CF chapter 25 Flashcards
Leasing contract
Contract allowing the firm to use specific assets for several years in exchange for periodic payments
Lessee
the party in a lease using the asset and liable for the periodic payments
Lessor
The party in a lease lending the asset and entitled to periodic payments
Operational lease
Firm uses the asset during the contract term, after which it is returned to the lessor
Financial lease
Firm has the obligation/right to buy the asset after the contract term
Direct lease
The lessor is an independent company that specializes in purchasing assets and leasing them to customers
Very often subsidiaries of commercial banks
Sales type lease
The lessor is the manufacturer of the asset, offering lease financing services
Usually through a financial services subsidiary
Sale and lease-back
Firm already owns the asset, but would prefer to lease it
◦ Firm sells the asset to the lessor in return for cash
◦ Leases it back to continue using the asset
Leveraged leases
The lessor borrows from a bank or other lender to obtain the initial capital to purchase the asset
The lessor uses the lease payments from the lessee to pay interest and principal on the loan
Special purpose entity/vehicle
Separate business partnership created by the lessee for the sole purpose of obtaining a lease
Synthetic lease
Lease that uses an SPE for lease constructions that are targeted to obtain specific favorableaccounting and/or tax treatments
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Primary determinants of lease payments
Residual value:
At the end of the leasing period, since (purchase price –residual value) will be
depreciated, and may differ for lessor or lessee
Other costs:
such as servicing and maintenance are (1) not that large, and (2) usually not very
different for lessor/lessee
PV(lease payments) formula
PV(Lease payments) = Purchase price - PV(residual value)
Fair market value leased (end of term options)
Lessee has the option to purchase the asset at its fair market value at the end of the lease term
◦ In perfect capital markets, there is no difference between an FMV lease and an operational lease
Fixed price lease (end of term options)
Lessee has the option to purchase the asset at the end of the lease term for a fixed price that is set
upfront
Since the lessee has an option to purchase, he will buy the asset elsewhere if the fair market value is
lower than the fixed price
Fair market value cap lease (end of lease options)
Lessee can purchase the asset at the minimum of its fair market value and a fixed price (or “cap”)
◦ Similar to the fixed price lease, but the lessee is not likely to go elsewhere to buy the asset at the end
of the lease term
Lease provisions (examples)
Early cancellation option for the lessee (at a fee)
◦ Buyout option allowing the lessee to purchase the asset before the end of the lease term
◦ Trade-in clauses allowing the lessee to upgrade to a newer model at certain points in time during the
lease term
Operating lease: accounting treatment
Viewed as rental of the asset
Capital lease (accounting treatment)
viewed as acquisition with long-term financing
Accounting treats any lease like a capital lease if:
Title to the property transfers to the lessee at the end of the lease term
◦ Lease contains an option to purchase the asset at a bargain price being substantially less than its fair
market value
◦ Lease term is 75% or more of the estimated life of the asset
◦ Present value of the minimum lease payments at the start of the lease is 90% or more of the asset’s
fair market value
True tax lease
Lessor receives the depreciation deduction associated with the ownership of the asset
Lessee can deduct the full amount of the lease payments as an operating expense
Lease payments are treated as revenue for the lessor
non-tax lease
Lessee receives the depreciation deduction for tax purposes
Lessee can also deduct the interest portion of the lease payments as an interest expense
The interest portion of the lease payment is interest income to the lessor
Tax authorities will classify a lease as a non-tax lease if it satisfies any of
Lessee obtains equity in the leased asset
◦ Lessee receives ownership of the asset on completion of all lease payments
◦ Total amount that the lessee is required to pay for a relatively short period of use constitutes an
inordinately large portion of the value of the asset
◦ The lease payments greatly exceed the current fair rental value of the asset
◦ The property may be acquired at a bargain price in relation to the fair market value of the asset at
the time when the option may be exercised
◦ Some portion of the lease payments is specifically designated as interest or its equivalent
The lease-equivalent loan is defined as
The loan that is required for the purchase of the asset that leaves the purchaser with the same net
future obligations as a lease would entail
Suspect reasons for leasing
Avoid capital expenditure spending
*Preserve (working) capital
*Reduce leverage through off-balance sheet financing
