Week 9 Flashcards
How does leasing work?
In leasing the lessor owns the asset, but it is used by the lessee in exchange for lease payments. A lease is a contractual agreement between these two parties. The rights and obligations depend on the nature of the lease, which could be operating or financing.
What are the motives of leasing for a firm?
The motives for leasing to a firm are: annual payment vs lump-sum purchase amount, lease payments are fully tax-deductible, it avoids asset obsolescence and technology risk, lease terms are normally comparable to bank finance.
What is an operating lease?
Operating leases are essentially a rental agreement, these are usually not fully-amortized, as such the term of the leases is less than the economic life of the asset (payments not enough to cover cost), they usually require the lessor to maintain and insure the asset, and the lessee gets a cancellation option, at little or no cost typically.
What is a financial lease?
A financial lease is fully-amortized, meaning the lease payments fully recover the cost of the asset. The lessor does not have to provide for maintenance or service of the asset. The lessee usually has a right to renew the lease at expiry, or activate a purchase clause. They generally cannot be cancelled.
What is a sale and lease-back agreement? Why might a firm do this?
Sale and lease-back agreements are a type of financial lease in which the owner of an asset sells the asset to another firm or financial institution for an amount usually equal to current market value, and immediately leases it back. Hence, the lessee receives cash today from the sale, but agrees to make periodic lease payments. These are done to free up financial resources for the firm and transfer the responsibility and risk of asset ownership.
What is a leveraged lease?
A leveraged lease is an extended form of financial lease for expensive or specialized asset. In this case, most of the funds needed to purchase the leased asset are borrowed by the lessor, in this case the lessor owns the asset, but a large proportion of the asset is paid with debt from the lender, the lessee then uses the asset and the lease payments are used to meet interest and principal on the loan payments and provide a return for the lessor (and tax benefits).
Do operating and financial leases appear on the balance sheet?
Operating leases do not appear on the balance sheet, capital (financial) leases appear on the balance sheet, with the present value of the lease payments on both sides.
What are the potential conditions for a lease to be a financial lease?
To be a financial (capital) lease one of these conditions must be met:
- The present value of lease payments amounts ot over 90% of the fair market value of the asset at the start of the lease.
- The lease transfers ownership of the asset to the lessee by the end of the lease terms
- The lease term is for over 75% of the estimated economic life of the asset.
- The lessee has a bargain purchase option and it is certain at the date of inception that the option will be exercised.
What are the benefits of leasing?
The benefits of leasing are:
Tax deductibility of lease payments, and deferral / smoothing of upfront purchase costs.
The benefits of borrowing and purchasing are the interest and depreciation tax shields.
How do we determine the NAL? How do we use it?
To determine the net advantage of leasing (NAL) we calculate the differential cash inflows and outflows from deciding to lease rather than purchasing the asset (without including the debt specific interest tax shield effect in buying scenario as it is included in our discount rate), we then discount these to present value using the after-tax cost of secured debt (the debt used to purchase the asset). We lease the asset rather than purchase if the NAL is positive, and vice versa.
What is the NAB?
We could use the net advantage of buying (NAB) which is the net advantage of leasing in reverse, in this case we purchase if it is positive and lease if vice versa.
What is the formula for NAL?
The net advantage of leasing = tax savings from leasing – tax savings from buying) – opportunity cost. Where the opportunity cost is the present value of lease payments and residual value – the purchase price of the asset.
What value do we use to compute the present value of the after-tax salvage value for NAB or NAL?
When dealing with the after-tax salvage value for the net advantage of leasing or buying we use the cost of capital.
How do we work out the lessor’s maximum payment for a lease?
Lessor’s required payment three-step process:
1.Compute the lessor’s amount to be amortized:
initial outlay – present value of after-tax salvage value – present value of depreciation tax shield.
2.Compute after-tax lease income required:
Amount to be amortized = present value of after-tax lease income.
3.Compute before-tax lease payment:
Lease payment = after-tax lease income required / (1- lessor’s marginal tax rate)
What are the comparative tax benefits of leasing vs buying? What does this mean for the firm’s debt capacity?
The comparative tax benefits are a key driver of the lease versus buy decision. The lease is a form of debt displacement, as it can be done instead of the normal debt (and equity finance), particularly in the case of financial (capital), where the lease payments become a form of liability (debt) and no equity. If a firm has an optimal capital structure, a purchase decision will lead to funding in line with the firm’s debt-to-equity ratio. This leads to greater debt and greater interest tax shields.
This means when the after-tax cash flows from the buy alternative are greater than those from the lease alternative, the firm can effectively carry more debt (have a higher optimal level of debt) under the purchase option. This is because the present value of the additional cash flows generated from purchasing the asset relative to leasing it, giving additional debt capacity. For two identical firms, a bank would be more willing to lend to the purchasing firm as it has more assets.
