Financial Analysis of Leasing

Download as pdf or txt
Download as pdf or txt
You are on page 1of 25

19-04-2024

FINANCIAL ANALYSIS
OF LEASING

Definition
◦ A lease is a contractual arrangement by which the owner of an asset
(the lessor) rents the assets to a lessee
◦ A lease can be defined as a right to use equipment or capital goods on
payment of a periodical amount (lease rent)
◦ We analyze long-term leases, in which the asset spends most of its
useful life with the lessee

1
19-04-2024

Definition
◦ There are two principal parties to any lease transactioin:
◦ The Lessor is the actual owner of the equipment who is permitting its use by
the other party on payment of the periodical amount
◦ The Lessee is the party acquiring the right to use the equipment on payment of
the periodical amount

Definition
◦ In economic terms, the leases we examine are considered by the
lessees as alternatives to purchasing an asset
◦ This analysis fits many long-term equipment leases but not short-term
leasing (car rentals, for example)
◦ Financial theory regards such leases as being essentially debt contracts:
◦ For the lessee, the lease is an alternative to purchasing the asset with debt, and
the lessor is essentially providing financing for the lessee

2
19-04-2024

Types of Leasing
◦ Many variants based on type and nature of leased equipment,
amortization period, residual value of equipment, period of leasing,
option for termination of lease, etc.
◦ They may be categorized as follows:
◦ Operating lease
◦ Financial lease
◦ Sale and Lease Back Lease
◦ Sales-Aid lease
◦ Most consider only the first two categories, operating and financial

Operating Lease
◦ The primary lease period is short and the lessor would not be able to
realise the full cost of the equipment and other incidental charges
during the initial lease period
◦ The lessor bears not only the initial cost of the machinery, but also
the cost of insurance, maintenance, and repair
◦ The lessee acquires the right to use the asset for a short duration
◦ The lease agreement can be terminated at short notice by both parties

3
19-04-2024

Operating Lease
◦ Operating leases may be preferred by the lessee under the following
circumstances:
◦ When the long-term suitability of the asset is uncertain
◦ When the asset is subject to rapid obsolescence
◦ When the asset is required for immediate use to tide over a temporary problem
◦ Computers and other office equipment are commonly leased under
such arrangements

Financial Lease
◦ A financial lease is a long-term arrangement which is irrevocable during the
primary lease period, generally the economic life of the leased asset
◦ Under this arrangement, the lessor is assured of realizing the full cost of
purchasing the leased asset, including the cost of financing it and other
administrative expenses, and perhaps a profit too
◦ All the risks incidental to the ownership and benefits arising from the
ownership except for the legal title are transferred to the lessee against an
irrevocable undertaking to make unconditional payments to the lessor as
per the agreed schedule
◦ The lessee has to bear the cost of insurance, maintenance and repair

4
19-04-2024

Example
◦ We consider a company that is faced with the choice of either
purchasing or leasing a piece of equipment
◦ We assume that the operating inflows and outflows from the
equipment are not affected by its ownership—irrespective of how the
asset is held (whether owned or leased), the owner/lessee will have the
same sales and must bear the responsibility for maintaining the
equipment
◦ According to Statement 13 of the Financial Accounting Standards
Board (FASB 13), the lease we are considering is one that “transfers
substantially all of the benefits and risks incident to the ownership of
property” to the lessee

Example
◦ The analysis concentrates exclusively on the cash flows from the lease
◦ It is assumed that the lessor pays taxes on the income from the lease
rentals and gets a tax shield on the depreciation of the asset, and that
the lessee can claim the rent as an expense
◦ The analysis assumes that the tax authorities treat the lessor as the
owner of the asset and the lessee as the user

10

5
19-04-2024

Leasing Example
◦ A company has decided to acquire the use of a machine costing $600,000
◦ If purchased, the machine will be depreciated on a straight-line basis to a
residual value of zero
◦ The machine’s estimated life is six years, and the company’s tax rate TC is
30%
◦ The company’s alternative to purchasing the machine is to lease it for six
years
◦ A lessor has offered to lease the machine to the company for $115,000
annually, with the first payment to be made today and with five additional
payments to be made at the start of each of the next five years

