Capital market imperfections and the incentive to lease

The corporate lease-versus-buy decision is typically analyzed under the Miller-Modigliani

framework of financial structure irrelevance, that is, studies usually begin by invoking the
assumptions of perfectly competitive capital markets with no transaction costs or information
asymmetries. The popularity of this approach owes largely to the finance literature’s
emphasis on tax-related incentives (e.g., Miller and Upton, 1976; Myers, Dill, and Bautista,
1976). Indeed, a thorough characterization of just the tax implications of the lease-versus-buy
decision and its interaction with a firm’s overall capital structure, even under the assumption
of complete markets, can be quite complex (Lewis and Schallheim, 1992).

Perhaps some of the most interesting factors in the lease-versus-buy decision have received
surprisingly little attention in the modern corporate finance literature. These are the ‘financial
contracting’ motivations suggested by Smith and Wakeman but precluded by the complete
markets framework. Such motiva- tions arise when outside investors are less informed than
firm insiders regarding ongoing operations or future prospects, or when conflicts of interest
between classes of corporate claimants are costly to resolve. The influence of such financial
market imperfections on corporate capital structure and financing policy has been the subject
of extensive analysis (e.g., see review by Harris and Raviv, 1992), yet, little theoretical or
empirical research in that area gives more than cursory consideration as to how leasing fits
into that equation. Similarly, much of the recent research on the behavior of capital expendi-
tures- beginning with Fazzarri, Hubbard, and Petersen (1988) - examines the influence of
capital market information imperfections on investment behavior. Here too, the option of
leasing is virtually ignored, despite the fact that leased equipment now accounts for roughly a
third of all equipment investment by business.

Financial contracting rationales for leasing

Justifying any particular financial contracting cost argument as an induce- ment to lease
necessitates a discussion of certain institutional features of lease obligations. A lease contract
can be classified in one of two categories, depend- ing on whether the lessor or lessee
technically ‘owns’ the leased item, and what the attendant risks and benefits are. Ownership
risks and costs include respons- ibility for casualty loss, wear and tear, and obsolescence,
while ownership benefits entail the right of use, entitlement to gains from asset value appreci-
ation, and ultimate possession of the property title. Whether or not a lessor retains ownership
depends on whether it has retained a meaningful residual interest in the equipment under the
lease agreement.

This dichotomy is complicated somewhat by the fact that the determination of ownership
may differ, depending on whether it is made for financial ac- counting purposes or for legal
and tax considerations. For financial accounting purposes, a lease is classified either as an
operating or a capital lease. SFAS No. 13, ‘Accounting for Leases’, defines the criteria that
differentiate operating and capital leases. Leases that do not substantially transfer the risks
and benefits of ownership from the lessor to the lessee are classified as operating leases. In
particular, a capital lease is defined by the following criteria: (i) ownership of the leased asset
is transferred to the lessee by the end of the lease term; (ii) a bargain purchase option is
available; (iii) the lease term is equal to 75% or more of the remaining economic life of the
leased asset; or (iv) the present value of the minimum lease payments equals or exceeds 90%
of the asset’s market value. At the inception of a capital lease, the lessee capitalizes the leased
asset and records the corresponding debt obligation on the balance sheet. Subsequently, the
lessee depreciates the leased asset and amortizes the debt liability. Thus, from an accounting
perspective, capital leases closely resemble purchases by the lessee and, therefore, require
disclosures similar to asset purchases. In contrast, operating leases represent off-balance-
sheet financing for the lessee, and are reflected on the income statement as rent expense.
From a legal and tax point of view, when the lessor retains ownership, the agreement is said
to be a ‘true’ lease; if not, it is a lease ‘intended as security’, and the lessor’s claim is
essentially viewed as a secured debt. Though our empirical analysis is based upon the
financial accounting classification, the analytical arguments behind our hypotheses rest, in
large part, upon the legal character- istics.’ Financial contracting rationales for the use of
secured debt, as opposed to unsecured debt or equity, are offered by Smith and Warner
(1979a) and Stulz and Johnson (1985). First, securing debt with a borrower’s assets may be a
cost-effective way of reducing asset substitution risks and may help to econom- ize on lender
monitoring costs. In addition, Stulz and Johnson demonstrate that a firm and its creditors can
mitigate the underinvestment problem (analyzed by Myers, 1977) by allowing subsequent
debt to be secured by the assets such borrowings can finance.

