CORPORATE FINANCE

Lecturer: Long Tran Dinh

Chapter 21
Leasing
 Key more than 40 percent of all commercial
jetliners worldwide are leased

concepts
Why is there are companies in the
business of buying assets, only to lease
them out?

and skills And why don’t the companies that lease,

do not purchase the assets themselves?

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

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 Chapter 0utline

21.2 Accounting and 21.3 Taxes, the IRS, 21.4 The Cash
21.1 Types of Leases
Leasing and Leases Flows of Leasing

21.5 A Detour for

21.6 NPV Analysis of 21.7 Debt 21.8 Does Leasing
Discounting and
the Lease-versus- Displacement and Ever Pay? The Base
Debt Capacity with
Buy Decision Lease Valuation Case
Corporate Taxes

21.10 Some
21.9 Reasons for
Unanswered
Leasing
Questions
Types of Leases
21.1 TYPES OF LEASES

• A lease is a contractual agreement between a lessee and

The Basics

lessor.
• The lessor owns the asset and for a fee allows the lessee to
use the asset.

Should a user in a low tax bracket purchase, he will receive

little tax benefit from depreciation and interest deductions.
Should the user lease, the lessor will receive the depreciation
shield and the interest deductions. In a competitive market,
the lessor must charge a low lease payment to reflect these
tax shields. The user is likely to lease rather than purchase.
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21.1 TYPES OF LEASES

Buying versus Leasing

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21.1 TYPES OF LEASES

Operating Leases
Usually not fully amortized. This means that the payments required under the terms of the lease are
not enough to recover the full cost of the asset for the lessor . This occurs because the term, or life,
of the operating lease is usually less than the economic life of the asset. The lessor expects to recover
the costs of the asset by renewing the lease or by selling the asset for its residual value.

Usually require the lessor to maintain and insure the asset

Feature of an operating lease is the cancellation option (the right to cancel the lease contract before
the expiration date)

The value of a cancellation clause depends on whether future technological or economic conditions
are likely to make the value of the asset to the lessee less than the value of the future lease
payments under the lease
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21.1 TYPES OF LEASES

Financial Leases
Essentially opposite of an 2 special types of financial leases
operating lease. are:

Do not provide for maintenance The sale and leaseback

or service by the lessor. arrangement
Financial leases are fully
amortized. The leveraged lease arrangement.
(third-party financial institution)
The lessee usually has a right
to renew the lease at expiry.

Generally, financial leases

cannot be canceled.

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Accounting and Leasing
21.2 ACCOUNTING AND LEASING

Sale and Leaseback

• 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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21.2 ACCOUNTING AND LEASING

Leveraged Leases - I

• A particular type of financial lease.

• A three-sided arrangement among 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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21.2 ACCOUNTING AND LEASING

Leveraged Leases - II Lessor borrows from lender to partially

finance purchase
• Lessor buys asset, Firm U leases it.

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.

In the event of a default by the lessor,

the lender has a first lien on the asset.
Also, the lease payments are made
directly to the lender after a default.

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Taxes, the IRS, and Leases
21.3 TAXES, THE IRS, AND LEASES

Tax-Oriented Leases

• A particular type of financial lease

• Lessor is the owner of the leased asset for tax purposes
• Make the most sense when the lessee is not in a position to efficiently
use tax credits or depreciation deductions that come with owning the
asset
• By arranging for someone else to hold title, a tax lease passes these
benefits on. The lessee can benefit because the lessor may return a
portion of the tax benefits to the lessee in the form of lower lease
payments.

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21.3 TAXES, THE IRS, AND LEASES

Taxes, the IRS, and Leases

• 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 I R S seeks to limit this, especially if the lease appears to be
set up solely to avoid taxes.

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21.3 TAXES, THE IRS, AND LEASES

Taxes, the IRS, and Leases

• The lessee can deduct lease payments if the lease is qualified by the I R S.
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.

