Review: Payout Policy

Major Topics
Understand how cash dividends are paid
Understand the issues surrounding
dividend policy decisions
Understand share repurchase as an
alternative to cash dividends
Understand the difference between cash
and stock dividends
 Leasing
Main Topics

Understand the different types of leases.

Understand how to apply NPV to the lease
vs. buy decision.
Understand the importance of tax rates in
determining the benefit of leasing.
 Leasing is popular in some industries!
airlines are turning
increasingly to operating
leases, in which they really
are renting the planes, for a
few years at a time, with a
leasing company bearing
the risk of any slump in
their second-hand values.
Over a third of the
world's airline fleet is
now rented (see chart)
and the proportion is likely
to keep growing. (The
Economist, 2012)
 What is a Lease?
The Basic Concept
A lease is a contractual agreement between a
lessee and a lessor.
Lessee the party that has the right to use an
asset and makes period payments to the
assets owner
Lessor owner of the asset and for a fee
allows the lessee to use the asset
Note that the lease decision is likely to be a
financing decision for the lessee and an
investment decision for the lessor. We will
discuss it more
 Types of Leases
Operating Lease

Financial Lease

Special types of Financial Lease, e.g.,

Sale and leaseback
 Operating Leases
Operating Lease (also called service lease): A
lease where a lessee received an equipment and
an operator of the equipment.
1. Payments are not high enough for the lessor to
recover the full cost of the asset (i.e., not fully
amortized). In addition, life of the lease is often
less than the economic life of the asset.
2. The lessor often provides the maintenance for
the asset.
3. It is often cancelable. That is, leasee has a
cancellation option.
 Financial Leases
Essentially opposite of an operating lease.
1. Do not provide for maintenance or service by
the lessor.
2. Financial leases are fully amortized. That is,
payments required under the terms of the
lease are typically sufficient to cover the
lessors cost of purchasing the asset and to
provide the lessor a fair return.
3. The lessee usually has a right to renew the
lease at expiry.
4. Generally, financial leases cannot be
cancelled (i.e., no cancellation option).
 Sale and Lease-Back
A special type of financial lease

Occurs when a company sells an asset it

already owns to another firm and immediately
leases it back from the another firm.
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.
 Sears tries tax scheme to save itself
November 7, 2014 12:44 pm

Shares of Sears Holdings (SHLD) are up nearly 40% Friday

after the struggling retailer announced a plan to sell
upwards of 300 stores to a separate entity with tax
advantages. Sears would then lease the stores back from
this entity, which is to be structured as a real-estate
investment trust. REITs are increasingly popular corporate
structures with companies that seek their unique corporate-
level tax advantages.
The stock is up $12.10, or 37%, to $44.78. The stores that
are sold and leased back would still be operated by Sears.
And Sears investors would be permitted to buy stock in the
new REIT entity.
Sears tries tax scheme to save itself November 7, 2014
 Accounting and Leasing:
Operating Lease vs. Capital Lease
In the old days (before 1976), leases led to off-
balance-sheet financing.
After the implementation of FAS 13 Accounting
for Leases (1976), leases should be either
classified as capital leases or operating leases.

Operating leases do not appear on the

balance sheet. (Big advantage of leasing over
purchasing! )
Capital leases appear on the balance
sheetthe present value of the lease
payments appears on both sides.
 Accounting and Leasing (Balance Sheet)

Consider a firm with 2 assets: a truck and some land.

Truck is purchased with debt (i.e., borrow 100K to buy a 100k Truck)
Truck $100,000 Debt $100,000
Land $100,000 Equity $100,000
Total Assets $200,000 Total Debt & Equity $200,000

Operating Lease
Truck Debt
Land $100,000 Equity $100,000
Total Assets $100,000 Total Debt & Equity $100,000

Capital Lease
Assets leased $100,000 Obligations under capital lease $100,000
Land $100,000 Equity $100,000
Total Assets $200,000 Total Debt & Equity $200,000
 Capital Lease 4-way test
A lease must be capitalized (i.e., a Capital
Lease) if any one of the following is met:
A. The lease transfers ownership of the property to the
lessee by the end of the lease term.
B. The lease contains a bargain purchase option. That
is, the lessess can purchase the asset at a price
below fair market value when the lease expires.
C. The lease term is equal to 75% or more of the
estimated economic life of the leased property.
D. The present value of the minimum lease payments
is equal to 90% or more of the fair value of the
leased property to the lessor.
 Operating Lease vs. Capital Lease
How many criteria of Capital Lease are met?
Terms and provisions of lease agreement between
Gardner company (lessor) and Martin company
(lessee) dated January 1,2013

