FIN 4510 Chapter 27 - Leasing

Lease

A contractual agreement between two parties: the lease and the lessor.

Lessee

The user of an asset in a leasing agreement and the lessee makes payments to the lessor.

Lessor

The owner of an asset in a leasing agreement and the lessor receives payments from the lessee.

Lease Agreements

Establish the terms of the lease, which can have various outcome (buyout, ownership at the end, etc)

• Leasing can be used more or less frequently depending on the industry

Operating Lease

A shorter-term lease under which the lessor is responsible for insurance, taxes, and upkeep.

Characteristics of operating leases:

• Payments received by the lessor are usually not enough to allow the lessor to fully recover the cost of the asset

• Frequently requires that the lessor maintain the asset, and the lessor also may be responsible for nay taxes or insurance

• Cancellation option can give the lessee the right to cancel the lease before the expiration date

Financial Lease

A longer-term lease fully amortized lease under which the lessee is responsible for maintenance, taxes, and insurance.

Characteristics of financial leases:

• Payments made under a financial lease (plus the anticipated residual or salvage value) are usually sufficient to fully cover the lessor’s cost of purchasing the asset and pay the lessor a return on the investment

• With a financial lease, the lessee (not the lessor) is usually responsible for insurance, maintenance, and taxes

  • Financial leases are often called triple net leases

• Financial lease generally cannot be canceled, at least not without a significant penalty

Tax-Oriented Lease (that is True Lease or Tax Lease)

A financial lease in which the lessor is the owner for tax purposes.

• Most appropriate when lessee is unable to efficiently use tax credits or depreciation deductions that come with owning the asset

Leveraged Lease

A financial lease in which the lessor borrows a substantial fraction of the cost of the leased asset on a nonrecourse basis, meaning that if the lessee defaults on the lease payment, the lessor does not have to keep making loan payments

Sale and Leaseback

A financial lease in which the lessee sells an asset to the lessor and then leases it back.

• Lessee receives cash from the sale of the asset and the lessee continues to use the asset

• Lessee may have the option to repurchase the leased asset at the end of the lease

Off-balance-sheet financing

Before November 1976 leasing was frequently called off-balance-sheet financing

• Firm could arrange to use an asset through a lease and not necessarily disclose existence of lease contract on the balance sheet

• Firms were required to report information about leasing activity only in the footnotes to their financial statements

Statement of Financial Accounting Standards No. 13 “Accounting for Leases”

• Issued November 1976

• Basic idea of FASB 14 is that certain financial leases must be capitalized

For accounting purposes, a lease is declared to be a capital lease if at least one of the following criteria is met:

• The lease transfers ownership of the property to the lessee by the end of the term of the lease

• The lessee has an option to purchase the asset that is relatively certain to be used

• The lease term is for a major part of the economic life of the asset

• The present value of the lease payments plus any other residual value equals or exceeds the value of the asset

• The asset is so specialized that it is expected to have no alternative use to the lessor at the end of the lease

Taxes

Lessee can deduct lease payments for income tax purposes, if the lease is deemed to be true by the IRS.

• IRS guidelines require that a lease be primarily for business purposes and not merely for purposes of tax avoidance

Right to Control

Generally, a lease is a contract that gives the lessee the right to control the use of a specific asset for a set period of time in exchange for payments made to the lessor.

Lessee has the right to control if, during the lease, the lessee:

• Has the right to essentially all the economic benefits from the use of the asset

• Has the tight to right to direct the use of the asset

Potential problems with the interest rate we calculated on the lease:

• We can interpret this rate as the internal rate of return, or IRR, on the decision to lease rather than buy; but doing so can be confusing.

  • Normally, the higher the IRR, the better; but we decided that leasing was a bad idea here.

  • The reason is that the cash flows are not conventional; the first cash flow is positive and the rest are negative, which is the opposite of the conventional case.

• We calculated the advantage of leasing instead of buying.

  • We could have done the opposite and come up with the advantage of buying instead of leasing, in which case the cash flows would be the same, but the signs would be reversed.

• Our interest rate is based on the net cash flows of leasing instead of buying. There is another rate that is sometimes calculated based solely on the lease payments.

Net Advantage to Leasing (NAL)

The NOV that is calculated when deciding whether to lease an asset or to buy it.

• Most popular means to leade analysis in the real world

Good Reasons for Leasing

• Tax Advantages

  • Lease contract allows lessor to take advantage of the depreciation and interest tax shields that cannot be used by lessee.

  • Firm in a high tax bracket will want to act as lessor, while low tax bracket firms will be lessees.

• Reduction of Uncertainty

  • Value of property at lease expiration is residual (or salvage) value

  • Lease contract is method of transferring uncertainty over residual value from the lessee to the lessor

• Lower Transaction Cost

  • For example, a person who lives in Los Angeles but must do business in New York for two days would find it cheaper to rent a hotel room for two nights instead of buying a condominium for two days (and then selling it).

  • May be major reason for short-term leases (operating leases), but is probably not a major reason for long-term leases.

• Fewer Restrictions and Security Requirements

  • Unlike secured loans, where the borrower will generally agree to a set of restrictive covenants, spelled out in the indenture, or loan agreement, such restrictions are not generally found in lease agreements.

  • With a secured loan, the borrower may have to pledge other assets as security, but with a lease, only the leased asset is so encumbered.

Dubious Reasons for Leasing

• 100 percent financing

• It is often claimed that an advantage to leasing is that it provides 100% financing, whereas secured equipment loans require an initial down payment.

  • A firm can borrow the down payment from another source that provides unsecured credit.

  • Leases do usually involve a down payment in the form of an advance lease payment (or security deposit).

• Low Cost

  • Unscrupulous lessors can encourage lessees to base leasing decisions on the “interest rate” implied by the lease payments, which is often called the implicit or effective rate.

  • Rate is not meaningful in leasing decisions and has no legal meaning.