Quiz 2 is only about Leasing Professor is Ms. Preeti Agrawal

1. A.
What
is
a
LEASE?
• Rental
agreement
• With
series
of
payments
• That
extends
for
a
year
or
more
B.
Parties
Involved:
a) Lessor
(Owner
of
Asset)
b) Lessee
(Borrower
of
Asset)
C.
Types
of
Lease:
1. Operational
Leases:
• Short
term
and
Cancelable
• at
the
option
of
the
lessee
2. Financial
Leases:
• Long-­‐Term
and
Non-­‐Cancelable
• Long-­‐Term:
extends
at
the
economical
life
of
the
asset
• Non-­‐cancelable
UNLESS
Lessor
is
reimburse
for
any
loss
D.
Leases
Differ
in
Service:
1. Full
Service/Rental/Lease:
• LESSOR
promises
to
maintain
and
insure
the
equipment
and
to
pay
property
tax
due
on
it
2. Net
Lease:
• LESSEE
promises
to
maintain
and
insure
the
equipment
and
to
pay
property
tax
due
on
it
3. Direct
Lease:
• LESSEE
identifies
the
equipment,
arranges
for
the
leasing
company
to
buy
it
from
the
manufacturer,
and
signs
a
contract
with
the
leasing
company.
4. Sale
and
lease-­‐back
Arrangements:
• The
firm
sells
an
asset
it
already
owns
and
leases
it
back
from
the
buyer
5. Leveraged
Lease:
• The
lessor
puts
up
some
of
the
money
required
to
purchase
the
asset
and
borrows
the
rest
from
a
lender.
• The
lender
is
given
a
senior
secured
interest
on
the
asset
and
an
assignment
of
the
lease
and
lease
payments.
The
lessee
makes
payments
to
the
lessor,
who
makes
payments
to
the
lender.
E.
Sensible
Reasons
for
Leasing:
• Short-­‐term
leases
are
convenient
•
Lower
Monthly
payment
•
Protection
against
obsolescence
•
Cancellation
options
are
valuable
o Some
leases
that
appear
expensive
really
are
fairly
priced
once
the
option
to
cancel
is
recognized.
•
Maintenance
is
provided
o Under
a
full-­‐service
lease,
the
user
receives
maintenance
and
other
services.
•
Standardization
leads
to
low
costs
o Standardization
makes
it
possible
to
“lend”
small
sums
of
money
without
incurring
large
investigative,
administrative,
or
legal
costs.
•
Leasing
and
financial
distress
o LESSOR
may
fare
better
during
Bankruptcy
i.
if
asset
is
deemed
“essential”
by
the
court
then
the
court
will
AFFRIM
the
lease.
The
lessee
must
still
continue
to
pay
the
lessor
and
continue
to
use
the
asset
(1
st
scenario)
ii. If
court
REJECTS
lease,
then
the
lessor
may
recover
asset
(2
nd
scenario)
iii. If
the
LESSEE
renegotiates
with
the
lessor,
lessor
might
be
forced
to
accept
lower
lease
payments
(3
rd
scenario)
• Tax
Shield
can
be
used:
o Lessor
owns
asset,
and
so
deducts
its
depreciation
o If
lessor
can
make
better
use
of
tax
shield
than
lessee,
then
lessor
should
own
equipment
and
pass
on
some
tax
benefits
to
lessee
o So
direct
tax
gain
to
lessor,
indirect
gain
to
lessee
F.
Dubious
Reasons
for
Leasing
• Leasing
avoids
capital
expenditure
controls
o Leasing
may
enable
an
operating
manager
to
avoid
the
approval
procedures
needed
to
buy
an
asset
•
Leasing
preserves
capital
If
Greymare
Bus
Lines
leases
a
$100,000
bus
rather
than
buying
it,
it
does
conserve
$100,000
cash.
It
could
also
(1)
buy
the
bus
for
cash
and
(2)
borrow
$100,000,
using
the
bus
as
security.
