Lecture 4

LEASING
Prepared
By
Otmar, B.A
 Lease and Leasing
 A lease is a contractual agreement between a lessee
and lessor.
 The agreement establishes that the lessee has the
right to use an asset and in return must make periodic
payments to the lessor, the owner of the asset.
 The lessor is either the asset’s manufacturer or an
independent leasing company.
 Leasing is a process by which a firm can obtain the
use of a certain fixed assets for which it must pay a
series of contractual, periodic, tax deductible
payments.
 Lease and Leasing
 If the lessor is an independent leasing company, it
must buy the asset from a manufacturer. Then the
lessor delivers the asset to the lessee, and the lease
goes into effect.
 As far as the lessee is concerned, it is the use of the
asset that is most important, not who owns the asset.
The use of an asset can be obtained by a lease
contract.
 Because the user can also buy the asset, leasing and
buying involve alternative financing arrangements for
the use of an asset (see figure).
Lease and Leasing
 Lease and Leasing
 Leases may be for houses, offices, telephones, cars trucks
or computers. Leasing should not be confused with hire
purchase, which also features periodic payments from the
user to the owner of the asset.
 The key difference between the two is that hire purchase
agreements are essentially a deferred payment mechanism
for the user eventually to own the asset. Since the intention
is to own the asset after a few years, the tax benefits of
ownership can be used by the asset operator from the
outset.
 The lessor could be a bank or specialist leasing company, or
it could be a company set up by high tax-paying investors
seeking capital allowances to offset against their income,
thereby reducing their tax payments.
 Lease and Leasing
 There are certain characteristics of a lease follow from
the broad definitions:
 The lessor cannot terminate the lease provided the lessee meets the
conditions specified.
 The lessor is not responsible for the suitability of the property to the
lessee’s business.
 The lease may be extended at the end of the obligatory period for a
further period.
 Leasing is clearly advantageous to manufacturers and
lessors, since it increases opportunities for business.
 The documentation for leasing is usually simpler than
debt or equity financing.
 The greatest disadvantage is the risk that insufficient
care will be taken of the equipment.
 Advantages of Leasing
 Leasing is less capital-intensive than purchasing, so it is
more suitable for a business which has constraints on its
capital.
 Leasing shifts risk to the lessor in cases where capital
assets tend to fluctuate in value
 Lease payments are considered expenses rather than
assets, which can be set off against revenue when
calculating taxable profit at the end of the relevant tax
accounting period.
 Leasing provides more flexibility to a business which
expects to grow in the relatively short term because a
lease is not usually obliged to renew a lease at the end of
its term.
Disadvantages of Leasing
 Usually lease terms are rigid and difficult to navigate in
circumstances where the business has to change its
operations substantially.
 Tactical legal considerations usually make it expedient
for lessees to default on their leases.
 If the business is successful, lessors may demand
higher rental payments when leases come up for
renewal.
 A net lease may shift some or all of the maintenance
costs onto the tenant.
Leasing Vs hire purchase
 Ownership of the asset: In lease, ownership lies with
the lessor. The lessee has the right to use the
equipment and does not have an option to purchase.
Whereas in hire purchase, the hirer has the option to
purchase. The hirer becomes the owner of the
asset/equipment immediately after the last installment
is paid.
 Duration: Generally lease agreements are done for
longer duration and for bigger assets like land,
property etc. hire purchase agreements are done
mostly for shorter duration and cheaper assets like
hiring a car, machinery etc.
Leasing Vs hire purchase
 Tax impact: In lease agreement, the total lease rentals
are shown as expenditure by the lessee. In hire
purchase, the hirer claims the depreciation of asset as
an expense.
 Extent of finance: Lease financing can be called the
complete financing option in which no down payments
are required but in case of hire purchase, the normally
20 to 25% margin money is required to be paid upfront
by the hirer. Therefore, we call it a partial finance like
loans etc.
Leasing Vs hire purchase
 Rental payment: The lease rentals cover the cost of using
an asset. Normally, it is derived with the cost of an asset
over the asset life. In case of hire purchase, installment is
inclusive of the principal amount and the interest for the
time period the asset is utilized.
 Repairs and maintenance: Repairs and maintenance of the
assets in financial lease is the responsibility of the lessee but
