Leasing
Lease Definition
• Under IFRS 16 a lease is defined as ‘a contract, or part of a contract, that conveys the right
to use an asset (the underlying asset) for a period of time in exchange for consideration’.
• IFRS 16 is clear that rights to operate or maintain an asset do not give a customer the right
to direct how and for what purpose the asset is used, except for when the ‘how and for what
purpose’ decisions are predetermined.
• IAS 17 - A lease is an agreement whereby the lessor conveys to the lessee, in return for a
payment or series of payments, the right to use an asset for an agreed period of time.
Three Key evaluations
Is there an identified asset? No
Yes
Does the customer have the right to
obtain substantially all of the economic No
benefits from use of the identified
asset throughout the period of use? Contract is not (does
not contain a lease)
Yes
Does the customer have the right to No
direct the use of the identified asset
Source: throughout the period of use?
Grant Thornton Yes
Contract is (contains) a lease
Why Leasing? Some Sensible Reasons for Leasing
• Short-term leases are convenient
• Would you buy a car for your road trip to Pondychery and then sell it after that?
• Cancellation options are valuable
• Maintenance is provided in case of full-service lease (DHL fleet leasing from HERTZ)
• Standardization leads to low costs
• Tax shields can be used
• Leasing and financial distress
Role of Leasing in Corporate Finance
• Leasing and Capital Structure:
• Leasing provides an alternative to debt financing and affects a firm’s leverage.
• Smith & Wakeman (1985) argue that firms lease assets to avoid debt-related costs and
maintain financial flexibility.
• Graham, Lemmon & Schallheim (1998) find that firms with high leverage tend to lease
more to bypass borrowing constraints.
• Tax Implications of Leasing:
• Leasing can provide tax advantages since lease payments are often tax-deductible
• Miller & Upton (1976) highlight how tax asymmetries influence leasing decisions.
Contd..
• Leasing and Firm Performance:
• Sharpe & Nguyen (1995) suggest that firms use leasing to manage liquidity constraints
and invest in core operations.
• Eisfeldt & Rampini (2009) examine how leasing helps financially constrained firms
acquire assets without large capital expenditures.
• Leasing and Corporate Governance:
• Beatty, Liao & Weber (2010) study how leasing reduces agency problems by aligning
incentives between managers and shareholders.
Types of Leasing (Operating Lease)
• As per IAS–17, An operating lease is a lease other than a finance lease.
• A lease is classified as an operating lease if it does not transfer substantially all the risks
and rewards incidental to ownership.
• Usually not fully amortized
• Have a life that is less than the economic life of the asset
• Short-term or cancellable lease where the lessor retains ownership risks.
• Usually requires the lessor to maintain and insure the asset
• Can often be cancelled by the lessee
For example, A company leases an office for 5 years but does not assume ownership.
Financial Lease
• As per IAS 17 - A finance lease is a lease that transfers substantially all the risks and
rewards incidental to ownership of an asset. The title may or may not eventually be
transferred.
1. Do not provide for maintenance or service by the lessor.
2. Financial leases are fully amortized.
3. The lessee usually has a right to renew the lease at expiry.
4. Generally, financial leases cannot be cancelled
Sale and Lease-Back Lease
• A firm sells an asset to a lessor and then leases it back to free up cash while retaining
operational use.. It is a particular type of financial lease.
• In this type of lease, two types of cashflows occur:
• The lessee receives cash today from the sale.
• The lessee agrees to make periodic lease payments, thereby retaining the use of the asset.
• Companies use sale and leaseback to unlock capital while continuing to use critical assets.
• Common in real estate, aviation, manufacturing, and infrastructure sectors.
• Helps firms improve liquidity, optimize capital structure, and reduce debt obligations
• Mcdonalds, Tesla, British Airways and many more
Leverage Lease
• A leveraged lease is a type of financial lease where the lessor finances a portion of the asset's
cost using borrowed funds from a lender usually a bank or financial institution. Big ticket
leases are usually leveraged leases.
• Leverage Lease is a three-side/parties arrangement.
• Lessee: The company or individual who leases and uses the asset.
• Lessor: the entity that owns the asset and leases it out. Usually, the lessor contributes less or a
small portion of the equity.
• Lender: The financial institution that provides debt financing to the lessor.
