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CHAPTER 26 Leasing 889

SUMMARY AND CONCLUSIONS

26.8
A large fraction of Americas equipment is leased rather than purchased. This chapter
has described different lease types, accounting and tax implications of leasing, and how
to evaluate financial leases.
1. Leases can be separated into two types, financial and operating. Financial leases are
generally longer-term, fully amortized, and not cancelable without a hefty
termination payment. Operating leases are usually shorter-term, partially amortized,
and cancelable.
2. The distinction between financial and operating leases is important in financial
accounting. Financial (capital) leases must be reported on a firms balance sheet;
operating leases are not. We discussed the specific accounting criteria for
classifying leases as capital or operating.
3. Taxes are an important consideration in leasing, and the IRS has some specific rules
about what constitutes a valid lease for tax purposes.
4. A long-term financial lease is a source of financing much like long-term borrowing.
We showed how to go about an NPV analysis of leasing to decide whether leasing
is cheaper than borrowing. A key insight was that the appropriate discount rate is
the firms aftertax borrowing rate.
5. We saw that the existence of differential tax rates can make leasing an attractive
proposition for all parties. We also mentioned that a lease decreases the uncertainty
surrounding the residual value of the leased asset. This is a primary reason cited by
corporations for leasing.

C h a p t e r R e v i e w a n d S e l f - Te s t P r o b l e m s
26.1 Lease or Buy Your company wants to purchase a new network file server for
its wide-area computer network. The server costs $75,000. It will be completely
obsolete in three years. Your options are to borrow the money at 10 percent or to
lease the machine. If you lease, the payments will be $27,000 per year, payable
at the end of each of the next three years. If you buy the server, you can depre-
ciate it straight-line to zero over three years. The tax rate is 34 percent. Should
you lease or buy?
26.2 NPV of Leasing In the previous question, what is the NPV of the lease to the
lessor? At what lease payment will the lessee and the lessor both break even?

A n s w e r s t o C h a p t e r R e v i e w a n d S e l f - Te s t P r o b l e m s
26.1 If you buy the machine, the depreciation will be $25,000 per year. This generates
a tax shield of $25,000 .34 $8,500 per year, which is lost if the machine is
leased. The aftertax lease payment would be $27,000 (1 .34) $17,820.
Looking back at Table 26.2, you can lay out the cash flows from leasing as
follows:
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Lease versus Buy Year 0 Year 1 Year 2 Year 3

Aftertax lease payment $17,820 $17,820 $17,820

Lost depreciation tax shield 8,500 8,500 8,500
Cost of machine $75,000
Total cash flow $75,000 $26,320 $26,320 $26,320

The appropriate discount rate is the aftertax borrowing rate of .10 (1 .34)
6.6 percent. The NPV of leasing instead of borrowing and buying is:
NPV $75,000 26,320 (1 1/1.0663)/.066
$5,420.09
so leasing is cheaper.
26.2 Assuming that the lessor is in the same tax situation as the lessee, the NPV to the
lessor is $5,420.09. In other words, the lessor loses precisely what the lessee
makes.
For both parties to break even, the NPV of the lease must be zero. With a
6.6 percent rate for three years, a cash flow of $28,370.26 per year has a pres-
ent value of $75,000. The lost depreciation tax shield is still $8,500, so the
aftertax lease payment must be $19,870.26. The lease payment that produces a
zero NPV is therefore $19,870.26/.66 $30,106.45 per year.

Concepts Review and Critical Thinking Questions

1. Leasing versus Borrowing What are the key differences between leasing and
borrowing? Are they perfect substitutes?
2. Leasing and Taxes Taxes are an important consideration in the leasing deci-
sion. Who is more likely to lease, a profitable corporation in a high tax bracket
or a less profitable one in a low tax bracket? Why?
3. Leasing and IRR What are some of the potential problems with looking at
IRRs in evaluating a leasing decision?
4. Leasing Comment on the following remarks:
a. Leasing reduces risk and can reduce a firms cost of capital.
b. Leasing provides 100 percent financing.
c. If the tax advantages of leasing were eliminated, leasing would disappear.
5. Accounting for Leases Discuss the accounting criteria for determining
whether or not a lease must be reported on the balance sheet. In each case, give
a rationale for the criterion.
6. IRS Criteria Discuss the IRS criteria for determining whether or not a lease is
tax deductible. In each case, give a rationale for the criterion.
7. OffBalance Sheet Financing What is meant by the term offbalance sheet
financing? When do leases provide such financing, and what are the accounting
and economic consequences of such activity?
8. Sale and Leaseback Why might a firm choose to engage in a sale and lease-
back transaction? Give two reasons.
9. Leasing Cost Explain why the aftertax borrowing rate is the appropriate dis-
count rate to use in lease evaluation.
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Refer to the following example for Questions 10 through 12:

