FIN2101
BUSINESS FINANCE II
Module 8
Analysis of Leases
Student Activities
Reading
Text,Chapter 18 (pp,652-61 only)
Text Study Guide,Chapter 18 (part only)
Study Book,Module 8
Tutorial Activities
Self Assessment Activity 8.1
Text Study Guide,Chapter 18,T/F 1-2,M/C 1-
4,Problem 1
Lease Finance Providers
Lease finance commitments,by type of lessor
Source 1999-2000 2000-2001 2001-2002
Banks $3 135m $2 062m $1 905m
Finance companies $2 556m $1 571m $1 812m
General financiers $1 472m $1 580m $1 625m
Other $ 744m $ 849m $1 271m
Totals $7 908m $6 061m $6 613m
Source,ABS,Year Book Australia 2003,Table 26.26
Assets Leased
Lease finance commitments,by type of goods leased
Type of Asset 1999-2000 2000-2001 2001-2002
MV & other transport $3 639m $2 529m $2 844m
Construction & earth moving equipment $ 319m $ 217m $ 232m
Agricultural machinery & equipment $ 328m $ 212m $ 220m
Automatic data processing equipment &
office machinery
$1 996m $1 944m $2 124m
Shop and office furniture,fittings & equipment $ 454m $ 343m $ 340m
Other goods $1 171m $ 815m $ 857m
Totals $7 907m $6 060m $6 617m
Source,ABS,Year Book Australia 2003,Table 26.27
Definitions
LEASE - A contract which grants a lessee the
right to use an asset in return for periodic
payments to the lessor.
LESSOR - The owner of the asset.
LESSEE - The party leasing the asset from its
owner.
Lease Document
Terms of the lease.
Asset to be leased.
Payments - when and how much?
Obligations of lessee and lessor - who pays for
insurance,maintenance,etc.
Whether lessee may acquire the asset at the end
of the lease.
Cancellation provisions.
Types of Leases
Operating lease - short-term (5 years or less).
The term of the lease is usually less than the
economic life of the asset.
Financial lease - more long-term,The
economic life of the asset and the term of the
lease are approximately equal.
Basic characteristics of each covered in text,pp.
652-4.
Operating Lease
Risks and rewards rest with lessor.
Generally cancellable at virtually no cost.
Sum of lease payments less than the initial cost to the
lessor.
May have a separate or inclusive maintenance contract
whereby the lessor assumes responsibility for
maintenance of the asset - service or maintenance lease.
Equipment reverts back to the lessor when lease is
terminated.
Finance Lease
Lessee incurs most of the risks and enjoys most
of the benefits.
Lessee normally responsible for maintenance,
etc.
Non-cancellable by either party.
Sum of lease payments exceeds the value of the
leased asset.
Lessee guarantees the residual value.
Residual Value
An option for the lessee to purchase the asset cannot
be explicitly provided for in the lease agreement.
However,the lessee indemnifies the lessor for any loss
resulting from the sale at the end of the lease term.
Usually through the lessee purchasing the asset for the
original residual value (usually between 10% and 40%
of the original cost).
Australian Case
Term generally less than economic life.
Cancellable (by the lessee).
Total of lease payments usually less than
purchase price.
Types of Financial Leases
Sale and Lease-Back Agreement
text,pp,653
Leveraged Lease
text,pp.653-4
Sale and Lease-Back Agreement
The owner of the asset sells it to another party
(for an amount usually equal to its market value)
who becomes the lessor by leasing it back to the
former owner.
Quite common in real estate.
A way of generating cash without having to part
with use of the asset.
Leveraged Lease
Often used to finance large-scale projects
(typically in excess of $15 million).
Lessor borrows most of the funds.
Common where it is difficult to find a lessor
who is able to finance the acquisition and able to
absorb the full benefits of the tax deductibility
of depreciation and interest costs.
Parties to a Leveraged Lease
Broker - organises and manages the lease.
Lender(s) - debt participants lending between
70% and 80% to the lessor.
Lessor(s) - provide the balance of the funds.
Lessee
Advantages of Leases
TO LESSOR:
Cheap way of acquiring asset.
Residual value.
Retains ownership in case of default.
Receives tax shields.
Advantages of Leases
TO LESSEE:
Use of asset but avoids big cash outlay.
Flexible way of acquiring use of an asset for a
short period of time.
For an operating lease,the burden rests with
lessor who is responsible for maintenance,etc.
Relatively low lease payments.
Flexible finance.
