Chapter 25 Principles of Corporate Finance Tenth Edition

Chapter 25 Principles of Corporate Finance Tenth Edition Leasing Slides by Matthew Will Mc. Graw-Hill/Irwin Copyright © 2011 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

Topics Covered Ø What is a Lease? Ø Why Lease? Ø Operating Leases Ø Valuing Financial Leases Ø When Do Financial Leases Pay? Ø Leveraged Leases 25 -2

Lease Terms Lease = A rental agreement that extends for a year or more and involves a series of fixed payments Ø Operating Leases - Short-term, cancelable lease Ø Financial Leases - Long-term, noncancelable lease – – Rental Lease Net lease Direct lease Leveraged lease - Full service - Sale and lease back 25 -3

Why Lease? Ø Sensible Reasons for Leasing – Short-term leases are convenient – Cancellation options are valuable – Maintenance is provided – Standardization leads to low costs – Tax shields can be used – Leasing and financial distress – Avoiding the alternative minimum tax 25 -4

AMT 25 -5

Why Lease? Ø Dubious Reasons for Leasing – Leasing avoids capital expenditure controls – Leasing preserves capital – Leases may be off balance sheet financing – Leasing effects book income 25 -6

FASB and Leases The FASB defines capital leases as leases that meet any one of the following requirements: 1. The lease agreement transfers ownership to the lessee before the lease expires. 2. The lessee can purchase the asset for a bargain price when the lease expires. 3. The lease lasts for at least 75% of the asset’s estimated economic life. 4. The present value of the lease payments is at least 90% of the asset’s value. 25 -7

Operating Lease Example Acme Limo has a client who will sign a lease for 7 years, with lease payments due at the start of each year. The following table shows the NPV of the limo if Acme purchases the new limo for $75, 000 and leases it our for 7 years. 25 -8

Operating Lease Example - cont Acme Limo has a client who will sign a lease for 7 years, with lease payments due at the start of each year. The following table shows the NPV of the limo if Acme purchases the new limo for $75, 000 and leases it our for 7 years. 25 -9

Financial Leases Example Greymare Bus Lines is considering a lease. Your operating manager wants to buy a new bus for $100, 000. The bus has an 8 year life. The Bus Saleswoman says she will lease Greymare the bus for 8 years at $16, 900 per year, but Greymare assumes all operating and maintenance costs. Should Greymare Buy or Lease the bus? 25 -10

Financial Leases Example - cont Greymare Bus Lines is considering a lease. Your operating manager wants to buy a new bus for $100, 000. The bus has an 8 year life. The Bus Saleswoman says she will lease Greymare the bus for 8 years at $16, 900 per year, but Greymare assumes all operating and maintenance costs. Should Greymare Buy or Lease the bus? Cash flow consequences of the lease contract to Greymare 25 -11

Financial Leases Example - cont Greymare Bus Lines is considering a lease. Your operating manager wants to buy a new bus for $100, 000. The bus has an 8 year life. The Bus Saleswoman says she will lease Greymare the bus for 8 years at $16, 900 per year, but Greymare assumes all operating and maintenance costs. Should Greymare Buy or Lease the bus? Cash flow consequences of the lease contract to Greymare : • Greymare saves the $100, 000 cost of the bus • Loss of depreciation benefit of owning the bus • $16, 900 lease payment is due at the start of each year • Lease payments are tax deductible 25 -12

Financial Leases Example - cont Greymare Bus Lines Balance Sheet with out lease Equivalent lease balance sheet 25 -13

Financial Leases Example - cont Greymare Bus Lines can borrow at 10%, thus the value of the lease should be discounted at 6. 5% or. 10 x (1 -. 35). The result will tell us if Greymare should lease or buy the bus. 25 -14

Financial Leases Example - cont Greymare Bus Lines can borrow at 10%, thus the value of the lease should be discounted at 6. 5% or. 10 x (1 -. 35). The result will tell us if Greymare should lease or buy the bus. 25 -15

Financial Leases Example - cont Greymare Bus Lines lease cash flows can also be thought of as loan equivalent cash flows. 25 -16

Financial Leases Example - cont Greymare Bus Lines lease cash flows can also be thought of as loan equivalent cash flows. 25 -17

Financial Leases Example - cont The Greymare Bus Lines lease cash flows can also be treated as a favorable financing alternative and valued using APV. 25 -18

Financial Lease Benefits Value of lease to lessor = Value of lease = 25 -19

Leveraged Lease Structure of a leveraged lease for a commercial aircraft 25 -20