In February 1996, Trans World Airlines (TWA) agreed to acquire 20 Boeing 757-200s,
in a deal valued at about $1 billion. Of the 20 planes, 10 would be purchased directly
from Boeing. However, the remaining 10 were to be obtained through International
Lease Finance Corp., a Century City, California, firm, on a 10-year lease.
10. Leasing versus Purchase Why wouldnt TWA just purchase all 20 planes?
That is, why lease 10?
11. Reasons to Lease Why would International Lease Finance Corp. be willing to
buy planes from Boeing and then lease them to TWA? How is this different from
just loaning money to TWA to buy the planes?
12. Leasing What do you suppose happens to the leased planes at the end of the
10-year lease period?

Questions and Problems

Use the following information to work Problems 1 through 6: Basic
You work for a nuclear research laboratory that is contemplating leasing a diagnostic (Questions 16)
scanner (leasing is a very common practice with expensive, high-tech equipment). The
scanner costs $2,000,000, and it would be depreciated straight-line to zero over four
years. Because of radiation contamination, it will actually be completely valueless in
four years. You can lease it for $600,000 per year for four years.
1. Lease or Buy Assume that the tax rate is 35 percent. You can borrow at 8 per-
cent before taxes. Should you lease or buy?
2. Leasing Cash Flows What are the cash flows from the lease from the lessors
viewpoint? Assume a 35 percent tax bracket.
3. Finding the Break-Even Payment What would the lease payment have to be
for both lessor and lessee to be indifferent about the lease?
4. Taxes and Leasing Cash Flows Assume that your company does not contem-
plate paying taxes for the next several years. What are the cash flows from leas-
ing in this case?
5. Setting the Lease Payment In the previous question, over what range of lease
payments will the lease be profitable for both parties?
6. MACRS Depreciation and Leasing Rework Problem 1 assuming that the
scanner will be depreciated as three-year property under MACRS (see Chapter
10 for the depreciation allowances).

Intermediate
Use the following information to work Problems 7 through 9:
(Questions 79)
The Wildcat Oil Company is trying to decide whether to lease or buy a new computer-
assisted drilling system for its oil exploration business. Management has decided that it
must use the system to stay competitive; it will provide $600,000 in annual pretax cost
savings. The system costs $5.5 million and will be depreciated straight-line to zero over
five years. Wildcats tax rate is 34 percent, and the firm can borrow at 9 percent. Lam-
bert Leasing Company has offered to lease the drilling equipment to Wildcat for pay-
ments of $1,240,000 per year. Lamberts policy is to require its lessees to make
payments at the start of the year.
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Intermediate 7. Lease or Buy What is the NAL for Wildcat? What is the maximum lease pay-
(continued ) ment that would be acceptable to the company?
8. Leasing and Salvage Value Suppose it is estimated that the equipment will
have an aftertax residual value of $500,000 at the end of the lease. What is the
maximum lease payment acceptable to Wildcat now?
9. Deposits in Leasing Many lessors require a security deposit in the form of a
cash payment or other pledged collateral. Suppose Lambert requires Wildcat to
pay a $200,000 security deposit at the inception of the lease. If the lease payment
is still $1,240,000, is it advantageous for Wildcat to lease the equipment now?
Challenge 10. Lease versus Borrow Return to the case of the diagnostic scanner used in
(Question 10) Problems 1 through 6. Suppose the entire $2,000,000 purchase price of the scan-
ner is borrowed. The rate on the loan is 8 percent, and the loan will be repaid in
equal installments. Create a lease versus buy analysis that explicitly incorporates
the loan payments. Show that the NPV of leasing instead of buying is not
changed from what it was in Problem 1. Why is this so?