Disadvantages of Leases
FOR LESSOR:
Burden of maintenance,operating costs,etc (for
operating lease).
Loss of tax benefits advantage.
Risk of obsolescence.
Disadvantages of Leases
FOR LESSEE:
Burden of operating and maintenance costs (for
financial lease).
Risk of obsolescence.
No direct access to tax benefits associated with
ownership.
Accounting for Operating Leases
Operating leases need not be capitalised.
The basic features of an operating lease must be
disclosed in a footnote to the firm’s financial
statements.
Accounting for Financial Leases
AAS17 requires explicit disclosure of financial
lease obligations on the firm’s balance sheet.
Lease payments under a financial lease must be
capitalised,ie the PV of all lease payments is
included as an asset and a corresponding liability
on the balance sheet.
Operating vs Financial Lease
The classification of a lease should depend on
the economic substance of the transaction rather
than a literal application of the guidelines in
AAS17.
Provided that substantially all of the risks and
benefits associated with ownership are
effectively transferred to the lessee,the lease is
then a financial lease and should be capitalised.
Tax Implications
LESSOR:
Benefit of depreciation tax savings (DTS).
Lease payments received are taxable.
LESSEE:
Lease payments under a ‘genuine lease’ are tax
deductible if the leased asset is used to generate
taxable income.
Setting Lease Rentals
Manning Leasing wants to set a lease rate that provides
it with a satisfactory risk-adjusted return,Manning’s
after-tax return on leases is 6%,and its marginal tax rate
is 30%,The cost of the asset involved is $150 000,and
it will be depreciated over its 6-year life using the
straightline method,Assume lease payments are in
advance.
Calculate the minimum annual lease payment that
Manning should quote.
Solution
Step 1 – Calculate PV of Ownership
122,50 $11 3 -
877,50 $36 000 $15 0 -
4.91 7 500 $7 000 $15 0 -
P V I F A 0.30
6
000 $15 0
000 $15 0 - PV
0,0 6,6
Step 2 – Calculate Minimum After-tax LPs
704.24 $21
5.212
122.50 $113
4.212 122.50 $113
P V I F A 122.50 $113
0,0 6,5
LP
LP
LPLP
LPLP
Step 3 – Calculate Minimum Before-tax LPs
00 6.0 6 $31
0.3 0 - 1
70 4.2 4 $21
T - 1
LP
LP
t a x-A
t a x-B
Financial Evaluation of Leases
Lease vs borrow and purchase.
NPV of lease option must be cheaper than cost
of an equivalent loan.
Use the after-tax cost of debt as discount rate.
Discount Rate
Financial leases have the same characteristics of
secured debt finance:
the security is the leased asset;
the lessor is the provider of the finance.
Lease contract is considered to be the same as
debt - impacts on the debt capacity and gearing
ratio of the firm.
Compare lease finance to debt finance.
Leasing Example
Purchase price $180 000
Depreciation - straightline to zero
Annual lease payments $50 000
Before-tax cost of debt 10% p.a.
Life (and lease period) 4 years
Tax rate 30%
Assumptions
All operating,maintenance and insurance costs
are borne by the lessee.
Lease payments are made at the end of the year
(in arrears).
Tax is in the same year.
The company will be profitable over the 4 years
of the lease.
Option 1 - Purchase the Asset
T im e
P e r iod
In itial
Ou tlay
DTS
(N ote 1)
NCF DCF @ 7%
(N ote 2)
P r e sent
Valu e
0 - 180 000 - 180 000 1 - 180 000
1 13 500 13 500 0.935 12 623
2 13 500 13 500 0.873 11 786
3 13 500 13 500 0.816 11 016
4 13 500 13 500 0.763 10 301
NP V = - $134 274
Option 2 - Lease the Asset
Tim e
P eri od
B - tax
Leas e
P ay m ents
Tax Sav i ngs
on L P
(See N ote 3)
NCF DCF
(@ 7% )
P res ent
V al ue
0
1 - 50 00 0 15 00 0 - 35 00 0 0.93 5 - 32 72 5
2 - 50 00 0 15 00 0 - 35 00 0 0.87 3 - 30 55 5
3 - 50 00 0 15 00 0 - 35 00 0 0.81 6 - 28 56 0
4 - 50 00 0 15 00 0 - 35 00 0 0.76 3 - 26 70 5
N P V = - $1 18 54 5
Conclusion,Leasing is the lower cost alternative
by $15 729.