[Link] lease term is 4 years. The lease is noncancelable and

requires equal payments of $32,923.45 at the end of each
year.
[Link] cost, and also fair value, of the equipment to Gardner
(lessor) at the inception of the lease is $100,000. The
equipment has an estimated economic life of 4 years and
has a zero estimated residual value at the end of lease term.
[Link] is no guarantee of the residual value by the Martin
Company.
[Link] Martin (lessee) Company agrees to pay all executory
costs.
 Operating Lease vs. Capital Lease
How many criteria of Capital Lease are met?
[Link] equipment reverts to Gardner at the end of the 4
years;
6. Martin Company's (lesee) incremental borrowing rate is
12.5% per year.
[Link] Gardner Company (lessor), the interest rate implicit in
the lease is 12%. Martin Company knows this rate.
[Link] Company uses the straight-line method to record
depreciation on similar equipment's.
[Link] present value of an ordinary annuity of four payments
of $32,923.45 at 12% is $100,000, calculated as follows:
3.037349 *$32,923.45 = $100,000.
 16

Executory Costs
Ownership-type costs such as
insurance, maintenance, and
property taxes are called executory
costs. Executory costs may be paid
by either the lessee or the lessor,
depending on how the lease
contract is written.
 Operating Lease vs. Capital Lease
How many criteria of Capital Lease are met?
Classification Criteria Criteria Met? Remarks
1. Transfer of ownership at end of lease

2. Bargain purchase option

3. Leas term is 75% or more of economic life

4. Present value of MLP is 90% or more

of fair value

Conclusion: the lease is ___________ lease.

 Taxes, the IRS, and Leases
The principal benefit of long-term leasing is tax
reduction (i.e., lessee can deduct lease payments for
income tax purposes).
Tax deduction may be accelerated , since it is
often spread over the lease term (rather than the
economic life of the property).
The speedup of lease payments would
greatly benefit the firm and give it a form of
accelerated depreciation.
Naturally, the IRS seeks to limit this, especially if
the lease appears to be set up solely to avoid
taxes. Therefore, the IRS set up rules
 Taxes, the IRS, and Leases
The lessee can deduct lease payments for income
tax purposes, if the lease is qualified by the IRS.
1. The term must be less than 30 years.
2. There can be no bargain purchase option.
3. The lease should not have a schedule of payments that
is very high at the start of the lease and low thereafter.
[Deal with speedup of lease payments]
4. The lease payments must provide the lessor with a fair
market rate of return.
5. The lease should not limit the lessees right to issue
debt or pay dividends.
6. Renewal options must be reasonable and reflect fair
market value of the asset.
The Cash Flows of Leasing
and
NPV of a lease
 The Cash Flows of Leasing
Consider a firm, ClumZee Movers (lessee), that
wishes to acquire a delivery truck.
The truck is expected to reduce costs by $4,500
per year (i.e., operating savings is $4,500).
The truck costs $25,000 and has a useful life of 5
years (i.e., annual depreciation is $5,000).
If the firm buys the truck, they will depreciate it
straight-line to zero.
They can lease it for 5 years from Tiger Leasing
(lessor) with an annual lease payment of $6,250.
Tax rate is 34%.
 The Cash Flows of Leasing
Cash Flows: Buy
Year 0 Years 1-5
Cost of truck $25,000
After-tax savings 4,500(1-.34) = $2,970
Depreciation Tax Shield 5,000(.34) = $1,700

Cash Flows: Lease

Year 0 Years 1-5
Aftertax Lease Payments 6,250(1-.34) = $4,125
After-tax savings 4,500(1-.34) = $2,970
 The Cash Flows of Leasing
Leasing Cash flows minus Buying Cash flows
Year 0 Years 1-5
Leasing $4,125 (Aftertax Lease Payments)
Buying $25,000 $1,700 (Depreciation Tax Shield )

Net $25,000 $5,825

Note that since the after-tax savings are equivalent
whether the asset is bought or leased, they could be
excluded as a cash flow in this analysis.
To compute the NPV of the lease, we use NPV formula.
Which discount rate should we use in the NPV formula?
 The Cash Flows of Leasing
Calculating the NPV of the lease
Compute Present Value of Riskless Cash Flows
In a world with corporate taxes, firms should discount
riskless cash flows at the aftertax riskless interest rate.
If we believe that the cash flow from leasing is almost
riskless, then we should use aftertax riskless rate of
interest as the discount rate.

Is the related Cash Flow riskless?