* A conditional sale refers to a transaction in which the purchaser receives possession of and the
right to use certain goods, but the title remains with the seller until the performance of a condition
is met by the buyer. 16
21.3 TAXES, THE IRS, AND LEASES

Accounting and Leasing

In the old days, under F A S 13 : For a capital lease, the present value of the lease payments appears on the
right side of the balance sheet. The identical value appears on the left side of the balance sheet as an asset.
While Operating leases are not disclosed on the balance sheet except in the footnotes
Starting in 2019, companies were required to disclose operating leases on their balance sheets. 17
The Cash Flows of Leasing
21.4 THE CASH FLOWS OF LEASING

• 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 5-year useful life.
• If the firm buys the truck, it will be depreciated straight-line to zero.
• They can lease it for five years from Tiger Leasing with an annual lease
payment of $6,250.
• Both firms face a 21 percent tax rate.

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21.4 THE CASH FLOWS OF LEASING
The Cash Flows of Leasing - I
CASH FLOWS: BUY Year 0 Years 1-5
Cost of truck −$25,000
Aftertax savings $4,500 × (1 − .21) = $3,555
Depreciation tax benefit _______ 5,000 × .21 = 1,050
−$25,000 $4,605

CASH FLOWS: LEASE Year 0 Years 1-5

Lease payments −$6,250 × (1−.21) = −$4,937.50

Aftertax savings 4,500 × (1−.21) = 3,555.00

−$1,382.50
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21.4 THE CASH FLOWS OF LEASING
The Cash Flows of Leasing - II

CASH FLOWS: LEASING INSTEAD OF BUYING

Year 0 Years 1–5

$25,000 −$1,382.50 − 4,605 = −$5,987.50

✓ We could also view the cash flows as buying minus leasing,

which would change the signs on the cash flows.

✓ The discount rate is the aftertax rate on the firm’s secured

debt.

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21.4 THE CASH FLOWS OF LEASING

Example 2

The International Boring Machine Corporation (IBMC) makes a pipe-boring

machine that can be purchased for $10,000. Xomox has determined that it
needs a new machine, and the IBMC model will save Xomox $6,000 per year in
reduced electricity bills for the next five years. These savings are known with
certainty because Xomox has a long-term electricity purchase agreement with
State Electric Utilities, Inc. Xomox has a corporate tax rate of 21 percent. For
simplicity, we assume that five-year straight-line depreciation is used for the
pipe-boring machine and the machine will be worthless after five years.
Friendly Leasing Corporation has offered to lease the same pipe-boring machine
to Xomox for $2,500 per year for five years. With the lease, Xomox would
remain responsible for maintenance, insurance, and operating expenses.
21.4 THE CASH FLOWS OF LEASING

Cash Flows to Xomox from Using the IBMC Pipe-Boring Machine: Buy versus Lease
21.4 THE CASH FLOWS OF LEASING
Incremental Cash Flow Consequences for Xomox from Leasing Instead of Purchasing

1. Operating costs are not directly affected by leasing. Xomox will save $4,740 (after taxes) from use
of the IBMC boring machine regardless of whether the machine is owned or leased. This cash
flow stream does not appear in Table.
2. If the machine is leased, Xomox will save the $10,000 it would have used to purchase the
machine. This saving shows up as an initial cash inflow of $10,000 in Year 0.
3. If Xomox leases the pipe-boring machine, it will no longer own this machine and must give up
the depreciation tax benefits. These lost tax benefits show up as an outflow.
4. If Xomox chooses to lease the machine, it must pay $2,500 per year for five years. The first
payment is due at the end of the first year. (This is a break: Often the first payment is due
immediately.) The lease payments are tax deductible and, as a consequence, generate tax
benefits of $525 (= .21 × $2,500)
21.4 THE CASH FLOWS OF LEASING

The net cash flows

Now that we have the cash flows, we can make our decision by discounting the
cash flows properly

• cash flows in the lease-versus-buy decision should be discounted at the aftertax

cost of debt

** If Xomox were losing money (or had loss carryforwards), it would not pay taxes,
and the tax shelters would be worthless (unless they could be shifted to someone
else)
A Detour for Discounting
and Debt Capacity with
Corporate Taxes
21.5 A Detour for Discounting & Debt Capacity with Corporate Taxes
• 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.

