INTRODUCTION TO

CORPORATE FINANCE
Laurence Booth W. Sean Cleary

Prepared by

Ken Hartviksen

CHAPTER 16 Leasing

Lecture Agenda
Learning Objectives Important Terms Leasing Arrangements Accounting for Leases Evaluating the Lease Decision Motivation for Leasing Summary and Conclusions
Concept Review Questions

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Learning Objectives
The basic characteristics of leases and how to differentiate between operating and financial (or capital) leases The accounting treatment of both operating and financial leases The benefits and disadvantages of leases How the lease decision can be evaluated using the discounted cash flow valuation methods
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Important Chapter Terms

Asset-based lending Asset Captive finance companies Financial lease Lessee Lessor Leveraged lease Off-balance-sheet Off-balancefinancing Operating lease Sale and leaseback (SLB) agreement Secured financing Small and medium-sized mediumenterprises (SMEs)

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Leasing Arrangements
Introduction

The decision to invest in an asset that has a long life is a capital budgeting decision. The decision to acquire is a separate decision from the decision on the method of financing the acquisition When these two decisions are combined, this is called assetasset-based lending because the financing is tied directly to a particular asset. Examples of asset-based lending include: asset Secured loans Conditional sales contracts Leases

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Leasing Arrangements
The Institutional Framework

Canadian Finance and Leasing Association (CFLA) acts as the trade association for asset-based lenders asset 160 members Represents three group of financial companies:
1. Independent asset-based finance companies asset Involved in machinery and equipment financing with 60% of customers begin SMEs. 40% of the assets financed are transportation equipment (buses, trucks, trailers or office equipment)

2. Captive finance companies of major manufacturers (eg. GMC Finance and Ford Credit Canada) where 1/3 of all new vehicles are leased. 3. Chartered banks
Chartered banks are not allowed to lease consumer household property and are therefore focussed on leasing commercial transportation equipment and real property such as land and buildings
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Lease
What is it?

A lease contract is an agreement where the owner conveys to the user the right to use an asset in return for a number of specified payments over an agreed period of time Lessor is the owner of the asset Lessee is the user of the asset

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Leasing
Types of Leases

Operating Lease
A lease where some of the benefits of ownership do not transfer to the lessee and remain with the lessor.

Financial (Capital) Lease

A lease where essentially all the benefits of ownership transfer to the lessee; also known as a capital or full payout lease.
(See Table 16-1 on the following slide for the distinguishing features between 16the two types of leases)
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Types of Leases
Operating versus Financial Leases
Table 16-1 Operating versus Financial Leases

OPERATING Lessee
Asset Not on alance sheet B/ ); isclose in footnotes xpense the full amount as rental expense

FINANCIAL Lessee
Report on B/

Lessor
eport on B/

Lessor
Not on B/

Lease payments

Claim as rental income

Depreciation expense (associated with leased asset)

Cannot claim

Claim

Decompose into interest an principal repayment, an expense the interest portion Claim

Claim the interest portion of payments receive as interest income Cannot claim

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Conditional Sales Agreement

What is it? CRA Perspective According to Canada Revenue Agency (CRA) a conditional sales agreement exists if one of the following occurs:
The lessee automatically acquires ownership at some point The lessee is required to buy the asset at some point or guarantee that the lessor gets a certain value for it The lessee has the right to buy the asset at some point for substantially less than the likely fair market value The lessee has the right to buy the asset at a price that would cause a reasonable person to conclude that they will buy it.

CRAs interest in this issue is that it must determine which party to the contract has the legal right to claim CCA for tax purposes. If any of the other above conditions are satisfied, CRA regards the user (lessee) as having the right to claim CCA.
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Financial/Capital/Full Payout Lease

What is it? Accounting Perspective According to the Canadian Institute of Chartered Accountants (CICA), all of the benefits of ownership transfer to the lessee with these lease agreements. The lessee is deemed to own the asset and will claim depreciation on the firms income statement and record the value as an asset and liability on the balance sheet. Such leases usually:
Require the lessee to carry out maintenance and insure the asset Provides the lessee with a fixed purchase option The lease agreement covers 75% of the economic life of the asset Is structured so that the present value of lease payments exceeds 90 % of the cost Involves fixed rental payments.
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Operating Lease
What is it? Accounting Perspective

If a lease is OT a capital lease, then it is an operating lease Operating leases do not transfer to the lessee the benefits of ownership (ability to deduct CCA)

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Sale and Leaseback Agreement

What is it?