Its
bank
balance
ends
up
the
same
whether
it
leases
or
buys
and
borrows.
It
has
the
bus
in
either
case,
and
it
incurs
a
$100,000
liability
in
either
case.
•
Leases
may
be
off
balance
sheet
financing
o In
some
countries
financial
leases
are
off-­‐
balance-­‐
sheet
financing;
that
is,
a
firm
can
acquire
an
asset,
finance
it
through
a
financial
lease,
and
show
neither
the
asset
nor
the
lease
contract
on
its
balance
sheet.
•
Leasing
effects
book
income
o Leasing
can
make
the
firm’s
balance
sheet
and
income
statement
look
better
by
increasing
book
income
or
decreasing
book
asset
value,
or
both.
o A
lease
that
qualifies
as
off-­‐balance-­‐sheet
financing
affects
book
income
in
only
one
way:
The
lease
payments
are
an
expense.
G.
Financial
accounting
Standard
Board(FASB)
and
Leases
The
FASB
defines
capital
leases
as
leases
that
meet
any
one
of
the
following
requirements:
•
The
lease
agreement
transfers
ownership
to
the
lessee
before
the
lease
expires.
•
The
lessee
can
purchase
the
asset
for
a
bargain
price
when
the
lease
expires.
•
The
lease
lasts
for
at
least
75%
of
the
asset’s
estimated
economic
life.
•
The
present
value
of
the
lease
payments
is
at
least
90%
of
the
asset’s
value.

2. H.
International
Financial
Reporting
Standards
(IFRS)
and
Lease
A
lease
is
classified
as
a
finance
lease
if
it
transfers
substantially
all
the
risks
and
rewards
incident
to
ownership.
All
other
leases
are
classified
as
operating
leases.
Classification
is
made
at
the
inception
of
the
lease.
I.
Situations
that
would
normally
lead
to
a
lease
being
classified
as
a
finance
lease
include
the
following:
i.
the
lease
transfers
ownership
of
the
asset
to
the
lessee
by
the
end
of
the
lease
term
ii.
the
lessee
has
the
option
to
purchase
the
asset
at
a
price
which
is
expected
to
be
sufficiently
lower
than
fair
value
at
the
date
the
option
becomes
exercisable
that,
at
the
inception
of
the
lease,
it
is
reasonably
certain
that
the
option
will
be
exercised
iii.
the
lease
term
is
for
the
major
part
of
the
economic
life
of
the
asset,
even
if
title
is
not
transferred
iv.
at
the
inception
of
the
lease,
the
present
value
of
the
minimum
lease
payments
amounts
to
at
least
substantially
all
of
the
fair
value
of
the
leased
asset
v.
the
lease
assets
are
of
a
specialized
nature
such
that
only
the
lessee
can
use
them
without
major
modifications
being
made
J.
Other
situations
that
might
also
lead
to
classification
as
a
finance
lease
are:
i.
if
the
lessee
is
entitled
to
cancel
the
lease,
the
lessor's
losses
associated
with
the
cancellation
are
borne
by
the
lessee
ii.
gains
or
losses
from
fluctuations
in
the
fair
value
of
the
residual
fall
to
the
lessee
(for
example,
by
means
of
a
rebate
of
lease
payments)
iii.
the
lessee
has
the
ability
to
continue
to
lease
for
a
secondary
period
at
a
rent
that
is
substantially
lower
than
market
rent
K.
Evaluation
of
Leases
◆ Lease
rentals
– Allowable
deduction
for
lessee
– taxable
income
for
lessor
◆ Depreciation
– Allowable
deduction
for
lessor
– Not
allowed
for
lessee
◆ Tax
payable
on
gain
from
sale
of
underlying
asset
– Payable
by
lessor
– Avoided
by
lessee
L.