Incremental Analysis Approach
Tim e
P eri od
Ini ti al
C os t
A vo i ded
A - tax
LP
D TS
F oreg one
NCF DCF
(@ 7 %)
P resent
V al ue
0 18 0 00 0 18 0 00 0 1 18 0 00 0
1 - 3 5 00 0 - 1 3 5 00 - 48 5 00 0.9 35 - 4 5 34 8
2 - 35 00 0 - 1 3 5 00 - 48 5 00 0.8 73 - 4 2 34 1
3 - 35 00 0 - 1 3 5 00 - 48 5 00 0,816 - 3 9 57 6
4 - 35 00 0 - 1 3 5 00 - 48 5 00 0.7 63 - 3 7 00 6
N P V = $ 15 72 9
What is the advantage of leasing,if any?
Conclusion,NPV > 0,lease,The NAL is $15 729.
Lease Payments in Advance
Tim e
P eri od
Ini ti al
C os t
A vo i ded
A - tax
LP
D TS
F oreg one
NCF DCF
(@ 7% )
P resent
V al ue
0 18 0 00 0 - 35 00 0 14 5 00 0 1 14 5 00 0
1 - 35 00 0 - 13 50 0 - 48 50 0 0.93 5 - 45 34 8
2 - 35 00 0 - 13 50 0 - 48 50 0 0.87 3 - 42 34 1
3 - 35 00 0 - 13 50 0 - 48 50 0 0.81 6 - 39 57 6
4 - 13 50 0 - 13 50 0 0.76 3 - 10 30 1
N P V = $7 43 4
Conclusion,NPV > 0,lease,The NAL is $7 434.
Salvage Value $40 000 End Year 4
Ti m e
P e r iod
In itial
Cost
Avoid e d
A - tax
LP
DTS
F or e gon e
A - tax
S alvage
Valu e
F or e gon e
NCF DCF
(@ 7% )
P r e sent
Valu e
0 180 000 - 35 000 145 000 1 145 000
1 - 35 000 - 13 500 - 48 500 0.935 - 45 348
2 - 35 000 - 13 500 - 48 500 0.873 - 42 341
3 - 35 000 - 13 50 0 - 48 500 0.816 - 39 576
4 - 13 500 - 28 000 - 41 500 0.763 - 31 665
NP V = - $13 930
Conclusion,NPV < 0,borrow and purchase.
BUSINESS FINANCE II
Module 8
Analysis of Leases
Student Activities
Reading
Text,Chapter 18 (pp,652-61 only)
Text Study Guide,Chapter 18 (part only)
Study Book,Module 8
Tutorial Activities
Self Assessment Activity 8.1
Text Study Guide,Chapter 18,T/F 1-2,M/C 1-
4,Problem 1
Lease Finance Providers
Lease finance commitments,by type of lessor
Source 1999-2000 2000-2001 2001-2002
Banks $3 135m $2 062m $1 905m
Finance companies $2 556m $1 571m $1 812m
General financiers $1 472m $1 580m $1 625m
Other $ 744m $ 849m $1 271m
Totals $7 908m $6 061m $6 613m
Source,ABS,Year Book Australia 2003,Table 26.26
Assets Leased
Lease finance commitments,by type of goods leased
Type of Asset 1999-2000 2000-2001 2001-2002
MV & other transport $3 639m $2 529m $2 844m
Construction & earth moving equipment $ 319m $ 217m $ 232m
Agricultural machinery & equipment $ 328m $ 212m $ 220m
Automatic data processing equipment &
office machinery
$1 996m $1 944m $2 124m
Shop and office furniture,fittings & equipment $ 454m $ 343m $ 340m
Other goods $1 171m $ 815m $ 857m
Totals $7 907m $6 060m $6 617m
Source,ABS,Year Book Australia 2003,Table 26.27
Definitions
LEASE - A contract which grants a lessee the
right to use an asset in return for periodic
payments to the lessor.
LESSOR - The owner of the asset.
LESSEE - The party leasing the asset from its
owner.
Lease Document
Terms of the lease.
Asset to be leased.
Payments - when and how much?
Obligations of lessee and lessor - who pays for
insurance,maintenance,etc.
Whether lessee may acquire the asset at the end
of the lease.
Cancellation provisions.
Types of Leases
Operating lease - short-term (5 years or less).
The term of the lease is usually less than the
economic life of the asset.
Financial lease - more long-term,The
economic life of the asset and the term of the
lease are approximately equal.
Basic characteristics of each covered in text,pp.
652-4.
Operating Lease
Risks and rewards rest with lessor.
Generally cancellable at virtually no cost.