in operating lease, its the responsibility of the lessor. In hire
purchase, the responsibility lies with the hirer.
 Depreciation: In lease financing, the depreciation is claimed
as an expense in the books of lessor. On the other hand, the
depreciation claim is allowed to the hirer in case of hire
purchase transaction.
 Types of lease
 Operating lease: Short-term, cancellable lease
agreements. The lessor is responsible for the
maintenance and insurance of the asset. For instance,
tourist renting a car, hotel rooms, etc.
 Financial lease or finance lease: Long term non
cancellable lease contract. For instance, plant,
machinery, building, ships and aircraft.
 Sale and lease-back: Special financial agreement in
which the user may sell an asset owned by him to the
lessor and lease it back from him. For instance,
shipping industry.
 Operating lease
 A lease where the lessee received an operator along with
the equipment was called an operating lease.
 A lease is an operating lease if it does not transfer
substantially all the risks and rewards incident to
ownership
 It is a contract that allows for the use of an asset, but
does not convey rights of ownership of the asset. It
represents an off-balance sheet financing of assets,
where a leased asset and associated liabilities of future
rent payments are not included on the balance sheet of
a company. The typical assets that are rented under
operating leases include real estate, aircraft and various
Equipments with long useful life spans.
 Operating lease
 Though the operating lease defies an exact definition
today, this form of leasing has several important
characteristics:
 Operating leases are 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.
Thus, the lessor must expect to recover the costs of the
asset by renewing the lease or by selling the asset for its
residual value.
 Operating leases usually require the lessor to maintain and
insure the leased assets.
 Operating lease
 Perhaps the most interesting feature of an operating lease is
the cancellation option. This option gives the lessee the right
to cancel the lease contract before the expiration date. If the
option to cancel is exercised, the lessee must return the
equipment to the lessor. 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.
 Operating leases may have a purchase option for the
lessee to buy the property at the end of the lease
term, sometimes at a fair market value and sometimes
at a stated price.
 finance lease
 A lease is a finance lease if it transfers substantially all
the risks and rewards incident to ownership
 It is a type of rental agreement that obliges the lessee
(the person making periodic lease payments) to make a
balloon payment at the end of the lease agreement
amounting to the difference between the residual and
fair market value of the asset.
 Since the lessee must purchase the leased asset upon
lease expiration, that person bears the risk that the asset
depreciates more than was expected by the end of the
lease. Of course, at the same time, the lessee stands to
realize a gain if the asset depreciates less than expected.
 finance lease
 Financial leases are the exact opposite of operating
leases, as is seen from their important characteristics:
i. Financial leases do not provide for maintenance or service
by the lessor.
ii. Financial leases are fully amortized.
iii. The lessee usually has a right to renew the lease on
expiration.
iv. Generally, financial leases cannot be canceled. In other
words, the lessee must make all payments or face the risk
of bankruptcy.
 Because of these characteristics, particularly (ii), this
lease provides an alternative method of financing to
purchase.
 finance lease
 The normal risks and benefits of ownership are the
responsibility of the lessee, although they are not the legal
owner of the property at any time during the lease period,
finance leases are often called full pay-out leases. It
follows that the lessee is responsible for repairs,
maintenance and insurance of the transportation property,
and that the risk of obsolescence lies with the lessee.
 The lessor does not consider the residual value of the
property at the end of the lease period important, and does
not need to be technically knowledgeable about property or
business. The lessor may demand that the lessee pay a
specified number of rentals on the first day of the lease
payment, with a corresponding rental holiday at the end of
the lease term.
 Sale and Leaseback
 A sale and leaseback occurs when a company sells an
asset it owns to another firm and immediately leases it
back. In a sale and leaseback two things happen:
 The lessee receives cash from the sale of the asset.
 The lessee makes periodic lease payments, thereby retaining
use of the asset.
 For example, in January 2018, FEP, distributor of Finix
electronic organizers, closed the sale and leaseback of
its corporate headquarters building. The company sold