Evaluation
of
LESSEE
• Add
cost
of
asset
• Subtract
lease
payments
•
Add
tax
shield
from
lease
payments
•
Subtract
depreciation
tax
shield
•
Subtract
residual
value
of
asset
•
Add/
subtract
tax
gain/loss
on
sale
of
asset
M.
Evaluation
of
LESSOR
• Subtract
Cost
of
asset
•
Add
lease
payments
•
Subtract
tax
shield
from
lease
payments
•
Add
depreciation
tax
shield
•
Add
residual
value
of
asset
•
Subtract/
Add
tax
loss/gain
on
sale
of
asset
EVALUATION
LESSEE
LESSOR
COST
OF
ASSET
+
-­‐
LEASE
PAYMENT
-­‐
+
TAX
SHIELD
FROM
LEASE
PAYMENT
+
-­‐
DEPRICIATION
TAX
SHIELD
-­‐
+
RESIDUAL
VALUE
OF
ASSET
-­‐
+
LOSS
ON
SALES
OF
ASSET
+
-­‐
GAIN
ON
SALE
OF
ASSET
-­‐
+

3. v
Acme
has
branched
out
to
rentals
of
office
furniture
to
start
up
companies.
Consider
a
$3000
desk.
Desks
last
for
six
years
and
can
be
depreciated
on
a
five-­‐
year
MACRS
schedule.
What
is
the
break-­‐even
operating
lease
rate
for
a
new
desk?
Assume
that
lease
rates
for
old
and
new
desks
are
the
same
and
that
Acme’s
pre-­‐tax
administrative
costs
are
$400
per
desk
per
year.
The
cost
of
capital
is
9%
and
the
tax
rate
is
35%.
Lease
payments
are
made
inn
advance,
that
is,
at
the
start
of
each
year.
The
inflation
rate
is
zero.
The
table
below
provides
the
depreciation
schedule:
Given:
• Initial
Cost:
$3000
• Pre
Tax
Admin
Cost=
$400
• Cost
of
Capital/
Discount
Rate:
9%
• Tax
Rate:
35%
CASH
FLOWS
-­‐3260
-­‐50
+76
-­‐58.40
-­‐139.04
-­‐139.04
+60.48
Break Even Lease Rate =
𝐵𝑟𝑒𝑎𝑘 𝑒𝑣𝑒𝑛 𝑙𝑒𝑎𝑠𝑒 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 (𝐶)
(1 + 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)
Present Value = C
!
!
−
!
!(!!!)
1 + 𝑟
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 = 𝐶! +
𝐶!
(1 + 𝑟)!
+
𝐶!
(1 + 𝑟)!
+ ⋯ +
𝐶!
(1 + 𝑟)!
Solution:
𝑃𝑉 = −3260 −
50
1 + 0.09 !
+
76
1 + 0.09 !
−
58.40
1 + 0.09 !
−
139.04
(1 + 0.09)!
−
139.04
(1 + 0.09)!
+
60.48
(1 + 0.09)!
PV=
3,439.80
3,439.80 = C
1
0.09
−
1
0.09 1 + 0.09
1 + 0.09
3,439.80
4.889651263
= C
C
=
703.49
Break Even Lease Rate =
703.49
(1 + 0.35)
Break
Even
Lease
Rate
=
1,082.29
v If
a
firm
can
borrow
at
9%
,
what
discount
rate
should
the
firm
use
to
discount
lease
cash
flows?
(The
marginal
tax
rate
for
the
firm
is
35%)
Tax
Shield=
0.09(1-­‐0.35)
Tax
Shield
=5.85%
v Nodhead
College
needs
a
new
computer.
It
can
either
buy
it
for
$250,000
or
lease
it
from
Compulease.
The
lease
terms
requires
Nodhead
to
make
six
annual
payments
(prepaid)
of
$62,000.
Nodhead
pays
no
tax.
Compulease
pays
tax
at
35%.
Compulease
can
depreciate
the
computer
for
tax
purposes
over
five
years.
The
computer
will
have
no
residual
value
at
the
end
of
year
5.
