Chapter 18

Lease Financing and Business Valuation

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Q1. What is the difference between a financial lease and an operating lease?
Answer: There are many differences between a financial lease vs. an operating lease. Let’s look
at the most significant differences between these two:
Basis for Comparison Financial Lease Operating Lease
Meaning A commercial arrangement in A commercial arrangement in
which the lessor allows the which the lessor allows the
lessee to use the asset for the lessee to use the asset for a
maximum part of its economic term smaller than the
life against payment of rentals economic life of the asset
is known as finance lease. against the payment of rentals
is known as operating lease.
The term of the lease A financial lease is a long- Operating lease is a short-term
term concept. concept.
Transferability The ownership is transferred The ownership remains with
to the lessee. the lessor.
Nature of contract The contract is called a loan The contract is called the
agreement/contract. rental agreement/contract.
Maintenance In the case of a financial lease, In the case of an operating
the lessee would need to take lease, the lessor would need to
care and maintain the asset. take care and maintain the
asset.
Risk of obsolescence It lies on the part of the lessee. It lies on the part of the lessor.
Cancellation Usually, during the primary In the case of an operating
terms, it can’t be done; but lease, the cancellation can be
there can be exceptions. made during the primary
period.
Tax advantage The expenses for the asset Even the lease rent deduction
such as depreciation and from the tax is allowed.
financing are allowed for a tax
deduction to a lessee.
Purchase Option A financial lease allows the In an operating lease, the
lessee to have a purchase lessee does not have an option
option at less than the fair to buy the asset during the
market value of the asset. lease period.
Example Plant and Machinery, Land, Projectors, Computers,
Office Building, etc. Laptops, Coffee Dispensers,
etc.

Q2. What is a sale and leaseback?

Answer: A sale and leaseback is special type of financial lease, often used with real estate, which
can be arranged by a user who currently owns some asset. In this transaction, an asset that is
previously owned by the seller is sold to someone else and then leased back to the first owner for
a long duration. In this way, a business owner can continue to use a vital asset but doesn't own it.

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The most common users of sale-leasebacks are builders or companies with high-cost fixed assets.
For example, in June 2022, BRB group, which is a subsidiary company of MRS Industry Ltd., sold
a ten-year-old building in Kushtia that warehoused the electric cable. The building was purchased
by Super Star Company, another electric goods manufacturer, for Tk.100 million, which
simultaneously signed a five-year operating lease with the BRB group. In summary, the BRB
group cashed out by selling the building, pocketed a good piece of change, and can now focus on
its business in large extent. Of course, the practice now must pay lease payments to the building’s
new owner Super Star Company.
Q3. How do per procedure payment terms differ from conventional terms?
Answer: Per procedure is a lease agreement in which payment is made to the lessor every time
the equipment is used while conventional terms are the fixed payment made by the lessee to the
lessor periodically.
Q4. What is the difference between a tax-oriented (guideline) lease and a non-tax-oriented
lease?
Answer: A tax orientated, also known as guideline lease follows the procedures, principals and
requirements of internal revenue services (IRS) which control the federal tax policies for a taxable
business. In contrast, the non-tax-oriented lease does not comply with the internal revenue services'
requirements and guidelines.
Q5. Why should the IRS care about lease provisions?
Answer: The internal revenue services (IRS) has mandate to care about lease provision in manner
that it allows the lessee to take advantage of the accelerated depreciation, interest included in, and
investment tax credit when the lease is for a capital asset. More specifically, the reason for the
IRS’s concern about lease terms is that:
∞ Without restrictions, a for-profit business could set up a lease transaction that calls for rapid
lease payments, which would be deductible from taxable income. The effect would be to
depreciate the equipment over a much shorter period than the IRS allows in its depreciation
guidelines. If just any type of contract could be called a lease and given tax treatment as a
lease, the timing of lease tax shelters could be sped up compared with depreciation tax
shelters. This speedup would benefit the lessee, but it would be costly to the government
and to individual taxpayers. For this reason, the IRS has established specific rules that
define a lease for tax purposes.
The primary point here is that if investor-owned businesses are to obtain tax benefits from leasing,
the lease contract must be written in a manner that will qualify it as a true lease under IRS
guidelines. Any questions about the tax status of a lease contract must be resolved by the potential
lessee prior to signing the contract.