11

Leasing Example
◦ One way of analyzing this problem is to compare the present values
of the cash flows to the company of leasing and of buying the asset
◦ The company believes that the lease payment and the tax shield from
depreciation are riskless
◦ Suppose, furthermore, that the risk-free rate is 5%
◦ Based on the following calculation, the company should lease the asset
because the leasing alternative has higher (less negative) net present
value (NPV)

12

6
19-04-2024

Leasing Example

13

Leasing Example

14

7
19-04-2024

Leasing Example
◦ This analysis suggests that leasing the asset is preferable to buying it
◦ However, it is misleading because it ignores the fact that leasing is very
much like buying the asset with a loan
◦ The financial risks are thus different when we compare a lease (implicitly a
purchase with loan financing) against a straightforward purchase without
loan financing
◦ If the company is willing to lease the asset, then perhaps it should also be
willing to borrow money to buy the assets
◦ This borrowing will change the cash flow patterns and could also produce
tax benefits
◦ Hence, our decision about the leasing decision could change if we were to
take the loan into account

15

Leasing – The Equivalent Loan Method


◦ The idea behind the equivalent-loan method is to devise a
hypothetical loan that is somehow equivalent to the lease
◦ It then becomes easy to see whether the lease or the purchase of an
asset is preferable
◦ Consider the previous example itself

16

8
19-04-2024

Leasing – The Equivalent Loan Method

17

Leasing – The Equivalent Loan Method


◦ Rows 2–6 give the various parameters of the problem
◦ The spreadsheet then compares two after-tax cash flows: that of the lease
and that of the buy
◦ We write outflows with a minus sign and inflows (such as the tax shield
from the depreciation) with a plus sign.
◦ The cash flow from leasing the asset in each of years 0–5 is:
(1 − tax rate) * lease payment
◦ • The cash flow from buying the asset is the asset cost in year 0 (an
outflow, hence negative) and the tax shield on the asset’s depreciation,
tax rate * depreciation
◦ in years 1–6 (an inflow, hence written here with a positive sign)

18

9
19-04-2024

Leasing – The Equivalent Loan Method


◦ The differential cash flow between the lease and the buy decision line (line
18) shows that leasing the asset, instead of buying it, results in the
following cash flows to the lessor:
◦ A cash inflow of $519,500 in year 0
◦ This inflow is the cash saved at time 0 by the lease: Purchasing the asset costs $600,000,
whereas leasing the asset costs at time 0 only $80,500 on an after-tax basis
◦ Thus, the lease initially saves the lessee $519,500.
◦ A cash outflow of $110,500 in years 1–5 and an outflow of $30,000 in year 6
◦ This outflow corresponds to the after-tax cost of the lease versus the buy in these years
◦ This cost has two components: the after-tax lease payment ($80,500) and the fact that when
leasing, the lessee does not get the tax shield on the asset’s depreciation ($30,000)

19

Leasing – The Equivalent Loan Method


◦ Thus, leasing instead of purchasing the asset is like getting a loan of
$519,500 with after-tax repayments of $110,500 in years 1–5 and an
after-tax repayment of $30,000 in year 6
◦ The lease, in other words, can be viewed as an alternative method of
financing the asset
◦ In order to compare the lease to the buy, we should compare the cost
of this financing with the cost of alternative financing

20

10
19-04-2024

Leasing – The Equivalent Loan Method


◦ The internal rate of return (IRR) of the differential cash flows (3.75%
in cell B20) gives the after-tax cost of the financing implicit in the
lease
◦ This is larger than the after-tax cost of firm borrowing, since in this
case (where the firm’s tax rate is 30% and its borrowing cost is 5%),
this cost is 3.5%
◦ Our conclusion: Buying is preferable to leasing

21

Leasing – The Equivalent Loan Method

The table shows the principal of a hypothetical bank loan bearing a 5% interest rate
At the beginning of year 0 (that is, at the time when the firm either purchases or leases the
asset), for example, the firm borrows $523,318 from the bank

22

11
19-04-2024

Leasing – The Equivalent Loan Method


◦ The alternative loan table shown above was constructed in the
following way
◦ The principal at the beginning of each of years 1–6 is the present
value of the lease versus buy outflows, discounted at
(1 − 30%) * 5%
◦ Thus, for example:

23

Leasing – The Equivalent Loan Method


◦ Once the principal at the start of each year is known, it is an easy
matter to construct the rest of the columns
◦ Interest = 5% * Principal at the beginning of the year
◦ Repayment of principal = Principal at the beginning of this year
− Principal at the beginning of next year
◦ After-tax payment = (1 − Tax rate) * Interest + Repayment of principal

24

12
19-04-2024

Leasing – The Equivalent Loan Method


◦ At the end of the year, the firm repays $118,350 to the bank
◦ $26,166 is interest ($26,166 = 5% * $523,318) and
◦ $92,184, is repayment of principal
◦ The net after-tax repayment in year 1—assuming full tax deductibility
of the interest payment—is
(1 − 30%) * $26,166 + $92,184 = $110,500
◦ which is the same after-tax differential cash flow calculated in the
original spreadsheet

25

Leasing – The Equivalent Loan Method


◦ Payments in subsequent years are calculated in a similar manner as
illustrated in the preceding paragraph
◦ At the beginning of year 6, there is still $28,986 of principal
outstanding; this is fully paid off at the end of the year with an after-
tax payment of $30,000
◦ If the firm is considering leasing the asset in order to get the
financing of $519,500, which the lease gives, it should instead borrow
$532,318 from the bank at 5%; it can repay this larger loan with the
same after-tax cash flows as are implicit in the lease
◦ The bottom line: Purchasing is still preferable to leasing the asset

26

13
19-04-2024

The Lessor’s Problem


◦ The lessor’s problem is the opposite of that of the lessee:
◦ The lessee must decide whether—given a rental rate on the leased asset—it is
preferable to buy the asset or lease it
◦ The lessor has to decide what minimum rental rate justifies the purchase of the
asset in order to lease it out
◦ One way of solving the lessor’s problem is to turn the above analysis
around
◦ We use the Excel Goal Seek (Data|What-If Analysis|Goal Seek) to
get the lessor’s minimum acceptable rental

27

28

14
19-04-2024

29

Asset Residual Value and Other Considerations


◦ In the above example we have ignored the residual value of the
asset—its anticipated market value at the end of the lease term
◦ Suppose, for example, you think that the asset will have a market value
of $50,000 in year 7
◦ Assuming that this value is fully taxed (we’ve depreciated the asset to
zero value over the first six years), the after-tax residual value will be
(1 − tax rate) * $100,000 = $60,000

30

15
19-04-2024

31

Asset Residual Value and Other Considerations


◦ The possibility of realizing an extra cash flow from asset ownership
makes the lease even less attractive than before
◦ The difference can be observed by noting that the return rate in cell
B22, the IRR of the differential cash flows, has increased from 3.75%
in our original example to 5.47%

32

16
19-04-2024

Asset Residual Value and Other Considerations


◦ However, the spreadsheet treats the residual value as if it has the same
certainty of realization as the depreciation tax shields and the lease
rentals
◦ There is no good practical solution to this problem
◦ An ad hoc way of dealing with it might be to reduce the $50,000 by a factor
that expresses the uncertainty about its realization
◦ We can use a “certainty equivalent factor” to achieve this
◦ The spreadsheet below assumes that the certainty-equivalence factor for the
residual value is 0.7

33

34

17
19-04-2024

Mini-Case: When Is Leasing Profitable for Both the


Lessor and the Lessee?
◦ The symmetry between the lessee’s problem and the lessor’s problem
suggests that if the lessee wants to lease, it will not be profitable for
the lessor to purchase the asset in order to lease it out.
◦ In some cases, however, it may be that the differences in tax rates
between the lessee and the lessor make it profitable for both to enter
into a leasing arrangement

35

Mini-Case: Greenville Electric Corp


◦ Greenville Electric Corp. is a public utility that pays no taxes
◦ Its credit rating is of the highest order since all of Greenville’s debts
are guaranteed by the city of Greenville
◦ Greenville Electric has decided that it requires a new turbine
◦ The turbine costs $12 million and will be depreciated to zero salvage
value over three years
◦ Greenville Electric borrows at 6%.
◦ Greenville can either lease or buy the plant