(i) the value of depreciation tax benefits depends on
whether the firm has enough positive taxable income.
(ii) tax rate is time-varying. So, the Cash Flow is
not completely riskless. A common practice:
discounting the cash flows from leasing at the aftertax
interest rate of (secure) debt.
NPV of the Lease-vs.-Buy Decision
There is a simple method for evaluating leases:
discount all cash flows at the aftertax interest rate on
secured debt issued by the lessee. Suppose that
aftertax interest rate on secured debt is 5 percent.
NPV Leasing Instead of Buying
Year 0 Years 1-5
$25,000 $5,825

CF0 $25,000 I/Y 5

CF1 $5,825 NPV NAL = -$219

F1 5 Ct 5 5
5,825
C0 +
NPV = =+
25, 000
=t 1 =t 1 (1 + r ) t
(1 + 5%) 5
A summary: NPV of the lease-vs-buy decision
(1) NPV of the lease-vs-buy decision is called NPV of
the lease or net advantage of leasing (NAL).
(2) NPV of the lease or NAL formula:
NAL = discount all cash-flow differences across
leasing and buying decisions
NAL = Purchase price of the leasing-asset
PV of (annual cash-flow differences)
NAL = Purchase price of the leasing-asset
PV of (|aftertax lease payment| + |depreciation
tax-shield benefit|)
NOTE: If annual cash-flow differences is annuity, then
NAL = Purchase price of the leasing-asset - (|aftertax lease
payment| + |depreciation tax-shield benefit|) * PVIFA
 The Cash Flows of Leasing
- Lease payment at the beginning of each year
Consider a firm, ClumZee Movers (lessee), that wishes
to acquire a delivery truck.
The truck is expected to reduce costs by $4,500 per year
(i.e., operating savings is $4,500).
The truck costs $25,000 and has a useful life of 5 years
(i.e., annual depreciation is $5,000).
If the firm buys the truck, they will depreciate it straight-
line to zero.
They can lease it for 5 years from Tiger Leasing (lessor)
with an annual lease payment of $6,250 paid at the
beginning of each year. Tax rate is 34%.
Suppose that aftertax interest rate on secured debt is
5 percent. How much is net advantage of leasing (NAL)?
 Example question
NPV of the lease-vs.-buy decision
The IBMC Co. makes a pipe-boring machine that can be
purchased for $10,000.
If Xomox Co. buys this machine, it will save $6,000 per year
in reduced electricity bills for the next five years. We
assume 5 year straight-line depreciation and the machine is
worthless after 5 years. Assume tax rate is 34%.
However, Friendly Leasing Co. has offered to lease the
same machine to Xomox for $2,500 each year for 5 years.
[If not specified, lets assume the lease payment is made at
the end of each year.]
Assume the before-tax cost of secure debt is 7.5757%.
(i) Find the cash flows from Buy and Lease options. What is
the after-tax cash flow from leasing relative to after-tax cash
flow from buying each year (i.e., Cash Flow differences)?
(ii) How much is the NPV of leasing relative to purchase?
 Example question
NPV of the lease-vs.-buy decision
Depreciation tax benefit = tax rate X Deprecia
expense per year = (34%)*(10,000/5-year) =
(0.34)*2000 = 680
 Example question (cont.)
NPV of the lease-vs.-buy decision
The IBMC Co. makes a pipe-boring machine that can be
purchased for $10,000. If Xomox Co. buys this machine,
it will save $6,000 per yare in reduced electricity bills for the
next five years. We assume 5 year straight-line depreciation
and the machine is worthless after 5 years. Tax rate is 34%.
However, Friendly Leasing Co. has offered to lease the
same machine to Xomox for $2,500 each year for 5 years.

Assume the before-tax cost of secure debt is 7.5757%.

NOTE: both the lessee and lessor have a tax rate of 34%.
(iii) What will be the cash flows from LESSORs viewpoint?
(iv) Break-even lease payment: What is the lease payment
make the lessee indifferent to whether it enters the lease?
 Leasing is a zero-sum game? No!
Reasons for Leasing
Good Reasons
Taxes may be reduced by leasing. (See next slide.)
The lease contract may reduce certain types of
uncertainty. For example, if there may be a
substantial uncertainty about the residual value of an
asset, then leasing is preferred.
Transactions costs can be higher for buying an asset
and financing it with debt or equity than for leasing
the asset.
Bad Reasons
Accounting As using operating leasing can
reduce liabilities and total assets, it can seemingly
inflate ROA.
 Break-even analysis
when tax rates are different
The IBMC Co. makes a pipe-boring machine that can be
purchased for $10,000. If Xomox Co. buys this machine,
it will save $6,000 per yare in reduced electricity bills for the
next five years. We assume 5 year straight-line depreciation
and the machine is worthless after 5 years.
However, Friendly Leasing Co. has offered to lease the
same machine to Xomox for $2,500 each year for 5 years.

Assume the before-tax cost of secure debt is 7.5757%.

Assume the lessees tax rate is 10%; the lessors is 34%

What is the lease payment make the lessee/lessor
indifferent to whether it enters the lease?
Reservation Payment of Leasee/Lessor (Lmax / Lmin)
 Summary
Understand the different types of leases.
Understand how to apply NPV analysis to
the lease vs. buy decision.
Understand the importance of tax rates in
determining the benefit of leasing.