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Q6: What is a tax-exempt lease?
Answer: A special type of financial transaction has been created for not-for-profit businesses
called a tax-exempt lease. In a tax-exempt lease, the implied interest portion of the lease payment
is not classified as taxable income to the lessor, so it is exempted from federal income taxes.
Tax-exempt leases provide a greater after-tax return to lessors than do conventional leases, so some
of this extra return can be passed back to the lessee in the form of lower lease payments. Thus, the
lessee’s payments on a tax-exempt lease could be lower than payments on a conventional lease.
Q7. Why is lease financing sometimes called off-balance-sheet financing?
Answer: The term off-balance sheet financing refers to an accounting practice that involves
recording corporate assets or liabilities in such a way that doesn't make them appear on a
company's balance sheet. Under certain conditions, neither the leased asset nor the contract
liabilities (present value of leased payments) appear on the lessee's balance sheet. The practice is
used to keep debt-to-equity (D/E) and leverage ratios low so that the business looks better.
Q8. How are leases accounted for on a business’s balance sheet? On its income statement?
Answer: Regardless of the type of lease, the lessor reports the lease as an asset on the balance
sheet and individual lease payments as income on the income and cash flow statements. They must
also account for the asset’s depreciation over time. On the other hand, the lessee reports the lease
as both an asset and a liability on the balance sheet due to their stake as a potential owner of the
asset and their required payment. They also report individual lease payments as expenses on the
income and cash flow statements.
Q9. What is the primary effect of the new lease accounting rules?
Answer: The new lease accounting rules causes firms to have similar balance sheets, both of which
will in essence resemble their actual finances. These rules have changed how leases are treated in
financial statements, which may have a material impact on financial ratios.
Q10. Explain how the cash flows are structured in conducting a dollar cost (NAL) analysis.
Answer: Net advantage to leasing (NAL) is a monetary benefit gain that results in monetary saving
from a choice of leasing an asset rather than purchasing the asset. Therefore, a dollar-cost analysis
will be present value cost of leasing an asset minus the present value cost of owning an asset of
the same kind, which results in monetary saving. If the cost of buying an asset that could be leased
is lower than leasing it, then the option of buying an asset would be a preferable alternative.
Symbolically,
Net advantage to leasing (NAL) = PV cost of leasing − PV cost of owning.
A positive NAL indicates that leasing is preferred to owning, and the greater the NAL, the greater
the advantage of leasing.
To compute the net advantage to leasing, we consider the maintenance cost of leasing to the cost
of fully acquiring the asset. In dollar analysis, the first-time decision to be made will be followed

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from start to end throughout the process of seeing up the cash flows in monthly, quarterly, semi-
annually, or annual intervals. In dollar analysis, we assume that the cash flows occur at the end of
the period. Still, if it occurs within the period, we take another interval to compute the net
advantage to lease analysis. It's recommendable to shorter intervals as longer intervals create
inconveniences. Therefore, as lease payment occurs monthly, there is a need to use a shorter
interval in computing the dollar cost analysis.
Q11. What discount rate should be used when lessees perform lease analyses?
Answer: The most appropriate comparison when making lease decisions is the cost of lease
financing versus the cost of debt financing, regardless of how the asset actually would be financed
if it were not leased. The asset may be purchased with available cash if it is not leased or financed
by a new equity sale, but because leasing is a substitute for debt financing, the appropriate
comparison would still be to debt financing. So, most analysts recommend that the firm’s cost of
debt financing at the time of performing lease analyses, because this rate seems reasonable.
Q12. What is the economic interpretation of the net advantage to leasing?
Answer: Net advantage to leasing (NAL) refers to the total monetary savings that would
potentially result from a person or a business choosing to lease an asset as opposed to purchasing
it outright.
The cost comparison can be formalized by defining the net advantage to leasing (NAL) as follows:
NAL = PV cost of leasing − PV cost of owning

= − Tk.125,617 − (−Tk.126,987)
= Tk.1,370
The positive NAL shows that leasing creates more value than buying, so the decision maker should
lease the equipment. Indeed, the value of the decision maker is increased by Tk.1,370 if it leases
rather than buys the equipment.
Q13. What is the economic interpretation of a lease’s IRR?
Answer: We can find the cost rate inherent in the cash flow stream. This is the equivalent after-
tax cost rate implied in the lease contract. For Example:

Given: Cost 6% after-tax cost of debt.

