Lecture 8 - Leasing Flashcards
Lease
typical contract specifies a series of fixed payments paid by lessee to lessor at regular intervals
@end of lease, asset is returned to lessor but lessee may have opp to buy asset
ownership costs
costs of maintaining the leased asset
insurance
maintenance
property taxes
full-service lease
lessor bears ownership costs
net lease
lessee bears ownership costs
sale and lease-back
lessee was original owner
ex. firm owning real estate sells property to institution and simultaneously lease property back
direct lease
lessor originally owned asset
true lease
lease expense for lessee is tax deductible
non-true lease
treated like debt; lessee deducts the interest & depr exp
operating lease
ST, generally full-service, lease is cancelable during contract period at option of lessee
how are operating leases accounted for?
NOT on B/S as asset/liability
just shows up as a footnote (off-balance sheet financing)
financial (capital) leases
LT, net-lease that extends over most of leased asset’s life that is not cancelable
generally fully amortized
how are financial leases accounted for?
PV of expected lease payments = liability on B/S; same value reported as asset to keep balance
financial lease payments are recorded as….
expenses, rather than interest & principal payments
fully amortized
PV of future rental payments = full price of leased equipment
first payment for a lease is usually due….
as soon as leasing contract is signed (YEAR 0!!)
steps for EAC
- calculate incremental FCF if buy
- est NPV of buying (r = A/T cost of borrowing)
- find EAC of buying
- compare to AT cost of leasing machine each year
for EAC method, NPV of buying will be…
negative bc there’s no incremental revenues (since you’ll have the asset either way)
EAC
PV of an asset’s costs calculated on an annual basis
EAC formula
NPV = (- EAC / r) * [1 - 1 / (1+r)^n ]
NEGATIVE EAC can cancel out NEGATIVE NPV!
n = # of years asset will be used
steps for calculating NPV of leasing vs buying directly
- calculate incremental FCF from buying asset
- calculate incremental CF of leasing
- take diff of CF (lease - buy)
- find NPV (with r = AT cost of buying)
why do we use A/T cost of leasing?
bc you can deduct this from tax bill and generate tax savings! (true lease?)
should you acquire the asset?
you need to do NPV of whether having the asset adds value to the firm!
EAC and NPV approach to leasing will only tell you whether to buy or lease it, not if you actually SHOULD have asset
possible assumptions made in EAC & NPV approaches
- firm has profits to shield via depr TS
- lease can’t be cancelled (if it can, you need to calculate option value)
- assume same discount rate for all CF
appropriate discount rate
what it would’ve cost the firm to instead borrow on its own to finance the purchase of the asset
if fraction λ of cost can be raised w/ debt, then the AT cost of borrowing =
λrD(1-T) + (1-λ)rE
usually assume λ=1 unless there’s a reason the firm couldn’t borrow full amount
how can a lessor add value?
- lower transaction costs
- lessor can pass on savings to lessee
- lessor can “lend” at a lower rate
lower transaction costs
fewer inconvenience costs (you don’t need to buy/sell asset for ST use)
lower search & maintenance costs (lessor might be better equipped)
how can lessors pass on savings?
- lessor may be better able to make use of depr/interest TS provided by buying asset (ex. if lessee isn’t profitable, and lessor transfers savings by charging lower lease exp)
- scrap value of asset is larger to lessor bc they can more easily find new owner
how can lessor’s “lend” at a lower rate?
lessor has advantages relative to bank
lessor fares better in bankruptcy (if lease is affirmed by court and still uses asset in bankruptcy, it must still continue payments and lessor gets $$)
possible strategic advantages to leasing
- may lower exit barriers for lessee (easier to end operating lease than sell asset)
- firm can focus on products/customers
dubious reasons to lease (3)
- avoids cap ex limits
- provides off-B/S financing
- makes firm look more profitable
what to do if 2 machines have unequal lives
use EAC!
steps for EAC with unequal lives
- calculate NPV of expected costs for each
- use NPV to find EAC of each machine
- choose one with lower EAC
* assumes replacement after expiration*