Lending and Borrowing

in a World with
Corporate Taxes
(interest rate is 10
percent and corporate
tax rate is 21 percent)

If it received $100 today, it could lend it out, thereby receiving $107.90 after corporate taxes at the
end of the year. Conversely, if it knows today that it will receive $107.90 at the end of the year, it
could borrow $100 today. (the increase in the firm’s optimal debt level) 27
 OPTIMAL DEBT LEVEL AND RISKLESS CASH FLOWS

Consider a firm that has determined that the current level of debt in its capital structure is optimal.
It is ensured that the firm will receive a guaranteed payment of $107.90 in one year

→ This future windfall is an asset that, like any asset, should raise the firm’s optimal debt level. How much does
this payment raise the firm’s optimal level?

The firm could borrow $100 today, perhaps paying the entire amount out as a dividend. It would owe the bank
$110 at the end of the year. Because it receives a tax rebate of $2.10 (= .21 × $10), its net repayment will be
$107.90. The borrowing of $100 today is fully offset by next year’s government lottery proceeds of $107.90.

→ implies that the firm’s optimal debt level must be $100 more than it previously was, no matter what level of
previous optimal debt.
NPV Analysis of the Lease
versus
Buy Decision
21.6 NPV ANALYSIS OF LEASE - BUY DECISION

• 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 benefits and the lease
payments at the aftertax interest rate on secured debt issued by the lessee.

• The detour leads to a simple method for evaluating leases: Discount all cash flows at the aftertax interest rate

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 NPV ANALYSIS OF LEASE - BUY DECISION

I. Discount all cash flows at the aftertax interest rate

A lease payment is like the debt service on a secured bond issued by the lessee, and
the discount rate should be the same as the interest rate on such debt. In general, this rate will be
slightly higher than the riskless rate

Assume that Xomox can either borrow or lend at the interest rate of 6.329114 percent. If the
corporate tax rate is 21 percent, the correct discount rate is the aftertax rate of 5 percent
[= .06329114 × (1 - .21)]. When 5 percent is used to compute the NPV of the lease, we have NAL (net
advantage to leasing) approach

→ Because the net present value of the incremental cash flows from leasing relative to purchasing
is negative, Xomox prefers to purchase
→

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 NPV ANALYSIS OF LEASE - BUY DECISION
II.a Compare purchase price with reduction in optimal debt level
under leasing alternative:
a. Debt Displacement and Lease Valuation

Considering the issues of debt displacement allows for a

more intuitive understanding of the lease-versus-buy
decision.

A firm that purchases equipment will generally issue debt

to finance the purchase. The debt becomes a liability of the
firm. A lessee incurs a liability equal to the present value of
all future lease payments. Because of this, we argue that
leases displace debt

→ 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 benefits of debt capacity will be lost—particularly the lower taxes associated with interest
expense. The interest tax shield will be lost.
Debt Displacement and
Lease Valuation
21.7 Debt Displacement and Lease Valuation
EXAMPLE 1:
• 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 $25,922.74 (see the next slide).
• In exchange for this, they get the use of a truck worth $25,000.
• Clearly the NPV is −$922.74, which agrees with our earlier calculations.
• 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.
Aftertax Lease Payments −$6,250 × (1 − .21) = −$4,937.50
Foregone Depreciation Tax Shield −5,000 × .21 = −1,050.00
−$5,987.50

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21.7 Debt Displacement and Lease Valuation

Suppose a firm initially has $100,000 of assets and a 150 percent optimal debt-equity ratio. The firm’s
debt is $60,000 and its equity is $40,000. As in the Xomox case, suppose the firm must use a new
$10,000 machine. The firm has two alternatives:
1. The firm can purchase the machine. If it does, it will finance the purchase with a secured loan and
with equity. The debt capacity of the machine is assumed to be the same as for the firm as a whole.
2. The firm can lease the asset and get 100 percent financing. That is, the present value of the
future lease payments will be $10,000. If the firm finances the machine with both secured debt and
new equity, its debt will increase by $6,000 and its equity by $4,000. Its optimal debt-equity ratio of
150 percent will be maintained.
Conversely, consider the lease alternative. Because the lessee views the lease payment as a liability,
the lessee thinks in terms of a liability-equity ratio, not a debt-equity ratio.