System of leverage lease
The lessor purchases the property with a view to lease it by paying
some amount from his pocket and
Borrows the remaining amount required to purchase it from a
lending institution like a bank, so the property is mortgaged to the
bank by the lessor.
It is mortgaged till all the loan taken from bank including interest
thereon is repaid by the lessor by way of collecting lease rent from
lessee periodically and credit it in the bank in the said loan account
Structure of a leveraged lease for Commercial Aircraft
Key features of leveraged Lease
• High Leverage: The lessor finances the asset mainly through debt.
• Non-Recourse Loan: The lender has claims only on the asset and lease payments, not on
the lessor’s other assets.
• Tax Benefits: The lessor claims depreciation and interest deductions, reducing taxable
income.
• Long-Term Lease: Usually structured over the asset's useful life (e.g., 10-20 years).
• Used for Expensive Assets: Common in aircraft, ships, power plants, and infrastructure.
• Example: Aircraft Leasing – Airlines lease planes from firms like AerCap, Air Lease
Corporation, GECAS.
• Shipping & Ports – Large cargo ships and port infrastructure are leased using leveraged
financing.
• Energy & Power Plants – Companies lease expensive power plants or renewable energy
assets.
Capital Lease
• A lease must be capitalized if any one of the following is met:
• The present value of the lease payments is at least 90 percent of the fair market value of
the asset at the start of the lease.
• The lease transfers ownership of the property to the lessee by the end of the term of the
lease.
• The lease term is 75 percent or more of the estimated economic life of the asset.
• The lessee can buy the asset at a bargain price at expiry.
The Cash Flows of Leasing (example)
• Consider a firm, Balaji Movers, that wishes to acquire a delivery truck.
• The truck is expected to reduce costs by $4,500 per year.
• The truck costs $25,000 and has a 5-year useful life.
• If the firm buys the truck, it will be depreciated straight-line to zero.
• They can lease it for five years from Tiger Leasing with an annual lease
payment of $6,250.
• Both firms face a 21 percent tax rate.
Cashflow - Buy Cash Flows: Lease
Year 0 Years 1-5 Year 0 Years 1-5
Cost of truck −$25,000 Lease payments −$6,250 × (1−.21) = −$4,937.50
Aftertax savings $4,500 × (1 − .21) = $3,555 Aftertax savings 4,500 × (1−.21) = 3,555.00
Depreciation tax _______ 5,000 × .21 = 1,050 −$1,382.50
benefit
−$25,000 $4,605 Cash Flows: Leasing Instead of Buying
We could also view the cash flows as buying minus
Year 0 Years 1–5
leasing, which would change the signs on the cash
flows. $25,000 −$1,382.50 − 4,605 = −$5,987.50
The discount rate is the after-tax rate on the firm’s
secured debt.
A Detour for Discounting and Debt Capacity with Corporate Taxes
• Present Value of Riskless Cash Flows
• In a world with corporate taxes, firms should discount riskless cash flows at the after-tax riskless
rate of interest.
• Optimal Debt Level and Riskless Cash Flows
• In a world with corporate taxes, one determines the increase in the firm’s optimal debt level by
discounting a future guaranteed aftertax inflow at the aftertax riskless interest rate.
17
NPV Analysis of the Lease-versus-Buy Decision
• A lease payment is like the debt service on a secured bond issued by the lessee.
• In the real world, many companies discount both the depreciation tax benefits and the lease
payments at the aftertax interest rate on secured debt issued by the lessee.
18
• Merck Inc. has decided to purchase a new machine that costs 2.1 million. The machine
will be depreciated on a straight-line basis and will be worthless after four years. The
corporate tax rate is 24 percent. The Bank has offered Merck Inc. a four-year loan for
2.1 million. The repayment schedule is four yearly principal repayments of 525,000 and
an interest charge of 9 per cent on the outstanding balance of the loan at the beginning
of each year. Both principal repayment and interest are due at the end of each year.
Leasing company offers to lease the same machine to Merck Inc. Lease payments of
640,000 per year are due at the beginning of each of the four years of the lease.
• A. should Merk lease the machine or buy it with bank financing?
• B. What is the annual lease payment that will make Merk indifferent to whether it leases
the machine or purchase it?
Solution
Year 0 Year 1 Year 2 Year 3 Year 4
Lease
Lease Payment -640,000 -640,000 -640,000 -640,000
Tax saving on lease Payment 153,600 153,600 153,600 153,600
Lost Depreciation tax shield -126,000 -126,000 -126,000 -126,000
Equipment Cost 2,100,000
1613100 -612,400 -612,400 -612,400 -126,000
Contd..
