14 1 B40 2302 Class 9 BM6 chapters 25 2 25 6 26 27 25 Leasing 26 Risk management 27 International risk management Based on slides created by Matthew Will Modified 11 07 2001 by Jeffrey Wurgler Irwin McGraw Hill The McGraw Hill Companies Inc 200 Principles of Corporate Finance Brealey and Myers Sixth Edition Leasing Slides by Matthew Will Jeffrey Wurgler Irwin McGraw Hill Chapter 25 2 25 6 The McGraw Hill Companies Inc 200 14 3 Topics Covered Why Lease Operating Short term Leases Financial Long term Leases Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 4 Why Lease Sensible Non tax Reasons for Leasing Short term leases are convenient Cancellation options are valuable Maintenance may be provided Standardization leads to low transaction costs Relative to bond or stock issue Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 5 Why Lease Sensible Tax Reasons for Leasing Tax shields can be used Lessor owns asset and so deducts its depreciation If lessor can make better use of tax shield than lessee then lessor should own equipment and pass on some tax benefits to lessee in form of lower lease payments So direct tax gain to lessor indirect gain to lessee Reduces the alternative minimum tax AMT Corporate tax max regular tax AMT Leasing as opposed to buying reduces lessee s AMT Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 6 Why Lease Dubious Reasons for Leasing Leasing avoids internal capital expenditure controls Leasing preserves capital Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 7 Why Lease Dubious Reasons for Leasing contd Leases may be off balance sheet financing In Germany all leases are off balance sheet In US only operating leases are off balance sheet Leasing affects book income Leasing reduces book income bec lease payments are expensed Buy and borrow alternative reduces book income through both interest and depreciation Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 8 Operating Leases Review Suppose you decide to lease a machine for one year Q What is the rental payment in a competitive leasing industry A The lessor s equivalent annual cost EAC Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 9 Operating Leases Example Calculate a competitive lease payment EAC 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 out for 7 years amounts in 000s 0 Initial cost Maintenance insurance selling and administrative costs Tax shield on costs Depreciation tax shield Total PV 7 98 15 Break even rent level Tax Break even rent after tax PV 7 98 15 Irwin McGraw Hill 1 Year 3 2 4 5 6 75 12 12 12 12 12 12 12 4 2 0 82 8 4 2 5 25 2 55 4 2 8 4 0 6 4 2 5 04 2 76 4 2 3 02 4 78 4 2 3 02 4 78 4 2 1 51 6 29 26 18 9 16 17 02 26 18 9 16 17 02 26 18 9 16 17 02 26 18 9 16 17 02 26 18 9 16 17 02 26 18 9 16 17 02 26 18 9 16 17 02 The McGraw Hill Companies Inc 200 14 10 Operating Leases Bottom line for lessee Operating lease or buy Buy if the lessee s equivalent annual cost of ownership and operation is less than the best available operating lease rate Otherwise lease Complication If operating lease includes option to cancel abandon need to factor that in Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 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 An alternative is to lease the bus for 8 years at 16 900 per year but Greymare still assumes all operating and maintenance costs Should Greymare buy or lease the bus Cash flow consequences of the financial lease contract 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 Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 12 Financial Leases Cash flow consequences of the financial lease contract amounts in 000s 0 Cost of new bus 100 00 Lost Depr tax shield Lease payment 16 90 Tax shield of lease pmt 5 92 Net cash flow of lease 89 02 Irwin McGraw Hill 1 2 7 00 16 90 5 92 17 98 11 20 16 90 5 92 22 18 Year 3 6 72 16 90 5 92 17 70 4 4 03 16 90 5 92 15 01 5 6 4 03 2 02 16 90 16 90 5 92 5 92 15 01 13 00 7 16 90 5 92 10 98 The McGraw Hill Companies Inc 200 14 13 Financial Leases How to discount CFs Since lessor is essentially lending money to lessee appropriate rate is the equivalent lending borrowing rate Lender pays tax on interest it receives net return is after tax interest rate Borrower deducts interest from taxable income net cost is after tax interest rate Thus after tax interest rate is effective rate at which company can transfer debt equivalent cash flows across time Suppose Greymare can borrow at 10 Then the lease payments should be discounted at 1 35 10 065 Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 14 Financial Leases Example contd 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 Buy don t lease 17 99 22 19 17 71 15 02 NPV lease 89 02 2 3 4 1 065 1 065 1 065 1 065 15 02 13 00 10 98 5 6 1 065 1 065 1 065 7 70 or 700 Irwin McGraw Hill The McGraw Hill Companies Inc 200 14 15 Financial Leases Example Equivalent loan cash flows Another way to think about where the lease value comes from or goes is to imagine a loan that generates exactly the same year 1 7 cash outflows as the lease This costs same but brings in 89 72 in year 0 vs 89 02 in the lease Thus borrowing and buying is 89 72 89 02 0 70 700 better than lease amounts in 000s 0 Amount borrowed at year end Interest paid 10 Tax shield 35 Interest paid after tax Principal repaid Net cash flow of equivalent loan Irwin McGraw Hill 1 2 Year 3 4 5 6 7 89 72 77 56 8 97 3 14 5 83 12 15 60 42 7 76 2 71 5 04 17 14 46 64 6 04 2 11 3 93 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