copy machines can employ expert technicians and maintain an inventory of spare parts required for maintenance. Some types of leases may even come with an operator, such as a truck with a driver (in fact, the term "operating lease" originated from such leases).
*Valid Arguments for Leasing* *Reduced Resale Costs*
Many assets are time consuming and costly to sell. If a firm needs to use the asset for only a short time, leasing it is probably less costly than buying and later reselling the asset. In this case, the lessor is responsible for finding a new user for the asset. Lessors are often specialized in finding new users and so face much lower costs.
*ACCOUNTING, TAX, AND LEGAL CONSEQUENCES OF LEASING*
Should the firm list the asset on its balance sheet and deduct depreciation expenses? Should the firm list the lease as a liability? Can the lease payments be deducted for tax purposes? In the event of bankruptcy, is the leased asset protected from creditors?
Example of True Tax Lease Problem (1/3)
Suppose Spafax rejects the lease we analyzed, and the lessor agrees to lower the lease rate to $11,400 per year. Does this change make the lease attractive? *Solution in pic* >Therefore, the lease is attractive at the new terms. *Evaluate* By reducing the lease payments by $600 ($390 after-tax) each, we can make the lease more attractive than borrowing and buying. It is important to re-evaluate the decision when the lease terms change.
Define: *Fair Market Value (FMV) Lease* *$1 out lease (finance lease)* *Fixed Price Lease* *Fair Market Value Cap Lease* *Example 23.3, End of Lease Options*
*FMV* gives the lessee the option to purchase the asset at its fair market value at the termination of the lease. *$1 out lease (finance lease)* ownership of the asset transfers to the lessee at the end of the lease for a nominal cost of $1.00 *Fixed Price* the lessee has the option to purchase the asset at the end of the lease for a fixed price that is set up front in the lease contract. *FMV Cap Lease* the lessee can purchase the asset at the minimum of its fair market value and a fixed price (the "cap").
*Lease Versus Borrow* (not lease versus buy) What is a lease-equivalent loan?
*Lease equivalent loan* The loan that is required on the purchase of the asset that leaves the purchaser with the same obligations as the lessee would have.
What are the 2 types of leases the IFRS distinguishes between? -Operating Lease -Finance LEase (EXAMPLE IN PIC)
*Operating Lease* Viewed as a RENTAL for accounting purposes. >Lessee reports payments as operating expense >Lessee does NOT report asset, deduct depreciation, or lease pmt as liability on balance sheet. These leases are disclosed in the financial statements *Finance Lease* Views as an ACQUISITION for accounting purposes. >Asset acquired listed on lessee's BS >Lessee incurs depreciation expenses for the asset >PV of future lease payments is listed as a liability >interest of lease payment is deducted as an interest expense
Examples of Types of Leases Sales Type? Sales and Leaseback?
*Sales Type* Lessor is the manufacturer (such as IBM, bot makes and leases computers) *Sales & Leaseback* Lessee sells the asset, and then makes paymenes to use it
What is security Interest? What is a true lease? >special case for aircrafts?
*Security Interest* the firm is assumed to have effective ownership of the asset, and the asset is protected against seizure. The lessor is then treated as any other secured creditor and must await the firm's reorganization or ultimate liquidation. *True Lease* the lessor retains ownership rights over the asset. special case for aircrafts: Within 60 days of filing under the CCAA, the lessee must choose whether to continue or repudiate an aircraft lease. If it continues the lease, it must settle all pending claims and continue to make all promised lease payments (including maintenance and insurance). If it repudi- ates the lease, the asset must be returned to the lessor
*Leases & Bankruptcy* What happens to leased assets when a company files bankruptcy? How do we decide how to treat leased property in bankruptcy?
- the firm's assets are protected from seizure by its creditors while existing management is given the opportunity to propose a reorganization plan - treatment of leased property in bankruptcy will depend on whether the lease is classified as a *security interest* or a *true lease* by the bankruptcy judge.
*THE LEASING DECISION* How should a firm decide whether to buy or lease an asset?
-Cash flows for True Tax Lease -Cash flows for Non-Tax Lease
*Cash Flows for a True Tax Lease* How does capital expenditure change if the asset is leased?
-If firm buys asset, its a Capex, depreciates overtime and generates CCA tax shield. -If it is leased, and is a TRUE TAX lease,there is no capex, but the payments are an operating expense
*TAX TREATMENT OF LEASES* When do you treat a lease as a sale transaction? What is a *True-Tax* Lease? What is a *Non-Tax* Lease? >Example of non-tax in pic
-When the lease results in eventual ownership (lease contract treated as lease, sales contract treated as sale) *True Tax Lease* A lease in which the lessor receives the depreciation deductions associated with the ownership of the asset. The lessee can deduct the full amount of the lease payments as an operating expense, and these lease payments are treated as revenue for the lessor. *Non-Tax Lease* A lease in which the lessee receives the depreciation deductions for tax purposes and can also deduct the interest portion of the lease payments as an interest expense. The interest portion of the lease payment is interest income for the lessor.
Leases Vs Loans. As an alternative to PAYING to use the asset, we could LOAN it. Assuming the loan is fairly priced, the loan payments would be such that? (23.2)
Assuming the loan is fairly priced, the loan payments would be such that *PV(Loan Payments) = Purchase Price*
If a company buys an asset, what change occurs to FCF? IF it leases? *Example situation in pic*
Buys: only change to free cash flow is from capital expenditures and the CCA tax shield Leases: the only change is a reduction in EBITDA, and therefore taxes, from the lease payment.
How does the law of one price relate to leasing? *EXAMPLE 23.2*
Cost of purchasing and reselling asset is equal to the cost of leasing *in a perfect capitalist market*
If we combine equation 23.1 and 23.2 we have
PV(Lease Payments) + PV(Residual Value) = PV(Loan Payments the cost of leasing and then purchasing the asset is equivalent to the cost of borrowing to purchase the asset
*Valid Arguments for Leasing* *reduced distress costs & increased debt capacity.* *Transferring risk*
assets leased under a true lease are not afforded bankruptcy protection and can be seized in the event of default. In addition, the lessor may be better able to recover the full economic value of the asset (by re-leasing it) than a lender would. Because of the higher recovery value in the event of default, a lessor may be able to offer more attractive financing through the lease than an ordinary lender could. Recent studies suggest that this effect is important for small firms and firms that are capital constrained *Transferring risk* there may be significant uncertainty about the residual value of the leased asset, and whoever owns the asset bears this risk. Leasing allows the party best able to bear the risk to hold it. For example, small firms with a low tolerance for risk may prefer to lease rather than purchase assets.
Allthingsmathematics Video on Leasing
https://www.youtube.com/watch?v=95ivQMSQq3w