• After tax discount rate is :
=0.09*(1-.24)
= 0.0684
So, the NAL of Leasing is
NAL = 1,613,100 -612,400(PVIFA6.84%,3 )-126,000/1.0684^4
=1,613,100-612,400*2.63200-126000/1.0684^4
=1,613,100-1,611,840-126,000/1.0684^4
= -124,740/1.0684^4
= -124,740/1.30297
= -95,735.1282 Since, the NAL is negative company should buy the asset.
Part B
The company is indifferent at the lease payment which makes the NAL of the lease equal to
zero. The NAL equation of the lease is:
0 = $2,100,000 – PMT(1 – .24) – PMT(1 – .24)(PVIFA6.84%,3) – $126,000(PVIFA6.84%,4)
0=2,100,000-PMT(1-.24)-PMT(1.24)(2.63200)-126,000(3.39948)
0=2,100,000-PMT(0.76)-PMT(0.76)(2.63200)-428,334.48
0=2,100,000-PMT(0.76)-2.00032PMT-428,334.48
0=2,100,000-2.7632PMT-428,334,48
2.7632PMT = 2,100,000-428,334
2.7632 PMT= 1,671,666
PMT= 1,671,666/2.7632 = 604,974
Question
• Mr. Rick is working for a nuclear research laboratory that is contemplating leasing a
diagnostic scanner. The scanner cost $4.3 million and 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 $1.275 million per year for
four years.
1. Assume that the tax rate is 21 percent. You can borrow at 8 percent before taxes.
Should you buy or lease.?
2. What are the cashflows from the lease from the lessor’s viewpoint? Assume a 21
percent tax rate?
Solution of Question 1
What is the depreciation tax shield?
Cost of scanner = $ 43 = (4300000/4)*(.21) = 225750
million What is the after-tax cost of debt?
Life of scanner = 4 years = 0.08*(1-.21)
Lease Price = 1.275 million = 0.0632
Borrowing Rate = 8% What are the after-tax lease payments?
Tax Rate = 21% =1275000*(1-.21)
=1007250
What are the total cash flows from leasing?
OCF= depreciation tax shield+ after-tax lease payments
= 225750+1007250
= 1233000
What is the net advantages from leasing?
NAL= 4300000-1233000*[(1-(1/(1+0.0632)^4)/0.0632]
NAL = 58636.0759
Should we lease or no?
The NAL is positive so we should lease
Solution of Question 2 and 3
• B. If the lessor has the same tax rate, the Net advantage to the lessor is negative
• Ques 3 what would the lease payment have to be for both the lessor and the lessee
to be indifferent about the lease?
• NAL = 0 = 4300000-OCF*[(1-(1/(1+0.0632)^4)/0.0632
=4300000-OCF*3.439857
OCF=4300000/3.439857
OCF=1250051.964
• Now we calculate the after tax lease payments
• After tax lease payment = OCF-depreciation tax shield
= 1250051.964- 225750 = 1024301.964
So the break even pre tax lease payments would be
Break even lease payment = 1024301.964/(1-.21)
= 1296584.764
• Question 4- Assume that your company does not contemplate paying taxes for the next
several years . What are the cash flows from leasing in this case?
• Because you don’t have to pay taxes so what are the effects that could have
A. No depreciation tax shiled
B. After tax lease payments will be same as the pre-tax lease payments
C. and the after tax cost of debt is same as the pre-tax cost
• So the cost of leasing will be same as 1275000
• Now, what is the Net advantage of leasing
• NAL = 4300000- 1275000*[(1-(1/(1+0.08)^4)/0.08]
• NAL = 77037.4375
Question 5 – Range of lease payment profitable for both lessor and lessee
• Break even lease payment of lessor is 1296584.764 (calculated in question 3)
• Now for lessee the Break even is
NAL=0= 4,300,000 – PMT (PVIFA 8%4)
= 4,300,000 – PMT*[(1-1/1+0.08)^4)/0.08]
=4,300,000 – PMT * 11.765
=4,300,000 – 3.3121 PMT
PMT = 4,300,000/3.3121
PMT = 1,298,269.979
So, the range of lease payment that will be beneficial for both parties are in the range
of 1,298,269.979 to 1296584.764