the building for TZS 10.3 million, and at the same time
agreed to a 10-year lease with the purchaser with an
initial annual payment of TZS 736,000.
 Leveraged Leases
 A leveraged lease is one where the property is acquired
using a large amount of debt finance and a small amount of
equity finance. Equity is normally between 20 and 40 per
cent of the total value of the property, resulting in high
gearing and thus high risk and potential reward for the
equity investors.
 Equity investors are prepared to accept this risk, often
because they are able to capture significant tax benefits
from having title to the asset.
 leveraged lease is a three-sided arrangement among
the lessee, the lessor, and the lenders:
 As in other leases, the lessee uses the assets and makes
periodic lease payments.
 Leveraged Leases
 As in other leases, the lessor purchases the assets, delivers
them to the lessee, and collects the lease payments.
However, the lessor puts up no more than 40 to 50 percent
of the purchase price.
 The lenders supply the remaining financing and receive
interest payments from the lessor. Thus, the arrangement
on the right side of the previous figure would be a leveraged
lease if the bulk of the financing was supplied by creditors.
 The lenders in a leveraged lease typically use a
nonrecourse loan. This means that the lessor is not
obligated to the lender in case of a default.
 Leveraged Leases
 However, the lender is protected in two ways:
 The lender has a first lien on the asset.
 In the event of loan default, the lease payments are made
directly to the lender.
 The lessor puts up only part of the funds but gets the
lease payments and all the tax benefits of ownership.
 Accounting and Leasing
 IAS 17: Leases prescribes the accounting policies and
disclosures applicable to leases, both for lessees and
lessors.
 Leases are required to be classified as either finance
leases (which transfer substantially all the risks and
rewards of ownership, and give rise to asset and liability
recognition by the lessee and a receivable by the lessor)
and operating leases (which result in expense recognition
by the lessee, with the asset remaining recognised by the
lessor).
 IAS 17 was reissued in December 2003 and applies to annual
periods beginning on or after 1 January 2005. IAS 17 will be
superseded by IFRS 16 Leases as of 1 January 2019.
 Accounting and Leasing
 IAS 17, Leases takes the concept of substance over
form and applies it to the specific accounting area of
leases.
 Substance over form is the concept that the financial
statements and accompanying disclosures of a business
should reflect the underlying realities of accounting
transactions. Conversely, the information appearing in
the financial statements should not merely comply with
the legal form in which they appear.
 The key point of the concept is that a transaction should
not be recorded in such a manner as to hide the true
intent of the transaction, which would mislead the
readers of a company's financial statements.
 Accounting and Leasing
 When applying this concept, it is often deemed
necessary to account for the substance of a transaction,
i.e. its commercial reality, rather than its strict legal
form. In other words, the legal basis of a transaction
can be used to hide the true nature of a transaction.
 It is argued that by applying substance, the financial
statements become more reliable and ensure that the
lease is faithfully represented.
 Why do we need to apply substance to a lease?
 A lease agreement is a contract between two parties, the
lessor and the lessee. The lessor is the legal owner of the
asset, the lessee obtains the right to use the asset in
return for rental payments.
Accounting and Leasing
 Historically, assets that were used but not owned were not
shown on the statement of financial position and therefore any
associated liability was also left out of the statement – this was
known as ‘off balance sheet’ finance and was a way that
companies were able to keep their liabilities low, thus distorting
gearing and other key financial ratios.
 This form of accounting did not faithfully represent the
transaction. In reality a company often effectively ‘owned’ these
assets and ‘owed a liability’.
 Under modern day accounting the IASB framework states that an
asset is ‘a resource controlled by an entity as a result of past
events and from which future economic benefits are expected to
flow to the entity’ and a liability is ‘a present obligation of the
entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources
embodying economic benefits’. These substance-based definitions
form the platform for IAS 17, Leases.
 Accounting and Leasing
 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, but all other leases as
operating leases, though FASB’s definition differs from
that of non-accountants.
 For example: A Co. purchased a truck with debt of TZS
1,000 million, the Co. has operating lease for the truck, and
