Chapter 21

Leasing
 Understand the different types of leases.
 Understand how to apply NPV to the lease vs. buy
decision.
 Understand the importance of tax rates in determining
the benefit of leasing.

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21.1 Types of Leases
21.2 Accounting and Leasing
21.3 Taxes, the IRS, and Leases
21.4 The Cash Flows of Leasing
21.5 A Detour for Discounting and Debt Capacity
with Corporate Taxes
21.6 NPV Analysis of the Lease-versus-Buy Decision
21.7 Debt Displacement and Lease Valuation
21.8 Does Leasing Ever Pay: The Base Case
21.9 Reasons for Leasing
21.10 Some Unanswered Questions

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 The Basics
◦ A lease is a contractual agreement between a lessee and
lessor.
◦ The lessor owns the asset and for a fee allows the lessee to
use the asset.

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 Buy Lease
Firm U buys asset and uses asset; Lessor buys asset, Firm U leases it.
financed by debt and equity.
Manufacturer of asset Manufacturer of asset

Firm U Lessor Lessee (Firm U)

1. Uses asset 1. Owns asset 1. Uses asset

2. Owns asset 2. Does not use asset 2. Does not own asset

Equity shareholders Creditors Equity

shareholdersz Creditors

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 Usually not fully amortized
 Usually require the lessor to maintain and insure the
asset
 Lessee enjoys a cancellation option

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Essentially opposite of an operating lease.
1. Do not provide for maintenance or service by the
lessor.
2. Financial leases are fully amortized.
3. The lessee usually has a right to renew the lease
at expiry.
4. Generally, financial leases cannot be cancelled.

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 A particular type of financial lease
 Occurs when a company sells an asset it already owns
to another firm and immediately leases it from them.
 Two sets of cash flows occur:
◦ The lessee receives cash today from the sale.
◦ The lessee agrees to make periodic lease payments, thereby
retaining the use of the asset.

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 A leveraged lease is another type of financial lease.
 A three-sided arrangement between the lessee, the
lessor, and lenders:
◦ The lessor owns the asset and for a fee allows the lessee to
use the asset.
◦ The lessor borrows to partially finance the asset.
◦ The lenders typically use a nonrecourse loan. This means
that the lessor is not obligated to the lender in case of a
default by the lessee.

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Lessor buys asset, Firm U leases it.

Manufacturer Lessor borrows from lender to

of asset partially finance purchase

The lenders typically use a

nonrecourse loan. This
Lessor Lessee (Firm U) means that the lessor is not
1. Owns asset 1. Uses asset obligated to the lender in
2. Does not use asset 2. Does not own asset case of a default by the
lessee.
In the event of a default by
the lessor, the lender has a
Equity first lien on the asset. Also,
shareholders Creditors the lease payments are
made directly to the lender
after a default.
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 In the old days, leases led to off-balance-sheet
financing.
 Today, leases are either classified as capital leases or
operating leases.
◦ Operating leases do not appear on the balance sheet.
◦ Capital leases appear on the balance sheet—the present
value of the lease payments appears on both sides.

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Truck is purchased with debt
Truck $100,000 Debt $100,000
Land $100,000 Equity $100,000
Total Assets $200,000 Total Debt & Equity $200,000

Operating Lease
Truck Debt
Land $100,000 Equity $100,000
Total Assets $100,000 Total Debt & Equity $100,000

Capital Lease
Assets leased $100,000 Obligations under capital lease
$100,000
Land $100,000 Equity $100,000
Total Assets $200,000 Total Debt & Equity $200,000

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 A lease must be capitalized if any one of the
following is met:
◦ The present value of the lease payments is at least 90
percent of the fair market value of the asset at the start of
the lease.
◦ The lease transfers ownership of the property to the lessee
by the end of the term of the lease.
◦ The lease term is 75 percent or more of the estimated
economic life of the asset.
◦ The lessee can buy the asset at a bargain price at expiry.

