Lecture 8 - Leasing

Question 1

Lease

Answer 1

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

Question 2

ownership costs

Answer 2

costs of maintaining the leased asset
insurance
maintenance
property taxes

Question 3

full-service lease

Answer 3

lessor bears ownership costs

Question 4

net lease

Answer 4

lessee bears ownership costs

Question 5

sale and lease-back

Answer 5

lessee was original owner

ex. firm owning real estate sells property to institution and simultaneously lease property back

Question 6

direct lease

Answer 6

lessor originally owned asset

Question 7

true lease

Answer 7

lease expense for lessee is tax deductible

Question 8

non-true lease

Answer 8

treated like debt; lessee deducts the interest & depr exp

Question 9

operating lease

Answer 9

ST, generally full-service, lease is cancelable during contract period at option of lessee

Question 10

how are operating leases accounted for?

Answer 10

NOT on B/S as asset/liability

just shows up as a footnote (off-balance sheet financing)

Question 11

financial (capital) leases

Answer 11

LT, net-lease that extends over most of leased asset’s life that is not cancelable

generally fully amortized

Question 12

how are financial leases accounted for?

Answer 12

PV of expected lease payments = liability on B/S; same value reported as asset to keep balance

Question 13

financial lease payments are recorded as….

Answer 13

expenses, rather than interest & principal payments

Question 14

fully amortized

Answer 14

PV of future rental payments = full price of leased equipment

Question 15

first payment for a lease is usually due….

Answer 15

as soon as leasing contract is signed (YEAR 0!!)

Question 16

steps for EAC

Answer 16

1. calculate incremental FCF if buy
2. est NPV of buying (r = A/T cost of borrowing)
3. find EAC of buying
4. compare to AT cost of leasing machine each year

Question 17

for EAC method, NPV of buying will be…

Answer 17

negative bc there’s no incremental revenues (since you’ll have the asset either way)

Question 18

EAC

Answer 18

PV of an asset’s costs calculated on an annual basis

Question 19

EAC formula

Answer 19

NPV = (- EAC / r) * [1 - 1 / (1+r)^n ]

NEGATIVE EAC can cancel out NEGATIVE NPV!
n = # of years asset will be used

Question 20

steps for calculating NPV of leasing vs buying directly

Answer 20

1. calculate incremental FCF from buying asset
2. calculate incremental CF of leasing
3. take diff of CF (lease - buy)
4. find NPV (with r = AT cost of buying)

Question 21

why do we use A/T cost of leasing?

Answer 21

bc you can deduct this from tax bill and generate tax savings! (true lease?)

Question 22

should you acquire the asset?

Answer 22

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

Question 23

possible assumptions made in EAC & NPV approaches

Answer 23

1. firm has profits to shield via depr TS
2. lease can’t be cancelled (if it can, you need to calculate option value)
3. assume same discount rate for all CF

Question 24

appropriate discount rate

Answer 24

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

Question 25

how can a lessor add value?

Answer 25

1. lower transaction costs
2. lessor can pass on savings to lessee
3. lessor can “lend” at a lower rate

Question 26

lower transaction costs

Answer 26

fewer inconvenience costs (you don’t need to buy/sell asset for ST use)
lower search & maintenance costs (lessor might be better equipped)

Question 27

how can lessors pass on savings?

Answer 27

1. 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)
2. scrap value of asset is larger to lessor bc they can more easily find new owner

Question 28

how can lessor’s “lend” at a lower rate?

Answer 28

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 $$)

Question 29

possible strategic advantages to leasing

Answer 29

1. may lower exit barriers for lessee (easier to end operating lease than sell asset)
2. firm can focus on products/customers

Question 30

dubious reasons to lease (3)

Answer 30

1. avoids cap ex limits
2. provides off-B/S financing
3. makes firm look more profitable

Question 31

what to do if 2 machines have unequal lives

Answer 31

use EAC!

Question 32

steps for EAC with unequal lives

Answer 32

1. calculate NPV of expected costs for each
2. use NPV to find EAC of each machine
3. choose one with lower EAC
   * assumes replacement after expiration*