Corporate Finance Thirteenth Edition

Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe /

Bradford D. Jordan

Chapter 21

Leasing

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 Key Concepts and Skills
• Understand the different types of leases.
• Understand how to apply NPV to the lease-versus-buy
decision.
• Understand the importance of tax rates in determining the
benefit of leasing.

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 Chapter Outline
21.1 Types of Leases
21.2 Accounting and Leasing
21.3 Taxes, the IRS, and Leases
21.4 The Cash Flows of Leasing
21.5 NPV Analysis of the Lease-versus-Buy Decision
21.6 Does Leasing Ever Pay? The Base Case
21.7 Reasons for Leasing

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 21.1 Types of Leases
The Basics
• A lease is a contractual agreement between a lessor (the
owner of the asset) and a lessee (another party).
• The lessor owns the asset and for a fee allows the lessee
to use the asset.

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 Figure 21.1 Buying versus Leasing

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 Operating Leases
A lease where the lessee receives an operator along with the
equipment is called an operating lease.
q usually not fully amortized
q have a life that is less than the economic life of the asset
q usually require the lessor to maintain and insure the asset
q can be cancelled by the lessee

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 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.
3. The lessee usually has a right to renew the lease at
expiry.
4. Generally, financial leases cannot be canceled.

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 Tax-Oriented Leases
A particular type of financial lease
Lessor is the owner of the leased asset for tax purposes
Make the most sense when the lessee is not in a position to
efficiently use tax credits or depreciation deductions that
come with owning the asset

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 Sale and Leaseback
A particular type of financial lease
Occurs when a company sells an asset it already owns to
another firm and immediately leases it from them.
Two sets of cash flows occur:
• The lessee receives cash today from the sale of the asset.
• The lessee makes periodic lease payments, thereby
retaining the use of the asset.

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 Leveraged Leases
A particular type of financial lease.
A three-sided arrangement among the lessee, the lessor, and
the lenders:
• The lessee uses the assets and makes periodic lease
payments.
• The lessor borrows to partially finance the asset (the lessor
puts up no more than 40 to 50% of the purchase price).
• The lenders supply the remaining financing and receive
interest payments from the lessor.

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 Leveraged Leases
Lessor buys asset, Firm U Lessor borrows from lender to
leases it. partially finance purchase
The lenders typically use a
nonrecourse loan. This means
that the lessor is not obligated
to the lender in case of a
default by the lessee.
In the event of a default by the
lessor, the lender has a first
lien on the asset. Also, the
lease payments are made
directly to the lender after a
default.

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 21.2 Accounting and Leasing
In the old days, leases led to off-balance sheet financing.
Today, leases are either classified as capital leases or
operating leases.
• Historically, only capital leases appeared on the balance
sheet; operating leases were only disclosed in the
footnotes.
• As of 2019, operating leases are required to be shown on
the balance sheet, too.

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Examples of Balance Sheets under FAS 13

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 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 price below fair market
value when the lease expires. This is frequently called a
bargain purchase price option.

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 21.3 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 of the lease 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.
4. The lease payments must provide the lessor with a fair
market rate of return.
5. The lease should not limit the lessee’s right to issue debt
or pay dividends.
6. Renewal options must be reasonable and reflect fair
market value of the asset.
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 Taxes, the IRS, and Leases
The reason the IRS is concerned about lease contracts is
that many times they appear to be set up solely to avoid
taxes.
Suppose a firm plans to purchase a $1 million bus that has a
five-year class life. Depreciation expense would be $200,000
per year, assuming straight-line depreciation.
Now suppose the firm can lease the bus for $500,000 per
year for two years and buy the bus for $1 at the end of the
two-year term.
The present value of the tax benefits from acquiring the bus
would clearly be less than if the bus were leased.

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 21.4 The Cash Flows of Leasing
Consider a firm, ClumZee 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.

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 The Cash Flows of Leasing
Cash Flows: Buy
Year 0 Years 1-5
Cost of truck −$25,000
Aftertax savings $4,500 × (1 − .21) = $3,555
Depreciation tax benefit _______ 5,000 × .21 = 1,050
−$25,000 $4,605

Cash Flows: Lease

Year 0 Years 1-5

Lease payments −$6,250 × (1−.21) = −$4,937.50
Aftertax savings 4,500 × (1−.21) = 3,555.00
−$1,382.50

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 The Cash Flows of Leasing
Incremental cash flow consequences for ClumZee Movers
from leasing instead of buying (lease minus buy):

Year 0 Years 1–5

$25,000 −$1,382.50 − 4,605 = −$5,987.50

The discount rate is the after-tax rate on the firm’s secured

debt.