Sum of lease payments less than the initial cost to the
lessor.
May have a separate or inclusive maintenance contract
whereby the lessor assumes responsibility for
maintenance of the asset - service or maintenance lease.
Equipment reverts back to the lessor when lease is
terminated.
Finance Lease
Lessee incurs most of the risks and enjoys most
of the benefits.
Lessee normally responsible for maintenance,
etc.
Non-cancellable by either party.
Sum of lease payments exceeds the value of the
leased asset.
Lessee guarantees the residual value.
Residual Value
An option for the lessee to purchase the asset cannot
be explicitly provided for in the lease agreement.
However,the lessee indemnifies the lessor for any loss
resulting from the sale at the end of the lease term.
Usually through the lessee purchasing the asset for the
original residual value (usually between 10% and 40%
of the original cost).
Australian Case
Term generally less than economic life.
Cancellable (by the lessee).
Total of lease payments usually less than
purchase price.
Types of Financial Leases
Sale and Lease-Back Agreement
text,pp,653
Leveraged Lease
text,pp.653-4
Sale and Lease-Back Agreement
The owner of the asset sells it to another party
(for an amount usually equal to its market value)
who becomes the lessor by leasing it back to the
former owner.
Quite common in real estate.
A way of generating cash without having to part
with use of the asset.
Leveraged Lease
Often used to finance large-scale projects
(typically in excess of $15 million).
Lessor borrows most of the funds.
Common where it is difficult to find a lessor
who is able to finance the acquisition and able to
absorb the full benefits of the tax deductibility
of depreciation and interest costs.
Parties to a Leveraged Lease
Broker - organises and manages the lease.
Lender(s) - debt participants lending between
70% and 80% to the lessor.
Lessor(s) - provide the balance of the funds.
Lessee
Advantages of Leases
TO LESSOR:
Cheap way of acquiring asset.
Residual value.
Retains ownership in case of default.
Receives tax shields.
Advantages of Leases
TO LESSEE:
Use of asset but avoids big cash outlay.
Flexible way of acquiring use of an asset for a
short period of time.
For an operating lease,the burden rests with
lessor who is responsible for maintenance,etc.
Relatively low lease payments.
Flexible finance.
Disadvantages of Leases
FOR LESSOR:
Burden of maintenance,operating costs,etc (for
operating lease).
Loss of tax benefits advantage.
Risk of obsolescence.
Disadvantages of Leases
FOR LESSEE:
Burden of operating and maintenance costs (for
financial lease).
Risk of obsolescence.
No direct access to tax benefits associated with
ownership.
Accounting for Operating Leases
Operating leases need not be capitalised.
The basic features of an operating lease must be
disclosed in a footnote to the firm’s financial
statements.
Accounting for Financial Leases
AAS17 requires explicit disclosure of financial
lease obligations on the firm’s balance sheet.
Lease payments under a financial lease must be
capitalised,ie the PV of all lease payments is
included as an asset and a corresponding liability
on the balance sheet.
Operating vs Financial Lease
The classification of a lease should depend on
the economic substance of the transaction rather
than a literal application of the guidelines in
AAS17.
Provided that substantially all of the risks and
benefits associated with ownership are
effectively transferred to the lessee,the lease is
then a financial lease and should be capitalised.
Tax Implications
LESSOR:
Benefit of depreciation tax savings (DTS).
Lease payments received are taxable.
LESSEE:
Lease payments under a ‘genuine lease’ are tax
deductible if the leased asset is used to generate
taxable income.
Setting Lease Rentals
Manning Leasing wants to set a lease rate that provides
it with a satisfactory risk-adjusted return,Manning’s
after-tax return on leases is 6%,and its marginal tax rate
is 30%,The cost of the asset involved is $150 000,and
it will be depreciated over its 6-year life using the
straightline method,Assume lease payments are in
advance.
Calculate the minimum annual lease payment that
Manning should quote.
Solution
Step 1 – Calculate PV of Ownership
122,50 $11 3 -
877,50 $36 000 $15 0 -
4.91 7 500 $7 000 $15 0 -
P V I F A 0.30
6
000 $15 0
000 $15 0 - PV
0,0 6,6
Step 2 – Calculate Minimum After-tax LPs
704.24 $21
5.212
122.50 $113
4.212 122.50 $113
P V I F A 122.50 $113
0,0 6,5
LP
LP
LPLP
LPLP
Step 3 – Calculate Minimum Before-tax LPs
00 6.0 6 $31
0.3 0 - 1
70 4.2 4 $21
T - 1
LP
LP
t a x-A
t a x-B
Financial Evaluation of Leases
Lease vs borrow and purchase.