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 The principal benefit of long-term leasing is tax
reduction.
 Leasing allows the transfer of tax benefits from those
who need equipment but cannot take full advantage
of the tax benefits of ownership to a party who can.
 Naturally, the IRS seeks to limit this, especially if the
lease appears to be set up solely to avoid taxes.

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 The lessee can deduct lease payments if the lease is
qualified by the IRS.
1. The term must be less than 30 years.
2. There can be no bargain purchase option.
3. The lease should not have a schedule of payments that is
very high at the start of the lease and low thereafter.
4. The lease payments must provide the lessor with a fair
market rate of return.
5. The lease should not limit the lessee’s right to issue debt
or pay dividends.
6. Renewal options must be reasonable and reflect fair
market value of the asset.
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Consider a firm, ClumZee Movers, that wishes to acquire a
delivery truck.
The truck is expected to reduce costs by $4,500 per year.
The truck costs $25,000 and has a useful life of 5 years.
If the firm buys the truck, they will depreciate it straight-
line to zero.
They can lease it for 5 years from Tiger Leasing with an
annual lease payment of $6,250.

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  Cash Flows: Buy
Year 0 Years 1-5
Cost of truck –$25,000
After-tax savings 4,500×(1-.34) =
$2,970
Depreciation Tax Shield _ 5,000×(.34) =
$1,700
 Cash Flows: Lease–$25,000 $4,670
Year 0 Years 1-5
Lease Payments –6,250×(1-.34) = –$4,125
After-tax savings 4,500×(1-.34) = $2,970
–$1,155
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Cash Flows: Leasing Instead of Buying
Year 0 Years 1-5
$25,000 –$1,155 – $4,670 = –$5,825

We could also view the cash flows as buying minus

leasing, which would simply change the signs on the
cash flows.
The discount rate is the aftertax rate on the firm’s secured
debt.

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 Present Value of Riskless Cash Flows
◦ In a world with corporate taxes, firms should discount
riskless cash flows at the aftertax riskless rate of interest.
 Optimal Debt Level and Riskless Cash Flows
◦ In a world with corporate taxes, one determines the
increase in the firm’s optimal debt level by discounting a
future guaranteed aftertax inflow at the aftertax riskless
interest rate.

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 A lease payment is like the debt service on a secured
bond issued by the lessee.
 In the real world, many companies discount both the
depreciation tax shields and the lease payments at the
aftertax interest rate on secured debt issued by the
lessee.

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• There is a simple method for evaluating leases: discount
all cash flows at the aftertax interest rate on secured debt
issued by the lessee. Suppose that rate is 5 percent.
NPV Leasing Instead of Buying
Year 0 Years 1-5
$25,000 –$1,155 – $4,670 = – $5,825

CF0 $25,000 I 5

CF1 –$5,825 NPV –$219.20

F1 5
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NPV Buying Instead of Leasing
Year 0 Years 1-5
– $25,000 $4,670 – $1,155 = $5,825

CF0 –$25,000 I 5

CF1 $5,825 NPV $219.20

F1 5

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 Considering the issues of debt displacement allows
for a more intuitive understanding of the lease versus
buy decision.
 Leases displace debt—this is a hidden cost of leasing.
If a firm leases, it will not use as much regular debt as
it would otherwise.
 The interest tax shield will be lost.

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 The debt displaced by leasing results in forgone interest
tax shields on the debt that ClumZee movers did not
take on when they leased instead of bought the truck.
 Suppose ClumZee agrees to a lease payment of $6,250
before tax. This payment would support a loan of
$25,219.20 (see the next slide).
 In exchange for this, they get the use of a truck worth
$25,000.
 Clearly the NPV is a negative $219.20, which agrees
with our earlier calculations.