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 21.5 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.

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 NPV Analysis of the Lease-versus-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 rate is 5 percent.
NPV Leasing Minus Buying
Year 0 1 2 3 4 5
CF 25000 -5987.5 -5987.5 -5987.5 -5987.5 -5987.5

Discount rate 5%

NPV -922.74

Because the net present value of the incremental cash flows from leasing
relative to purchasing is negative, the firm prefers to purchase.
The NPV we have computed here is often called the net advantage to leasing
(NAL).

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 21.6 Does Leasing Ever Pay? The
Base Case
In the above example, ClumZee Movers chose to buy because the
NPV of leasing was −$922.74 to them.
Note that this is the opposite of the NPV that Tiger Leasing would
have:
• Cash Flows: Tiger Leasing
Year 0 Years 1 to 5
Cost of truck −$25,000
Depreciation tax Shield $5,000 × .21 = $1,050.00
Lease payments _______ 6,250 × (1 − .21) = 4,937.50
−$25,000 $5,987.50

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 21.7 Reasons for Leasing
Good Reasons
• Taxes may be reduced by leasing.
• The lease contract may reduce certain types of uncertainty.
• Transactions costs can be higher for buying an asset and
financing it with debt or equity than for leasing the asset.

Bad Reasons
• Accounting
• 100 percent financing

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 Impact of Taxes Example
Now suppose a world without a flat corporate tax rate where
ClumZee movers is in the 21 percent tax bracket and Tiger
Leasing is in a 34 percent tax bracket. If Tiger reduces the lease
payment to $6,200, can both firms have positive NPV?
Cash Flows: Tiger Leasing
Year 0 Years 1-5
Cost of truck −$25,000
Depreciation tax Shield $5,000 × .34 = $1,700
Lease payments _______ 6,200 × (1 − .34) = 4,092
−$25,000 $5,792

NPV = $76.33

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 Impact of Taxes Example
Cash Flows ClumZee Movers: Leasing Instead of Buying

Year 0 Years 1 to 5
Cost of truck we didn’t buy $25,000
Lost depreciation tax –$5,000 × .21 = −$1,050
shield
Aftertax lease payments _______ 6,200 × (1 − .21) = −4,898
$25,000 −$5,948

NPV = −$751.73

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 Tiger Leasing’s Reservation Payment
What is the smallest lease payment that Tiger Leasing will accept?
Set their NPV to zero and solve for $Lmin:

Year 0 Years 1 to 5
Cost of truck −$25,000
Depreciation tax shield $5,000 × .34 = $1,700
Lease payments _______ $Lmin × (1 − .34) = $Lmin × (1 − .34)
−$25,000 $1,700 + $Lmin × (1 − .34)

This is $6,173.29 on a pretax basis.

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 ClumZee’s Reservation Payment
What is the highest lease payment that ClumZee Movers can pay?
Set their NPV to zero and solve for $Lmax:

Year 0 Years 1 to 5
Cost of truck $25,000
Depreciation tax shield -$5,000 × .21 =-$1,050
Lease payments _______ -$Lmax × (1 − .21) = -$Lmax × (1 − .21)
$25,000 -$1,050 - $Lmax × (1 − .21)

This is $5,980.22 on a pretax basis.

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 Is a Lease Possible?
The most that ClumZee Movers can afford to pay is
$5,980.22
The least that Tiger Leasing can accept is $6,173.29
So, there will not be a lease in this case.

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 Quick Quiz
Compare operating and financing leases.
Explain why tax rates affect the lease-versus-buy decision.

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 Exercises
Wolfson Corporation 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
Sur Bank has offered Wolfson 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 percent on the outstanding balance of the loan at
the beginning of each year. Both principal repayments and interest are due
at the end of each year. Cal Leasing Corporation offers to lease the same
machine to Wolfson. Lease payments of $640,000 per year are due at the
beginning of each of the four years of the lease.
• Should Wolfson lease the machine or buy it with bank financing?
• What is the annual lease payment that will make Wolfson indifferent to
whether it leases the machine or purchases it?

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 Year 0 Year 1 Year 2 Year 3 Year 4
Lease:
Lease payment
Tax savings on
lease
Total
Buy:
Equipment cost
Depreciation tax
benefit
Total
Lease minus Buy

Discount rate
After-tax discount
rate

NPV or NAL

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