As mentioned, the present value of the lease liability is $10,000. If the leasing firm is to maintain a
liability-equity ratio of 150 percent, debt elsewhere in the firm must fall by $4,000 when the lease is
instituted. Because debt must be repurchased, net liabilities rise by only $6,000 (= $10,000 - 4,000)
when $10,000 of assets are placed under lease.
21.7 Debt Displacement and Lease Valuation
21.7 Debt Displacement and Lease Valuation
II.b Compare purchase price with reduction in optimal debt level
under leasing alternative:
b. Optimal Debt Level In The Xomox Example

Previously (slide 24): cash flows from the purchase alternative relative to the cash flows from
the lease alternative

→ The additional debt level of the purchase alternative relative to the lease alternative is by
discounting the future riskless cash inflows at the aftertax interest rate

→ whatever the optimal amount of debt would be under the lease

alternative, the optimal amount of debt would be $10,369.10 more
under the purchase alternative
21.7 Debt Displacement and Lease Valuation
In other words, the incremental loan from the purchase alternative relative to the cash flows
from the lease alternative can be paid off by the extra cash flows of $2,395 per year
In details: Because the purchasing firm borrows $10,369.10 more at Year 0 than does the leasing firm, the
purchasing firm will pay interest of $656.27 (= $10,369.10 × .06329114) at Year 1 on the additional debt.
The interest allows the firm to reduce its taxes by $137.82 (= $656.27 × .21), leaving an aftertax outflow of
$518.45 (= $656.27 - 137.82) at Year 1.
The purchasing firm can repay $1,876.55 (= more cash generate Buy vs Lease – interest expense = $2,395 −
518.45 ) of the loan at Year 1 and still have the same net cash flow that the leasing firm has
→ The annual cash flow of $2,395, which represents the extra cash from purchasing instead of leasing, fully
amortizes the loan of $10,369.10. (outstanding balance goes to zero over the five years)
→
21.7 Debt Displacement and Lease Valuation
II.c Compare purchase price with reduction in optimal debt level
under leasing alternative:
→ The analysis tell us the additional debt capacity from purchasing and indicate whether the lease
is preferred to the purchase
By leasing the equipment and having $10,369.10 less debt than under the purchasing alternative,
the firm has exactly the same cash flows in Years 1 to 5 that it would have through a levered
purchase. We can ignore cash flows beginning in Year 1 when comparing the lease alternative to the
purchase-with-debt alternative. However, the cash flows differ between the alternatives at Year 0:
1. The purchase cost at Year 0 of $10,000 is avoided by leasing. This should be viewed as a cash
inflow under the leasing alternative.
2. The firm borrows $10,369.10 less at Year 0 under the lease alternative than it can under the
purchase alternative. This should be viewed as a cash outflow under the leasing alternative.
Because the firm borrows $10,369.10 less by leasing but saves only $10,000 on the equipment,
the lease alternative requires an extra cash outflow at Year 0 relative to the purchase alternative
of - $369.10 (= $10,000 - 10,369.10).
→ Because cash flows in later years from leasing are identical to those from purchasing with debt,
the firm should purchase.
Does Leasing Ever Pay?
The Base Case
21.8 DOES LEASING EVER PAY? THE BASE CASE

Reasons for Leasing

• Good Reasons
1/ Taxes may be reduced by leasing.
Should a user in a low tax bracket purchase, he will receive little tax benefit from depreciation and
interest deductions. Should the user lease, the lessor will receive the depreciation shield and the
interest deductions. In a competitive market, the lessor must charge a low lease payment to reflect
these tax shields. The user is likely to lease rather than purchase.