Co. has capital lease for the truck. State the accounting
implications of this distinction in the balance sheet. Also, the
Co. issued TZS1,000 of equity to purchase land.
 Taxes and Leases
 The lessee can deduct lease payments for income tax
purposes if the lease is qualified by the Gvt Agency,
because tax shields are critical to the economic viability of
any lease, all interested parties generally obtain an opinion
from the Gvt Agency before agreeing to a major lease
transaction. The opinion of the Gvt Agency will reflect the
following guidelines:
 The term of the lease must be less than 30 years. If the
term is greater than 30 years, the transaction will be
regarded as a conditional sale.
 The lease should not have an option to acquire the asset at
a price below its fair market value. This type of bargain
option would give the lessee the asset’s residual scrap value,
implying an equity interest.
 Taxes and Leases
 The lease should not have a schedule of payments that is
very high at the start of the lease term and thereafter very
low. Early balloon payments would be evidence that the
lease was being used to avoid taxes and not for a legitimate
business purpose.
 The lease payments must provide the lessor with a fair
market rate of return. The profit potential of the lease to
the lessor should be apart from the deal’s tax benefits.
 The lease should not limit the lessee’s right to issue debt or
pay dividends while the lease is operative.
 Renewal options must be reasonable and reflect the fair
market value of the asset. This requirement can be met by
granting the lessee the first option to meet a competing
outside offer.
 Taxes and Leases
 The reason the Gvt Agency is concerned about lease
contracts is that many times they appear to be set up
solely to avoid taxes.
 For example: Suppose a firm plans to purchase a TZS 5
million wagon that has a five-year class life. Depreciation
expense would be TZS 1,000,000 per year, assuming
straight-line depreciation. Now suppose the firm can lease
the wagon for TZS 500,000 per year for two years and buy
the wagon for TZS 5 million at the end of the two-year term.
The present value of the tax benefits from acquiring the
wagon would clearly be less than if the wagon were leased.
The speedup of lease payments would greatly benefit the
firm and give it a form of accelerated depreciation. If the tax
rates of the lessor and lessee are different, leasing can be a
form of tax avoidance.
 Cash Flows of Leasing
 In this part we identify the basic cash flows used in
evaluating a lease.
 Consider the decision confronting the Juan corporation,
which manufactures cars. Business has been expanding, and
Juan currently has a five-year backlog of cars orders for the
Tanzania Transport Company. The CMC makes a car that
can be purchased for TZS10 Million. Juan has determined
that it needs a new cars, and the CMC model will save Juan
TZS 6 Million per year in reduced electricity bills for the next
five years. These savings are known with certainty because
Juan has a long-term electricity purchase agreement with
TANESCO. Juan has a corporate tax rate of 34%. We
assume that five-year straight-line depreciation is used for
the car, and the car will be worthless after five years.
 Cash Flows of Leasing
 However, FLC has offered to lease the same car to Juan for
TZS 2.5 Million per year for five years. With the lease, Juan
would remain responsible for maintenance, insurance, and
operating expenses. Komaji, a recently hired Accountant by
professional graduated from NIT having a knowledge of
Transport costing and finance, has been asked to calculate
the incremental cash flows from leasing the CMC car in lieu
of buying it.
 Operating costs are not directly affected by leasing. Juan will
save TZS 3.96 Million (after taxes) from use of the CMC car
regardless of whether the car is owned or leased. Thus, this
cash flow stream does not appear in the incremental cash
flow consequences for Juan from leasing instead of
purchasing.
 PV of Riskless Cash Flows
 Consider a corporation that lends TZS 10,000 for a year.
If the interest rate is 10%, the firm will receive TZS
11,000 at the end of the year. Of this amount, TZS 1,000
is interest and the remaining TZS 10,000 is the principal
amount.
 A corporate tax rate of 34% implies taxes on the interest
of TZS 340 (= 0.34 × TZS 1,000). Thus, the firm ends
up with TZS 10,660 (= TZS 11,000 – TZS 340) after
taxes on a TZS 10,000 investment. With corporate taxes,
the firm should discount riskless cash flows at the after-
tax riskless rate of interest.
 Let us assume that Juan can either borrow or lend at the
interest rate of 7.57575 percent.
 NPV of Lease Vs Buy Decision
 If the corporate tax rate is 34%, the correct discount
rate is the after-tax rate of 5%[= 7.57575% × (1 –
.34)]. Refer to Juan incremental cash flows from
leasing versus purchasing. When 5% is used to
compute the NPV of the lease, we have:
NPV = 10,000 – 2,330 x A5.05 = -87.68