If the financially troubled lessee chooses instead to assume the lease, and thus retain the
equipment, the lessor is entitled to continue receiving compen- sation in accordance with the
original lease agreement, since such obligations are classified as administrative expenses in
the bankruptcy code. In fact, the lessor’s entire claim, including delinquencies, late fees, and
other damages suffered, is classified as an administrative claim that must be paid immediately
or ‘within a reasonable period (Sweig, 1993).

Related empirical studies

Among previous analyses of the incentives to lease, Krishnan and Moyer (1994) is perhaps
closest in spirit to our study. They hypothesize that leasing reduces bankruptcy costs in
comparison to financing with ordinary debt, and argue that leases have all the advantages of
secured debt and then some. As a consequence, leases should be more widely used by riskier,
less established firms. This hypothesis is supported by their empirical finding that firms with
lower and less stable operating earnings are more likely to lease. Nonetheless, their analysis
examines the use of capital leases and ignores operating leases

Other empirical analyses have attempted to gauge the effect of capitalized leases on overall
debt capacity, but such studies fail to control for the underlying factors that determine debt
capacity. Ang and Petersen (1984) examine the relation between the book value of capital
leases and a firm’s use of other debt. They find that leases are complementary to debt, that is,
firms with leases also appear to have more nonlease debt (relative to book equity). As pointed
out by Smith and Wakeman (1985), this result probably reflects the difficulty of control- ling
for debt capacity, that is, firms with higher debt capacity may also have (omitted)
characteristics that make leasing relatively attractive. Bayless and Diltz (1988) control for
such considerations by using an experimental setting in which banks are queried regarding
the amount they would be willing to lend under various hypothetical circumstances. Bayless
and Diltz found that, in the case of a term loan decision, banks did not treat outstanding
capital leases and debt differently; however, leases had a somewhat negative relative effect
on credit line decisions. They conclude that the fungibility of leases and other debt should
generally depend upon the particular use for which the firm’s other debt has been targeted

In summary, we find strong evidence that a corporation’s propensity to lease is substantially

influenced by the financial contracting costs associated with information problems. The main
results concern the total lease share, or the percentage of firms’ total annual costs of property,
plant, and equipment use accounted for by capital or operating leases. After controlling for
firm size and other factors, our estimates suggest that the total lease share of a low-rated firm
that pays no cash dividends is about 25 percentage points higher than that of a highly rated
dividend-paying firm. Not surprisingly, we also find that tax-related motivations help explain
the relative propensity to lease

Given that equipment under lease accounts for nearly a third of the total annual new
equipment investment in the U.S. in recent years, the implications of these findings are
clearly far-reaching. Our results suggest that a comprehensive analysis of corporate capital
structure should not disregard the role of leasing, which serves as a means of alleviating
financial contracting costs. Our results also suggest that microeconomic studies of fixed
capital investment and its dynamics should consider the role of off-balance-sheet financing as
reflected in rental expense. For example, our finding that leasing by small firms substantially
exceeds that of large firms, particularly in manufacturing; suggests that current research
focusing on the relative behavior of small- versus large-firm investment can generate
misleading conclusions to the extent that these studies ignore the leasing option. Indeed, an
examination of the dynamics of lease financing and equipment investment should prove
fruitful in future research.

Because of asymmetric information problems and a lack of collateral, many high-tech

firms, especially small firms, are likely to face financing constraints. Adverse selection and

moral hazard problems, together with financial distress, suggest that the marginal cost of debt

finance may rise rapidly and potentially lead to large funding gaps. For high-tech firms, new

equity finance has several potential advantages over debt finance. In our panel of over 2400