An agreement in which the owner of an asset sells it to another party and then leases the asset back Popular type of lease for organizations in low tax brackets because they are unable to use the tax shield offered by CCA SLBs can mean that part of the tax savings can be transferred back to the seller in the form of lower lease payments, reducing the cost of the asset 1989 federal budget significantly reduced the benefits from such agreements by forcing the lessor to deduct depreciation on leased assets only from income derived from leasing.
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Leveraged Lease
What is it?

A three-way agreement among the lessee, the lessor, threeand a third party lender in which the lessor buys the asset with only a small down payment and the lender supplies the financing Popular in U.S. because lessor puts up only a portion of the asset purchase price, but receives all of the tax benefits of ownership ot popular in Canada because CRA restricts use of CCA to the party at risk, and CCA deductions cannot be carried over to offset taxes on other income

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Accounting for Leases

Accounting for Leases

Financial leases are included on the balance sheet of the lessee

Present value of all lease payments is recorded on the right-hand side of the balance sheet right The same amount is recorded as an asset on the left-hand side of the balance left-

Operating leases are off-balance-sheet off-balancefinancing for the lessee (included only in the notes to the financial statements)

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Accounting for Leases

Financial Statement Effects of Lease Classification

Capital/Financial/Full Payout Leases:

Income Effects 1. Net income will generally be lower for capital leases in the early years and higher in the later years. 2. CFO will be higher with capital leases. CCA may be deducted in measuring Net Income after tax, however, CCA is added back when determining CFO. Capital/ financial leases expense only the interest portion of the payments in determining EBT. Balance Sheet Effects 1. Lower current ratios, higher debt and leverage ratios, lower asset turnover and lower profitability ratios (especially in the early years of asset life)

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Accounting for Leases

Financial Statement Effects of Lease Classification

Operating Leases:
Income Effects 1. Net income will generally be higher for operating leases in the early years and lower in the later years because interest expense charged for the financial lease declines as the liability is amortized by the lease payments. 2. CFO will be lower with operating leases since the full lease payment is subtracted from CFO, unlike financial leases where only the interest portion of the payments is subtracted. Balance Sheet Effects 1. Higher current ratios, lower debt and leverage ratios, higher asset turnover and higher profitability ratios (especially in the early years of asset life)
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Evaluating the Lease ecision

Lease Versus Buy

Leasing is an alternative means of obtaining the use of an asset There are four main differences in the cash flows for a company that leases an asset instead of buying it:
1. It does not have to pay for the asset up front 2. It does not get to sell the asset when it is finished with it, if it is an operating lease, or if title is not transferred through a financial lease 3. It makes regular lease payments. If the lease is an operating lease, then the full amount of the lease payments is tax deductible; only the interest portion is deductible for capital leases 4. Operating leases are not depreciated.
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Evaluating the Lease ecision

Lease Versus Buy Evaluative Frameworks

IRR of Leasing Analysis

Estimate incremental cash flows that result from leasing Solve for the discount rate (IRR) that equates the incremental cash flows with the initial value of the asset. (This is the after-tax IRR or cost of leasing) after If IRR of leasing > after-tax cost of borrowing (borrow and afterbuy the asset) If IRR of leasing < after-tax cost of borrowing (lease the afterasset)

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Evaluating the Lease ecision

Lease Versus Buy Evaluative Frameworks

NPV of Leasing Analysis

Estimate incremental cash flows that result from leasing Calculate NPV using after-tax cost of borrowing as afterthe discount rate.
If NPV of leasing is (borrow and buy the asset) If NPV of leasing + after-tax cost of borrowing (lease the afterasset)

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Motivation for Leasing

1. Cheaper financing (which party can make better use of the CCA tax shield/) 2. Reduce the risks of asset ownership 3. Implicit interest rates 4. Maintenance 5. Convenience 6. Flexibility 7. Capital budgeting restrictions 8. Financial statement effects
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Summary and Conclusions

In this chapter you have learned: That firms can gain the use of assets through leasing rather than outright ownership The general differences between operating and financial leases How to evaluate a potential lease decision using discounted cash flow analysis The various reasons firms might have for entering into lease arrangements
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Copyright
Copyright 2007 John Wiley & Sons Canada, Ltd. All rights Ltd. reserved. reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be unlawful. addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her Ltd. backown use only and not for distribution or resale. The author and the resale. publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein. herein.

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