The
interest
rate
is
8%.
a.
What
is
the
NPV
of
the
lease
for
Nodhead
College?
Given:
𝑃𝑉 =
62,000
(1 + 0.08)!
!
!!!
NPV
cash
flow
of
Nodhead
is:
250,000
–
value
of
PV
=
-­‐59,500
b.
What
is
the
NPV
for
Compulease?
- Adjusted
discount
rate=
rD(1
-­‐
Tc)
- The
after
tax
interest
rate
is:
(1 − 0.35)× 0.08 = 0.052 = 5.2%
- The
NPV
cash
flow
of
Compulease
is
40.0
or
$40,000
c.
What
is
the
overall
gain(loss)
from
leasing?
40,000 − 59,500 = −19,500
v Suppose
that
National
Waferonics
has
before
it
a
proposal
for
a
four-­‐year
financial
lease.
The
table
below
summarizes
the
lease
cash
flows
of
the
proposal:
These
flows
reflect
the
cost
of
machine,
depreciation
tax
shields,
and
the
after-­‐tax
lease
payments.
Ignore
salvage
value.
Assume
the
firm
could
borrow
at
10%
and
faces
a
35%
marginal
tax
rate.
a.
What
is
the
value
of
the
equivalent
loan?
– Adjusted
discount
rate=
rD(1
-­‐
Tc)
– 0.10
×
(1
–
0.35)
=
0.065
=
6.5%
– The
value
of
the
equivalent
loan
is
the
present
value
of
the
cash
flows
for
years
1,
2
and
3:
$59,307.30

4. b.
What
is
the
value
of
the
lease?
- The
value
of
the
lease
is:
$62,000
–
$59,307.30
=
$2,692.70
c.
Suppose
the
machine’s
NPV
under
normal
financing
is
($5,000).
Should
Thor
Inc.
invest?
- National
Waferonics
should
not
invest.
The
lease’s
value
of
+$2,692.70
does
not
offset
the
machine’s
negative
NPV.
On
the
other
hand,
the
company
would
be
happy
to
sign
the
same
lease
on
a
more
attractive
asset.
EQUATIONS:
Break Even Lease Rate =
𝐵𝑟𝑒𝑎𝑘 𝑒𝑣𝑒𝑛 𝑙𝑒𝑎𝑠𝑒 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 (𝐶)
(1 + 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)
Present Value = C
1
𝑟
−
1
𝑟(1 + 𝑟)
1 + 𝑟
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 = 𝐶! +
𝐶!
(1 + 𝑟)!
+
𝐶!
(1 + 𝑟)!
+ ⋯ +
𝐶!
(1 + 𝑟)!
𝐴𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒 = 𝑟!"#$%&'((1 − 𝑇!"#$"#%&'"()
𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑 𝑜𝑓 𝐿𝑒𝑎𝑠𝑒 𝑃𝑎𝑦𝑚𝑒𝑛𝑡
= 𝐴𝑛𝑛𝑢𝑎𝑙 𝐿𝑒𝑎𝑠𝑒 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 × 𝑇𝑎𝑥 𝑟𝑎𝑡𝑒
𝐷𝑒𝑝𝑟𝑖𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑
= 𝑑𝑒𝑝𝑟𝑖𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑚𝑜𝑢𝑛𝑡 𝑐𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒
𝐷𝑒𝑝𝑟𝑐𝑖𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝐴𝑚𝑜𝑢𝑛𝑡 = 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 × 𝑑𝑒𝑝𝑟𝑖𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒
𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 = 𝑃𝑟𝑒 𝑇𝑎𝑥 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒
𝐵𝑒𝑓𝑜𝑟𝑒 𝑇𝑎𝑥 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 =
𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑝𝑎𝑦𝑚𝑒𝑛𝑡
(1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)
𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 = 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 + 𝑑𝑒𝑝 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑
+ 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑎𝑑𝑚𝑖𝑛 𝑐𝑜𝑠𝑡