Dr. P.V. Viswanath

pviswanath@pace.edu

Asset Based Financing Techniques: The Case of Leasing
©P.V. Viswanath, 1999,2007

• Introduction
• Kinds of leases
• Valuation of Financial Leases
  • Example
• Leasing and the Optimal Capital Structure
• Leasing and Taxation
• Other Advantages of Leasing

Introduction

A lease is a contractual agreement between two parties, an owner of an asset (lessor) and the user of the asset (lessee).  The agreement specifies that the lessee has the right to use the asset, and in turn must make periodic payments to the lessor.

Kinds of leases

 Operating Leases:

• The term of the lease is usually less than the economic life of the asset.  Consequently, the asset is not fully amortized: lease payments are not enough to recover the entire cost of the asset.
• The lessor is required to maintain and insure the assets.
• There is of ten a cancellation option that gives the lessee the option to cancel the lease contract before expiration.

 Financial or Capital Leases:

A financial lease substitutes for a purchase.  Hence:

• Financial leases do not provide for maintenance or service by the lessor.
• Financial leases are fully amortizded.
• The lessee usually has a right to renew the lease on expiration.
• Financial leases usually cannot be cancelled.

 Types of financial leases:

• Sale and lease-back: In this kind of lease, a company sells an asset it owns to another firm and leases it back immediately.
• Leveraged lease: In this case, the lessor finances the asset partly by debt.

Valuation of financial leases:

A valuation technique that is convenient in the valuation of leases is the weighted-average-cost-of-capital method. 

In the conventional application of the WACC method, we have an initial outflow of cash, which is financed by some combination of debt and equity.  The unlevered cash flows generated by this initial investment is discounted at the WACC. 

In the case of a lease, on the other hand, we have an initial inflow, which reduces the amount of borrowing necessary from other sources.  This initial inflow commits us to regular payments over time, which may be considered as reductions in profits generated by other projects.  In this sense, a lease is an anti-project.  As such, it is to be evaluated exactly as any other project would be, but for the fact that the signs are reversed.   

The final question is what the applicable WACC will be.  That depends on the debt-equity ratio that is appropriate.  Note that the cash flows in leasing are similar to those involved in borrowing.  The annual lease payments have to be made irrespective of the size of the firm's cash flows from operations.  Hence leasing effectively displaces an equivalent amount of borrowing.  Consequently, the appropriate WACC simply involves the cost of debt financing.  The WACC, therefore, is simply rB(1- t). 

Cash-flow implications of leasing 

Since the alternative to leasing is purchasing, we are interested in the incremental cash flows to leasing over and above the purchasing alternative.  Assuming that we are dealing with a financial lease, the lessee is permitted to deduct the entire amount of the lease payment. 

On the other hand, he loses the depreciation tax deduction and the investment tax credit.

Finally, he is absolved from the requirement to put up the initial purchase price for the equipment, while foregoing the salvage value at the end of the project. 

As we know, under all capital budgeting approaches, each cash flow is discounted by the rate of return appropriate for cash flows of similar riskiness.  All the cash flows above, except for the salvage value recapture, possess debt characteristics.  However, the salvage value is riskier and hence must be discounted at the discount rate appropriate for its own risk.  Thus, if that risk is the same as the risk of the firm in general, it should be discounted at the firm weighted-average-cost-of-capital. 

In general, the formula for lease evaluation is: 

where

P = purchase price of the asset,
N = life of the lease,
L_t = lease payment in year t,
E_t = the total incremental difference in operating or other expenses in year t between the leasing and buying alternatives,
D_t = the depreciation deduction in year t,
SAL = expected salvage value at the end of the lease,
k = weighted average cost of capital of the firm, and
ITC = investment tax credit.

Example

(Emery and Finnerty, 1991, p. 652) Eastern Shovels Corporation has the option of leasing electric shovels for 4 years with an annual lease payment of $3.745 m.  Eastern's corporate tax rate is 40%, and it can obtain secured financing for the shovels at a rate of 15.5%.  The weighted average cost of the capital for the firm is 20%.  Is it more profitable for Eastern to buy the shovels for $13 m. or to lease them, if the shovels have a salvage value of $5,000,000 at the end of the 4 years?  Assume straight-line depreciation.

Consider Eastern's incremental cash flows for leasing:

The discount rate, from the information given to us is 15.5(1-.4) = 9.3%.  Using this discount rate, we get an NPV for the lease of 13000 -5,000/(1.2)4  - 3,047 = $781.96 m., where the first two terms refer to
 the purchase price and the PV of the salvage value, while the last term refers to the present value of the lease related cash flows. 