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21.8 DOES LEASING EVER PAY? THE BASE CASE

Impact of Taxes Example - I

• Now suppose a world without a flat corporate tax rate where ClumZee movers is in the
21 percent tax bracket and Tiger Leasing is in a 34 percent tax bracket. If Tiger reduces
the lease payment to $6,200, can both firms have positive NPV?
• Cash Flows: Tiger Leasing
Year 0 Years 1-5
Cost of truck −$25,000
Depreciation tax $5,000 × .34 =
Shield $1,700
Lease payments _______ 6,200 × (1 − .34) = 4,092
−$25,000 $5,792

• NPV = $76.33
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21.8 DOES LEASING EVER PAY? THE BASE CASE

Impact of Taxes Example - II

• Cash Flows ClumZee Movers: Leasing Instead of Buying

Year 0 Years 1 to 5

Cost of truck we didn’t buy $25,000

Lost depreciation tax shield –$5,000 × .21 = −$1,050

Aftertax lease payments _______ $6,200 × (1 − .21) = −$4,898

$25,000 −$5,948

• NPV = −$751.73

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21.8 DOES LEASING EVER PAY? THE BASE CASE

Tiger Leasing’s Reservation Payment - I

• What is the smallest lease payment that Tiger Leasing will accept? Set their NPV to zero
and solve for $Lmin:

Year 0 Years 1 to 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)

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21.8 DOES LEASING EVER PAY? THE BASE CASE

Tiger Leasing’s Reservation Payment - II

• Step One is to find the aftertax cost of the truck.
• Step Two is to find the aftertax payment required.

This is $6,173.29
on a pretax basis.

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21.8 DOES LEASING EVER PAY? THE BASE CASE

ClumZee’s Reservation Payment - I

• What is the highest lease payment that ClumZee Movers can pay? Set their N P V
to zero and solve for $Lmax:

Year 0 Years 1 to 5

Cost of truck −$25,000

Depreciation tax shield $5,000 × .21 = $1,050

Lease payments _______ $Lmax × (1 − .21) = $Lmax × (1 − .21)

−$25,000 $1,050 + $Lmax × (1 − .21)

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21.8 DOES LEASING EVER PAY? THE BASE CASE

ClumZee Movers’ Break-Even Payment - II

• Step One is to find the aftertax cost of the truck.
• Step Two is to find the aftertax payment required.

This is $5,980.22 on a
pretax basis.

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21.8 DOES LEASING EVER PAY? THE BASE CASE

Is a Lease Possible?

• The most that ClumZee Movers can afford to pay is $5,980.22

• 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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Reasons for Leasing
21.9 REASONS FOR LEASING

Good Reasons Bad Reasons

• 1/ The lease contract may reduce certain • 1/ Accounting
types of uncertainty. • Leasing can have a significant effect on the
• When the lease contract is signed, there may be appearance of the firm’s financial statements. If
substantial uncertainty about what the residual a firm is successful at keeping its leases off the
value of the asset will be. books, the balance sheet and, potentially, the
• Under a lease contract, this residual risk is income statement can be made to look better.
borne by the lessor. Conversely, the user bears • 2/ 100 percent financing
this risk when purchasing. • Leasing provides 100 percent financing, whereas
• 2/ Transactions costs can be higher for buying secured equipment loans require an initial down
an asset and financing it with debt or equity payment. Suggest that leases do not permit a
than for leasing the asset. greater level of total liabilities than do purchases
• The costs of changing an asset’s ownership are with borrowing
generally greater than the costs of writing a lease
agreement. Leases generate agency costs, as well.
For example, the lessee might misuse or overuse
the asset because she has no interest in the
asset’s residual value. This cost will be implicitly
paid by the lessee through a high lease payment.
Although the lessor can reduce these agency
costs through monitoring, monitoring itself is
costly. Leasing is most beneficial when the
transaction costs of purchase and resale
outweigh the agency costs and monitoring costs
of a lease 50
Some Unanswered
Questions
21.10 SOME UNANSWERED QUESTIONS

• Are the Uses of Leases and 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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Quick Quiz

1. Compare operating and financing leases.

2. Explain why tax rates affect the lease-versus-buy decision.

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THANKS!
Any questions?
You can find me at long.trandinh@westernsydney.edu.vn +84 83 456 1007

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