United States high-tech firms, we find that most small firms obtain little debt financing. The
IPO, however, is typically very large relative to the existing assets of the firm and it often
leads to a dramatic change in the firm’s size. After going public, new equity financing
remains important for some firms, but most firms appear to obtain the bulk of their financing
from retained earnings. Overall, new equity finance appears to be very important to the rapid
growth of young high-technology firms. The issues addressed in our research have several
implications for public policy. It is likely that firms in many countries conduct too little
investment in the high-tech sector compared to a benchmark model with perfect capital
markets. Given the problems of debt finance outlined in section 1, together with our findings
on its limited use, overlending (e.g., de Meza, this issue) is unlikely to be present in the high-
tech sector. de Meza (this issue) also discusses the possibility that asymmetric information
can lead to too much equity financing. Even developed countries, however, often do not have
well-developed markets for external equity finance. When there are relatively few publicly
traded companies, it seems unlikely that there are socially excessive levels of external equity
financing.

Venture capital is the form of equity financing that is currently best suited to address the
capital market imperfections inherent in the financing of young high-tech companies. Venture
capitalists typically monitor the firms they fund closely and have effective tools to partially
overcome information and agency problems. In the United States, the majority of venture
capital is invested in the high-tech sector, where monitoring and information evaluation are
important. One role of venture capitalists is to provide start-up funding for new firms. Should
a new firm reach a stage where it requires large amounts of funding, a second role of venture
capitalists is to use their reputation to provide some assurance to public investors about the
quality of the firm and the value of the IPO (Megginson and Weiss, 1991).26 Given our
findings on the relative size of IPOs, the certification role played by venture capitalists is
likely to be important. There are a wide range of public policies that may improve high-tech
firms’ access to equity financing, including venture capital. Lerner (this issue) examines
public venture capital programs as a public policy response to the financing problems faced
by SMEs. Jeng and Wells (2000) examine the determinants of venture capital funding in 21
countries. Their review of public policy in such countries as the United States, the United
Kingdom, Portugal, Norway, and Israel indicates that the institutional and legal environment,
including tax policy, can play an important role in encouraging the expansion of equity
finance. For some countries, such as Portugal and Norway, they report that government
funding of venture capital has been associated with large increases in the flow of private
funds into venture capital (p. 278). Governments can also actively encourage the
development of stock markets for small high-tech companies, including the reduction of
regulatory barriers to listing. In the US, low barriers to listing on the NASDAQ and the
NASDAQ Small Cap enhance the ability of a young high-tech firm to obtain new equity
finance. The regional system of exchanges that form the recently developed Euro NM, as
well as the EASDAQ and the AIM in the United Kingdom, are
all examples of markets that are similar to NASDAQ in terms of their relatively low barriers
to listing. These markets should aid in the development of the European high-tech sector.
Financial obstacles to entrepreneurship and to the growth of the high-tech sector have been
the focus of much public policy discussion in Europe and have been identified as potential
weaknesses of the European Union (Bank of England, 1996; European Commission, 1998,
1999b). There is concern that a lack of venture capital (private equity) may be an important
barrier to the development of the European high-tech sector. While venture capital in Europe
has grown rapidly in the past few years, it is significantly smaller than in the US.27 Venture
capital in the United States is also concentrated in the high-tech sector to a much larger
degree than it is in Europe, and United States venture capitalists focus more intensively on
early-stage investments.28 There is also continued concern that small high-technology firms
in Europe have more difficulty than their United States counterparts in gaining access to
public equity capital. In 1997, for example, small firms raised more than 7 times the amount
of capital on the Nasdaq as was raised on the Easdaq, Euro.NM, and AIM, combined
(European Commission, 1998).

To promote the growth of small high-tech firms, we believe that European policymakers
have correctly emphasized the development of markets for public equity finance and private
venture capital. Debt is likely to be a poor substitute for equity. High-tech firms unable to
obtain equity financing may face substantial financial barriers to entry and mobility. Our
results suggest that institutional factors that affect the availability and cost of equity financing
may be an important determinant of the comparative advantage of nations in the production
of high-tech goods.
Reference

1. Steven A. Sharpe , Hien H. Nguyen. Journal of Financial Economics 39 (1995) 271-

279. Capital Market Imperfections and The Incentive to lease.
s
2. Robert A. Carpenter. Capital Market Imperfections, High-Tech Invesment , and New
Equity Financing.
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