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We can see the cost rate inherent in the cash flow stream is 5.6%. This is the equivalent after-tax
cost rate implied in the lease contract. Because this cost rate is less than the 6 percent after-tax cost
of a loan, leasing is less expensive than borrowing and buying.
Q14. What are some economic factors that motivate leasing—that is, what asymmetries might
exist that would make leasing beneficial to both lessors and lessees?
Answer: The economic factors that motivate leasing are demonstrated below:
i. Tax rate differentials
ii. Ability to bear obsolescence (residual value) risk
iii. Ability to bear utilization risk
iv. Ability to bear project life risk
v. Maintenance services
vi. Low information costs
vii. Lower risk in bankruptcy
Q15. Would it ever make sense to lease an asset that has a negative NAL when evaluated by a
conventional lease analysis? Explain your answer.
Answer: Yes, if the NAL is less negative than the NAL for buying things. We know NPV is the
present value of a project, assuming that an asset is financed using debt and equity financing. In
lease analysis, the NAL is the additional present value of an asset attributable to leasing, as opposed
to conventional (debt) financing. Thus, as an approximation of the value of a leased asset to the
business, the asset’s NPV can be increased by the amount of NAL. The less NAL value is
measured, the more Adjusted NPV will be. Econometrically:
Adjusted NPV = NPV + NAL
The value added through leasing, in some cases, can turn unprofitable (negative NPV) projects
into profitable (positive adjusted NPV) projects.
Q16. Briefly describe two approaches commonly used to value businesses.
Answer: The two common approaches used to value businesses are briefly described below:
i. Discounted cash flow approach: The discounted cash flow (DCF) approach to valuing a
business involves the application of classical capital budgeting procedures to an entire
business. To apply this approach, two key items are needed: (1) a set of statements that
estimates the cash flows expected from the business and (2) a discount rate to apply to
these cash flows. The development of accurate cash flow forecasts is by far the most
important step in the DCF approach.
ii. Market multiple approach: Another method for valuing entire businesses is market
multiple analysis, which applies a market-determined multiple to some proxy for value,
typically some measure of revenues or earnings. As in the DCF valuation approach, the
basic premise here is that the value of any business depends on the cash flows that the
business produces. The DCF approach applies this premise in a precise manner, while
market multiple analysis is more ad hoc.

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Q17. What are some problems that occur in the valuation process?
Answer: Clearly, the valuation of any business can only be considered a rough estimate. However,
the following problems are occurred in the valuation process:
∞ Developing reasonable assumptions for projections based on historical trends and expected
future occurrences and documenting the reasoning behind those assumption choices.
∞ Requesting, tracking and reviewing the necessary documents.
∞ Calculating a discount rate that appropriately reflects the risk inherent in the subject entity
and documenting the reasons for using (or not using) the methods used for calculating the
WACC.
∞ Building a comprehensive valuation report.
∞ Finding robust private-company industry data against which to benchmark the subject
entity.
∞ Gathering the appropriate market comparable both public and private.
Q18. Which approach do you believe to be best? Explain your answer.
Answer: The two approaches are discussed in the text, namely, discounted cash flow (DCF)
approach and market multiple approach. The bottom line is that both methods have problems. In
general, business valuations should use both the DCF and market multiple methods, as well as
other available methods. Then a great deal of judgment must be applied to reconcile the valuation
differences that typically occur.
DCF approach has strong theoretical support, one has to be concerned about the validity of the
estimated cash flows and the discount rate applied to those flows. Sensitivity analyses demonstrate
that it does not take much change in the terminal value growth rate or discount rate estimates to
create large differences in estimated value. Thus, the theoretical superiority of the DCF approach
is offset to some degree by the difficulties inherent in estimating the model’s input values.
The market multiple method is more ad hoc, but its proponents argue that a proxy estimate for a
single year, such as measured by EBITDA (Earnings before interest, taxes, depreciation, and
amortization), is more likely to be accurate than a multiple year cash flow forecast. Furthermore,
the market multiple approach avoids the problem of having to estimate a terminal value. Of course,
the market multiple approach has problems of its own. One concern is the comparability between
the business being valued and the firm (or firms) that set the market multiple.

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