 Because the net present value of the incremental cash

flows from leasing relative to purchasing is negative,
Juan prefers to purchase.
 Debt Displacement and Lease
Valuation
 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.
 The balance sheet illustrate how leasing might affect
debt (debt displacement elsewhere in the firm when a
lease is instituted).
 Debt Displacement and Lease
Valuation

 Suppose a firm initially has TZS 100,000 of assets and

a 150% optimal debt–equity ratio. The firm’s debt is
TZS 60,000, and its equity is TZS 40,000. As in the
Juan case, suppose the firm must use a new car with
TZS 10,000. The firm has two alternatives:
 The firm can purchase the car. If it does, it will finance the
purchase with a secured loan and with equity. The debt
capacity of the car is assumed to be the same as for the firm
as a whole.
 The firm can lease the asset and get 100 percent financing.
That is, the present value of the future lease payments will
be TZS 10,000.
 Debt Displacement and Lease
Valuation

 If the firm finances the car with both secured debt and new
equity, its debt will increase by TZS 6,000 and its equity by
TZS 4,000. Its optimal debt–equity ratio of 150% 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-to-equity ratio, not
just a debt-to-equity ratio. As just mentioned, the present
value of the lease liability is TZS 10,000. If the leasing firm
is to maintain a liability-to-equity ratio of 150%, debt
elsewhere in the firm must fall by TZS 4,000 when the
lease is instituted. Because debt must be repurchased, net
liabilities rise by only TZS 6,000 (= TZS 10,000 – TZS
4,000) when TZS 10,000 of assets are placed under lease.
 Debt Displacement and Lease
Valuation
Assets Liabilities
Initial situation: TZS TZS
Current 50,000 Debt 60,000
Fixed 50,000 Equity 40,000
Total 100,000 Total 100,000
Buy with secured loan:
Current 50,000 Debt 66,000
Fixed 50,000 Equity 44,000
Car 10,000 Total 110,000
Total 110,000
Lease:
Current 50,000 Lease 10,000
Fixed 50,000 Debt 50,000
Car 10,000 Equity 40,000
Total 110,000 Total 110,000
 Debt Displacement and Lease
Valuation
 Debt displacement 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. Optimal Debt Level in the Juan Example:
Details Y0 Y1 Y2 Y3 Y4 Y5
Net cash flows from purchase
alternative relative to lease
alternative -10,000 2,330 2,330 2,330 2,330 2,330

 That is, whatever the optimal amount of debt would be

under the lease alternative, the optimal amount of debt
would be TZS 10,087.68 more under the purchase
alternative.
 Debt Displacement and Lease
Valuation
 Imagine there are two identical firms except that one firm
purchases the car and the other leases it. We know that the
purchasing firm generates TZS 2,330 more cash flow after
taxes in each of the five years than does the leasing firm.
 Further imagine that the same bank lends money to both
firms. The bank should lend the purchasing firm more
money because it has a greater cash flow each period.
Question comes, how much extra money should the bank
lend the purchasing firm so that the incremental loan can
be paid off by the extra cash flows of TZS 2,330 per year?
 Since the purchasing firm borrows TZS 10,087.68 more at
year 0 than does the leasing firm, the purchasing firm will
pay interest of TZS 764.22 (=TZS 10,087.68 × .0757575)
at year 1 on the additional debt.
 Debt Displacement and Lease
Valuation
 The interest allows the firm to reduce its taxes by TZS
259.83 (= TZS 764.22 × .34), leaving an after-tax outflow
of TZS 504.39 (= TZS 764.22 – TZS 259.83) at year 1. We
know that the purchasing firm generates TZS 2,330 more
cash at year 1 than does the leasing firm.
 As the purchasing firm has the extra TZS 2,330 coming in
at year 1 but must pay interest on its loan, how much of
the loan can the firm repay at year 1 and still have the
same cash flow as the leasing firm?. The purchasing firm
can repay TZS 1,825.61 (= TZS 2,330 – TZS 504.39) of the
loan at year 1 and still have the same net cash flow that
the leasing firm has. After the repayment, the purchasing
firm will have a remaining balance of TZS 8,262.07 (= TZS
10,087.68 – TZS 1,825.61) at year 1.
 Debt Displacement and Lease
Valuation
 Thus, the annual cash flow of TZS 2,330, which represents
the extra cash from purchasing instead of leasing, fully
amortizes the loan of TZS 10,087.68.
 Analysis of debt capacity has two purposes: First, we want to
show the additional debt capacity from purchasing, and Second,
we want to determine whether the lease is preferred to the
purchase.
 By leasing the equipment and having TZS 10,087.68 less
debt than under the purchase alternative, the firm has
exactly the same cash flow in years 1 to 5 that it would
have through a levered purchase. Thus, 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
 Debt Displacement and Lease
Valuation
Details Y0 Y1 Y2 Y3 Y4 Y5

Outstanding balance of loan 10,087.68 8,262.07 6,345.17 4,332.42 2,219.05 0.00

Interest 764.22 625.91 480.69 328.22 168.11
Tax deduction on interest 259.83 212.81 163.44 111.59 57.16
After-tax interest expense 504.39 413.10 317.25 216.63 110.95
Extra cash that purchasing firm
generates over leasing firm 2,330.00 2,330.00 2,330.00 2,330.00 2,330.00
Repayment of loan 1,825.61 1,916.90 2,012.75 2,113.37 2,219.05
 Debt Displacement and Lease
Valuation