36

18
19-04-2024

Mini-Case: Greenville Electric Corp


◦ The lease offer it has is $2.3 million per year for six years (starting
today)
◦ The lessee is a captive leasing subsidiary of United Turbine Corp., the
manufacturer of the turbine
◦ United Turbine Leasing also borrows at 6% and has a tax rate of 30%
◦ The lease is profitable to both lessor and lessee
◦ Greenville Electric gets financing at a cost of 5.96%, compared to its
borrowing cost of 6%
◦ United Turbine gets an after-tax return of 4.41%, compared to its after-tax
borrowing cost of 4.2%
◦ Both Greenville Electric and United Turbine profit

37

38

19
19-04-2024

39

Leveraged Lease
◦ In a leveraged lease, the lessor finances the purchase of the asset to be
leased with debt
◦ From the point of view of the lessee, there is no difference in the
analysis of a leveraged or a non-leveraged lease
◦ From the lessor’s point of view, however, the cash flows of a
leveraged lease present some interesting problems

40

20
19-04-2024

Leveraged Lease
◦ At least six parties are typically involved in a leveraged lease:
◦ the lessee
◦ the equity partners in the lease
◦ the lenders to the equity partners
◦ an owner trustee
◦ an indenture trustee, and
◦ the manufacturer of the asset
◦ In most cases, a seventh party is also involved:
◦ a lease packager (a broker or leasing company)

41

42

21
19-04-2024

Leveraged Lease
◦ The two major problems related to the analysis of leveraged leases are
these:
◦ The straightforward financial analysis of the lease from the point of view of
the lessor
◦ This concerns the calculation of the cash flows obtained by the lessor and a
computation of these cash flows’ net present value (NPV) or internal rate of return
(IRR)
◦ The accounting analysis of the lease
◦ Accountants use a method called the multiple phases method (MPM) to calculate a
rate of return on leveraged leases
◦ The MPM rate of return is different from the IRR

43

Leveraged Lease - Example


◦ A leasing company is considering the purchase of an asset whose cost
is $1,000,000
◦ The asset will be purchased with $200,000 of the company’s equity
and with $800,000 of debt
◦ The interest on the debt is 10%, so that the annual payment of
interest and principal over the 15-year term of the debt is $105,179
◦ The company will lease the asset out for $110,000 per year, payable at
the end of each year

44

22
19-04-2024

Leveraged Lease - Example


◦ The lease term is 15 years
◦ The asset will be depreciated over a period of eight years, using a
standard Internal Revenue Service (IRS) depreciation schedule for
assets with a 7-year life
◦ Because the asset will be fully depreciated at the time it is sold (year
16), the whole anticipated residual value ($300,000) will be taxable
◦ Since the company’s tax rate is 30%, this means that the after-tax cash
flow from the residual is (1 − 30%) * 300,000 = $210,000

45

Leveraged Lease - Example


Year Depreciation
1 14.28%
2 24.49%
3 17.49%
4 12.50%
5 8.92%
6 8.92%
7 8.92%
8 4.48%

46

23
19-04-2024

47

Assignment – Part I (Due on 10/04/24)


◦ Your company is considering either purchasing or leasing an asset that
costs $1,000,000. The asset, if purchased, will be depreciated on a straight-
line basis over six years to a zero-residual value. A leasing company is
willing to lease the asset for $300,000 per year; the first payment on the
lease is due at the time the lease is undertaken (i.e., year 0), and the
remaining five payments are due at the beginning of years 1–5. Your
company has a tax rate TC = 40% and can borrow at 10% from its bank.
◦ Should your company lease or purchase the asset?
◦ What is the maximum lease payment it will agree to pay?
◦ Would your decision change if the asset had a pre-tax salvage value of
$20,000?

48

24
19-04-2024

Assignment – Part II (Due on 10/04/24)


◦ Hemp Airlines (HA, “we fly high”) is about to buy five CFA3000
commuter jets. Each airplane costs $50 million. A friendly bank has put
together a consortium to finance the deal. The consortium includes a 20%
equity investment and an 80% debt component. The debt has an interest
rate of 8% annually and is a term loan over 10 years. At the end of each of
the next 10 years, HA will pay a lease payment of $35 million. At the end
of the 10-year lease term, Hemp has the option to buy the aircraft for $10
million each; it is anticipated that it will exercise this option in which the
planes are priced at their anticipated fair market value. The airplanes will be
depreciated on a straight-line basis over five years to zero salvage value.
◦ If the equity partner in the lease has a tax rate of 35%, what is its expected
compound rate of return?

49

50

25

You might also like