L10: Capital Structure - Pecking Order, Leasing Flashcards
What is a lease?
A contractual agreement that establishes the right of one party (lessee) to use an asset in exchange for making periodic payments to another (lessor).
What are some common types of leases?
- Sales-type lease: The lessor is the manufacturer of the asset. The lease is often bundled with services from the manufacturer (part of broader sales/pricing strategy).
- Direct lease: The lessor is an independent company that purchases assets and leases them to customers.
- Sales and leaseback: A company sells an asset it owns to another company and immediately leases it back.
- Leveraged lease: A lessor receives financing (borrow from bank or other lender) to purchase an asset and uses the asset and lease payments from the lessee as collateral.
What is the net advantage to leasing?
The NPV of the difference in free cash flow of leasing rather than buying.
NAL = NPV(Leasing) - NPV(Buying)
While the NAL can always be computed as a mathematical object, it is only economically meaningful if both leasing and buying are NPV positive projects. For instance, suppose both NPVs are negative. We can compute the NAL and it will tell us which option is worse. However, the value maximizing decision is to do neither.
In what way is lease debt-like?
- Involves acquiring the right to use an asset (like receiving financing for an investment)
- A lease agreement commits the firm to making periodic lease payments in the future (like repayment of debt).
- The failure of the firm to make a lease payment puts the firm in financial distress (like defaulting on a loan).
- If the event the firm reneges on the lease payment, the lessor has the right to reclaim the leased asset (much like creditors seizing collateral).
What is the lease equivalent loan?
The secured loan required on the purchase of the assets that leaves the buyer with the same obligations as the lessee.
Makes the appropriate adjustments to the cash flows rather than to the discount rate.
Amortize a portion of the loan every period. Because the interest tax shield only applies to the interest portion of loan payments, one must calculate the principal amount outstanding after every period (due to gradual amortization)
What can be said about tax gains from leasing?
- The tax advantage from leasing mainly stems from the accelerated tax deductions.
- A tax gain occurs if the lease shifts the more valuable deductions to the party with the higher tax rate.
In general:
- If lease payments deductions are faster than the depreciation tax deductions, there are tax gains if the lessor is in a lower tax bracket than the lessee.
- If lease payments deductions are slower than the depreciation tax deductions, there are tax gains if the lessor is in a higher tax bracket than the lessee.
What are the criteria for lease classification for taxes by the IRS?
The lessee can deduct lease payments as an operating expense if the lease is qualified by the IRS.
- The term of the lease must be less than 30 years.
- There can be no bargain purchase option.
- The lease should not have a schedule of payments that is very high at the start of the lease and low thereafter.
- The lease payments must provide the lessor with a fair market rate of return.
- The lease should not limit the lessee’s right to issue debt or pay dividends.
- Renewal options must be reasonable and reflect fair market value of the asset.
What can be said about leasing and moral hazard?
- Leasing involves acquiring the right to use an asset for a specified period of time without a transfer of ownership.
- The lessee might overuse/misuse the asset because a lack of ownership means the lessee has no interest in the asset’s residual value.
- The lessor anticipates the potential agency conflict and takes steps to mitigate it. These steps involve costs that are ultimately borne by the lessee.
- Moral hazard problems associated with the lessee tend to increase the effective cost to use an asset via leasing (relative to buying).
What can be said about leasing and costs of ownership transfer?
- Leasing involves acquiring the right to use an asset for a specified period of time without a transfer of ownership.
- The transfer of ownership involves significant direct costs (legal, intermediation, etc).
- The transfer of ownership often involves significant indirect costs (inspection cost, discounting due to adverse selection, etc).
- Costs associated with the transfer of ownership tend to make acquiring the right to use an asset cheaper via leasing (relative to buying).
What does Gilligan, T. W. (2004) suggest about lemons and leasing (used business aircraft market)?
- Examines the used business aircraft market in North America from 1980 to 1989.
- Capture quality uncertainty at the brand/model level with a proxy (air-worthiness directive by the FAA).
- Documents positive relationships between uncertainty about quality of used aircrafts and the amount of leasing.
- Leased aircrafts (all else equal) wear down faster.
What is information sensitivity?
A financial security’s information sensitivity tells us how much its value changes in response to changes in the distribution of the underlying payoff.
- Financial securities with higher information sensitivity incurs more adverse selection costs (i.e. they sell for less).
- Issuing financial securities with higher information sensitivity results in a higher cost of capital.
- For any given financial security, firms should issue when adverse selection is minimized.
What does Myers, S. C., & Majluf, N. S. (1984) suggest about pecking order?
Firms should issue securities in order of information sensitivity, for least to greatest.
Often (but not always), the ordering is:
Cash → Debt → Equity
When are lease payments typically made?
At the beginning of each payment period (first is due immediately after lease).
What are some end-of-term lease options?
- Asset is returned to the lessor, who can sell it at the residual value.
In many cases, the lease allows the lessee to obtain ownership of the asset for some price:
- Fair market value (FMV) lease: lessee has the option to purchase the asset at its FMV at the termination of the lease.
- $1.00 out lease (finance lease): ownership transfers to the lessee at the end for a nominal cost of $1.00. Hence, the lessee will continue to have use of the asset for its entire economic life. Effectively purchased the asset by making the lease payments. similar to financing the asset with a standard loan.
- Fixed price lease: option to purchase the asset at the end for a fixed price that is set upfront in the lease contract. Depending on the market value, you can make your choice.
- Fair market value cap lease: lessee can purchase the asset at the minimum of its FMV and a fixed price (the cap).
Is a lessor in a superior position than a lender is the lessee firm defaults?
Yes, since they retain ownership rights over the asset. Either, the lease assumes the lease and must settle all pending claims and continue to make all promised lease payments, or they reject the lease and the asset must be returned to the lessor (pending claims become unsecured claims).