 The purchase cost at year 0 of TZS 10,000 is avoided by

leasing. This should be viewed as a cash inflow under the
leasing alternative.
 The firm borrows TZS 10,087.68 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 TZS 10,087.68 less by leasing but
saves only TZS 10,000 on the equipment, the lease
alternative requires an extra cash outflow at year 0 relative
to the purchase alternative of – TZS 87.68 (= TZS 10,000 –
TZS 10,087.68). Because cash flows in later years from
leasing are identical to those from purchasing with debt,
the firm should purchase.
 Debt Displacement and Lease
Valuation

 Two Methods for Calculating Net Present Value of Lease

Relative to Purchase
 Method 1: Discount all cash flows at the after-tax
interest rate: - 87.68 = 10,000 – 2,330 x A5.05
 Method 2: Compare purchase price with reduction in
optimal debt level under leasing alternative: - 87.68 =
10,000 (purchase price) – 10,087.68 (reduction in
optimal debt level if leasing)
 Payment of Lessee
 We can now solve for LMAX, the payment that makes the
value of the lease to the lessee zero. When the lessee is in
a zero tax bracket, his cash flows, in terms of LMAX, are as
follows:
Details Y0 Y1 Y2 Y3 Y4 Y5
Cost of Car 10,000
Lease payment -LMAX -LMAX -LMAX -LMAX -LMAX

 This implies that:

Value of lease = 10,000 - LMAX x A5.05
 The value of the lease equals zero when:
LMAX = 10,000/A5.0757575 = TZS 2,476.62
 Payment of Lessor
 We now solve for LMIN, the payment that makes the value of
the lease to the lessor zero. The cash flows to the lessor, in
terms of LMIN, are these:
Details Y0 Y1 Y2 Y3 Y4 Y5
Cost of Car -10,000
Depreciation tax shield
[680 = 2,000 x .34)
After-tax lease 680 680 680 680 680
payment (tc = .34)
-LMIN x (.66) -LMIN x (.66) -LMIN x (.66) -LMIN x (.66) -LMIN x (.66)

 This chart implies that: Value of lease = - 10,000 + 680 x

A5.05 + LMIN x (.66) x A5.05
 The value of the lease equals zero when: LMIN = 10,000/((.66)
x A5.05) – [680/.66] = 3,499.62 – 1,030.30 = 2,469.32
47
 What Happens?
 The calculation states that; after performing the
calculation, the lessor knows that the lessee will never
be able to charge a payment above TZS 2,476.62, and
 The second calculation states that; after performing
the calculation, the lessee knows that the lessor will
never agree to a lease payment below TZS 2,469.32.
 A Reduction of Uncertainty
 We have noted that the lessee does not own the property
when the lease expires.
 The value of the property at this time is called the residual
value, and the lessor has a firm claim to it.
 When the lease contract is signed, there may be substantial
uncertainty about what the residual value of the asset will
be.
 Thus, under a lease contract, this residual risk is borne by
the lessor.
 Conversely, the user bears this risk when purchasing.
 Transaction Costs
 The costs of changing an asset’s ownership are generally
greater than the costs of writing a lease agreement. Consider the
choice that confronts a person who lives in Arusha but must do
business in DSM for two days. It would clearly be cheaper to rent
a hotel room for two nights than it would be to buy an apartment
house for two days and then to sell it. Unfortunately, leases
generate agency costs as well. For example, the lessee might
misuse or overuse the asset because she/he 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. Thus, leasing is
most beneficial when the transaction costs of purchase and resale
outweigh the agency costs and monitoring costs of a lease. This
occurs in short-term leases but not in long-term leases.
 question
 Q Corporation is a relatively new firm. Q has
experienced enough losses during its early years to
provide it with at least eight years of tax loss carry
forwards. Thus, Q’s effective tax rate is zero. Q plans
to lease equipment from New Leasing Company. The
term of the lease is five years. The purchase cost of
the equipment is TZS 650,000. New Leasing Company
is in the 35% tax bracket. There are no transaction
costs to the lease. Each firm can borrow at 7 percent.
 What is Q’s reservation price
 What is New Leasing Company’s reservation price?
 question
 Super Sonics Entertainment is considering
buying a car that costs TZS 435 billion. The
car will be depreciated over five years by the
straight-line method and will be worthless at
that time. The company can lease the car
with year-end payments of TZS 107.5 million.
The company can issue bonds at a 9 percent
interest rate. If the corporate tax rate is 35
percent, should the company buy or lease?