NPV of lease option must be cheaper than cost
of an equivalent loan.
Use the after-tax cost of debt as discount rate.
Discount Rate
Financial leases have the same characteristics of
secured debt finance:
the security is the leased asset;
the lessor is the provider of the finance.
Lease contract is considered to be the same as
debt - impacts on the debt capacity and gearing
ratio of the firm.
Compare lease finance to debt finance.
Leasing Example
Purchase price $180 000
Depreciation - straightline to zero
Annual lease payments $50 000
Before-tax cost of debt 10% p.a.
Life (and lease period) 4 years
Tax rate 30%
Assumptions
All operating,maintenance and insurance costs
are borne by the lessee.
Lease payments are made at the end of the year
(in arrears).
Tax is in the same year.
The company will be profitable over the 4 years
of the lease.
Option 1 - Purchase the Asset
T im e
P e r iod
In itial
Ou tlay
DTS
(N ote 1)
NCF DCF @ 7%
(N ote 2)
P r e sent
Valu e
0 - 180 000 - 180 000 1 - 180 000
1 13 500 13 500 0.935 12 623
2 13 500 13 500 0.873 11 786
3 13 500 13 500 0.816 11 016
4 13 500 13 500 0.763 10 301
NP V = - $134 274
Option 2 - Lease the Asset
Tim e
P eri od
B - tax
Leas e
P ay m ents
Tax Sav i ngs
on L P
(See N ote 3)
NCF DCF
(@ 7% )
P res ent
V al ue
0
1 - 50 00 0 15 00 0 - 35 00 0 0.93 5 - 32 72 5
2 - 50 00 0 15 00 0 - 35 00 0 0.87 3 - 30 55 5
3 - 50 00 0 15 00 0 - 35 00 0 0.81 6 - 28 56 0
4 - 50 00 0 15 00 0 - 35 00 0 0.76 3 - 26 70 5
N P V = - $1 18 54 5
Conclusion,Leasing is the lower cost alternative
by $15 729.
Incremental Analysis Approach
Tim e
P eri od
Ini ti al
C os t
A vo i ded
A - tax
LP
D TS
F oreg one
NCF DCF
(@ 7 %)
P resent
V al ue
0 18 0 00 0 18 0 00 0 1 18 0 00 0
1 - 3 5 00 0 - 1 3 5 00 - 48 5 00 0.9 35 - 4 5 34 8
2 - 35 00 0 - 1 3 5 00 - 48 5 00 0.8 73 - 4 2 34 1
3 - 35 00 0 - 1 3 5 00 - 48 5 00 0,816 - 3 9 57 6
4 - 35 00 0 - 1 3 5 00 - 48 5 00 0.7 63 - 3 7 00 6
N P V = $ 15 72 9
What is the advantage of leasing,if any?
Conclusion,NPV > 0,lease,The NAL is $15 729.
Lease Payments in Advance
Tim e
P eri od
Ini ti al
C os t
A vo i ded
A - tax
LP
D TS
F oreg one
NCF DCF
(@ 7% )
P resent
V al ue
0 18 0 00 0 - 35 00 0 14 5 00 0 1 14 5 00 0
1 - 35 00 0 - 13 50 0 - 48 50 0 0.93 5 - 45 34 8
2 - 35 00 0 - 13 50 0 - 48 50 0 0.87 3 - 42 34 1
3 - 35 00 0 - 13 50 0 - 48 50 0 0.81 6 - 39 57 6
4 - 13 50 0 - 13 50 0 0.76 3 - 10 30 1
N P V = $7 43 4
Conclusion,NPV > 0,lease,The NAL is $7 434.
Salvage Value $40 000 End Year 4
Ti m e
P e r iod
In itial
Cost
Avoid e d
A - tax
LP
DTS
F or e gon e
A - tax
S alvage
Valu e
F or e gon e
NCF DCF
(@ 7% )
P r e sent
Valu e
0 180 000 - 35 000 145 000 1 145 000
1 - 35 000 - 13 500 - 48 500 0.935 - 45 348
2 - 35 000 - 13 500 - 48 500 0.873 - 42 341
3 - 35 000 - 13 50 0 - 48 500 0.816 - 39 576
4 - 13 500 - 28 000 - 41 500 0.763 - 31 665
NP V = - $13 930
Conclusion,NPV < 0,borrow and purchase.