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Calculate the increase in debt capacity by discounting
the difference between the cash flows of the purchase
and the cash flows of the lease using the aftertax
interest rate.
After-Tax Lease Payments –6,250×(1 –.34) = –
$4,125
Forgone Depreciation Tax Shield –5,000×(.34) = –
$1,700 –$5,825

N I/Yr PV PMT FV

5 5 $25,219.20 –$5,825 0

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 In the above example, ClumZee Movers chose to buy,
because the NPV of leasing was a negative $219.20
 Note that this is the opposite of the NPV that Tiger Leasing
would have:
• Cash Flows: Tiger Leasing
Year 0 Years 1–5
Cost of truck –$25,000
Depreciation Tax Shield 5,000×(.34) = $1,700
Lease Payments 6,250×(1-.34) = $4,125
–$25,000 $5,825
CF0 –$25,000 I 5
CF1 $5,825 F1 5 NPV $219.20
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 Good Reasons
◦ Taxes may be reduced by leasing.
◦ The lease contract may reduce certain types of uncertainty.
◦ Transactions costs can be higher for buying an asset and
financing it with debt or equity than for leasing the asset.
 Bad Reasons
◦ Accounting

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 Suppose ClumZee movers is actually in the 25% tax
bracket and Tiger Leasing is in the 34% tax bracket.
If Tiger reduces the lease payment to $6,200, can
both firms have a positive NPV?
 Cash Flows: Tiger Leasing
Year 0 Years 1-5
Cost of truck –$25,000
Depreciation Tax Shield 5,000×(.34) = $1,700
Lease Payments 6,200×(1 –.34) = $4,092
–$25,000 $5,792
NPV = 76.33

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Cash Flows ClumZee Movers: Leasing Instead of Buying

Year 0 Years 1-5

Cost of truck we didn’t buy $25,000
Lost Depreciation Tax Shield
After-Tax Lease Payments
$25,000
NPV = -$543.91
5,000×(.25) = –$1,250
6,200×(1 –.25) = –$4,650
–$5,900

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 What is the smallest lease payment that Tiger Leasing
will accept? Set their NPV to zero and solve for $Lmin:
Year 0 Years 1-5
Cost of truck -$25,000
Depreciation Tax Shield 5,000×(.34) = $1,700
Lease Payments $Lmin × (1 –.34) = $Lmin × (1 –
.34)
-$25,000 $1,700 + $Lmin × (1 –.34)
5
$1,700
$25,000  
5
.66  Lmin  $1,700
NPV  0  $25,000   t
(1.05) t t 1 (1.05)
t 1 Lmin  5
$1
5
$1 5
$1,700 .66  
$25,000  .66  Lmin   (1.05)t t
t  t 1
(1.05)
t 1 (1.05) t 1

Lmin  $6,173.29
 21-29
 Step one is to find the aftertax cost of the truck.
Step two is to find the aftertax payment required.

Step Two
CF0 −25,000 N 5
Step One

CF1 $1,700 I/Yr 5

F1 5 PV − $17,639.89

I 5 PMT $4,074.37
This is $6,173.29
NPV −$17,639.89 FV 0 on a pre-tax basis.

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 What is the highest lease payment that ClumZee
Movers can pay? Set their NPV to zero and solve for
$Lmax:

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Step one is to find the aftertax cost of the truck.
Step two is to find the aftertax payment required.

CF0 −25,000 N 5

Step Two
Step One

CF1 $1,250 I/Yr 5

F1 5 PV − $19,588.15

I 5 PMT $4,524.37

This is $6,032.49
NPV −$19,588.15 FV 0 on a pre-tax basis.

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 The most that ClumZee movers can afford to pay is:
$6,032.49
 The least that Tiger Leasing can accept is:
$6,173.29
 So, there will not be a lease in this case.

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 Are the Uses of Leases and of Debt Complementary?
 Why are Leases offered by Both Manufacturers and
Third Party Lessors?
 Why are Some Assets Leased More than Others?

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 Compare operating and financing leases.

 Explain why tax rates affect the lease vs. buy

decision.

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