The Equivalent Loan Interpretation

This last term 3,047 = $9806.77 represents the amount that would need to be borrowed to generate the annual lease related cash flows of $3,047.  Hence this amount is termed the equivalent loan.  This observation gives us another way of interpreting the $781.96 NPV of the lease.   

The purchase alternative requires an initial outlay of $13 m. with an additional risky inflow of $5 m. at the end of 4 years, giving us a net outlay in current dollars of $10,588.74 m.   

The lease alternative, on the other hand, requires taking an equivalent loan of $9806.77 to fund the lease-related flows.   

In other words, by leasing, we are effectively borrowing $9806.77, and obtaining the same services as the purchase alternative, which requires $10,588.74 m.  Hence the saving under the lease alternative is 10,588.74-9806.77 = $781.96.

Leasing and the optimal capital structure 

An objection may be raised at this point that, even though the similarity of leasing and debt financing led us to use 100% debt financing for purposes of computing the discount rate for the lease related cash flows, such a high leverage level might be suboptimal.  This may, indeed be true.   

Hence it may be optimal, say, to repurchase some debt to offset the excessive leverage undertaken for the purchase of the shovels.   

While this may certainly be the case, such deleveraging will have to be undertaken both for the leasing alternative and the purchase with 100% borrowing alternative.

Leasing and Taxation

IRS rules governing deductability of  lease payments

Because of the favorable tax implications of leasing, the IRS imposes certain conditions to ensure that leasing is not done solely for the purpose of tax avoidance.   These restrictions ensure that the lease is sufficiently dissimilar to a conditional sale. 

• The term of the lease must be less than 30 years.
• The lease should not have an option to acquire the asset at a price below fair market value.
• Lease payments should not be excessively shifted to the beginning of the lease.
• The lease payments should provide the lessor with a fair market rate of return; i.e. the profit potential of the lease should be independent of the tax benefits of the lease.
• The lease should not limit the lessee's right to issue debt or pay dividends during the life of the lease.
• Renewal options must be reasonable and reflect the fair market value of the asset.

When is leasing advantageous from a tax viewpoint?

Since the lessor purchases the asset and turns around and leases it to the lessee, the evaluation of the lease from the point of view of the lessor is exactly the same as from the lessee's point of view, except that the signs of the cash flows are switched around. 

If the tax rates for lessor and lessee were the same, it follows that the gain to the lessee from leasing would equal the loss to the lessor.  Hence for leasing to make sense economically, there must be some asymmetries between lessor and lessee.  In our example, the lease would also make sense for the lessor if his tax rate were lower than the lessee's.  For example, if the lessor's tax rate were 20%, his flows would be  

The present value of the lease to the lessor is:

-13000 + 3396 + 5000/(1.2)4= -13000 + 10228.54 + 2411.27 =

-$360.19, where a discount rate of (1-.2) x 15.5% = 12.4% is used.

Hence, there is a net gain to leasing, of  ($781.96 - $360.19 =) $421.77.  (In order to induce the lessor to offer the lease, the lessee may have to make somewhat higher lease payments so that the lessor's NPV is positive as well.) 

In this particular example, the lease made sense when the lessor had a lower tax rate.  However, in general, where accelerated depreciation is allowed for tax purposes, it may be more advantageous for the party with the higher tax rate to be the lessor, who can use the depreciation tax deduction.   

In general, if the lessor's tax rate is higher, it would be optimal for depreciation to be accelerated and for lease payments to be concentrated towards the end of the lease.   

If the lessee's tax rate is higher, the reverse would be optimal.   

In both cases, the advantage to leasing is greater, the greater the interest rate--with a zero interest rate, there would be no advantage to postponing the payment of taxes.

Other advantages of leasing 

Transactions Costs:

An operating lease, being akin to a rental, is usually short-term.  Hence, it is cheaper to write a lease agreement for a short period, than to incur the costs of changing the asset's ownership. 

Reduction of Uncertainty:

When the risk of obsolescence is great, or there is otherwise great uncertainty regarding the residual value of an asset, it is optimal for the user (lessee) to transfer this residual risk to another party (lessor) who has greater expertise in the market for that asset.  This transfer of risk can be achieved by a short-term lease with a cancellation option. 

Cheaper way of borrowing:

A lessor who specializes in financial leases for particular types of assets can better evaluate the cash flow distribution generated by these assets, as well as the agency costs that may be peculiar to the asset.  Hence investigative costs are minimized.  In addition, the lease contract can be standardized, implying lower transactions costs.  From the point of view of the lessee, the lease contract can, thus, represent a cheap method of financing an asset.

 Greater flexibility:

To the extent that a lease satisfies the restrictions of FAS 31, it need not appear on the company's balance sheet; it is, thus, not included in conventional definitions of debt.  Hence, leases may provide a way of circumventing restrictive covenants in bond indentures.

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