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Lease Financing

Short- and Intermediate-Term Funding Alternatives

©2006 Thomson/South-Western

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Introduction

The first half of this chapter deals with lease financing from the perspective of both the owner and the user of an asset

It examines the type of analysis that should go into a lease versus borrow-and-purchase decision to maximize shareholder wealth.

The second half of the chapter discusses other intermediate-term sources of funding available to a company, such as term loans and equipment loans.

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Glossary of Leasing Terms

This Web site has a glossary of leasing terms for researching the right alternative between leasing or borrowing and purchasing assets:http://www.ge.com/capital/vendor/glosterm.htm

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Lease Contract

Leases Alternative to term financing Arrangements to transfer tax benefits

Lessee Obtains use of an asset Specific period of time Ownership to lessor Agrees to make a series of payments to lessor

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Types of Leases

Operating lease Service lease • Maintenance lease Maintenance and insurance included

Financial lease Noncancelable Lessee responsible for

Maintenance • Insurance • Property taxes Direct lease Sale and leaseback

Leveraged lease Three-party financial lease Lessee • Lessor • Lender

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Sale and Leaseback Transaction

Investigate the sale and leaseback transaction at this Web site:http://www.amcity.com/southflorida/stories/

012797/focus5.html

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Advantages to Leasing

Flexible Convenient Lower payments Avoid some risk of obsolescence Smoother earnings and EPS 100% financing Liquidity

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Disadvantages to Leasing

More expensive

Salvage value foregone

Difficult approval for modifications

May not be canceled

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Tax Considerations

A lease must have economic benefits separate from tax considerations.

Recognized by IRS as a lease (Rules) Remaining useful life < 30 years Reasonable ROI Renewal options Purchase options Level schedule of lease payments 20% equity Property valuable only to the lessee

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Leases and Accounting Practices

Types of Leases Financial leases Operating leases

FASB requires that leases be capitalized.

Value of lease Equal to the PV of the lease payments Discounted at the firm’s borrowing rate for

a secured loan with similar maturity Disclosure of details in footnotes

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Footnotes: Financial Leases As of the date of the balance sheet

Gross amount of assets by major classes

Amount of accumulated lease amortization

Future minimum lease payments

In total for each of the next five fiscal years

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Footnotes: Operating Leases As of the date of the latest balance sheet

Future minimum rental payments required In total for each of the following five fiscal years

An income statement is presented for rental

expense in each period

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Lease Payments: Lessor’s perspective

Lessor’s required payment three-step process Step 1: Compute the lessor’s amount to be amortized

Initial outlay

Less: PV of after-tax salvage

Less: PV of depreciation tax shelter

Equals: Amount to be amortized

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Lease Payments (continued)

Step 2: Compute after-tax lease income required

Amount to be amortized = PV of after-tax lease payment

Step 3: Compute before-tax lease payment

LeasePayment =

After-tax lease income required

1 – lessor’s marginal tax rate

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Lease vs. Borrowing to Buy Compute the NAL (net advantage to

leasing)

If NAL is positive, it is cheaper to lease. If NAL is negative, it is cheaper to own.

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Factors affecting the NAL

Considerations Installed costs PV of after-tax lease payments PV of depreciation tax shield PV of after-tax operating costs if owned AND

PV of after-tax salvage value at the

lessee’s weighted cost of capital

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Small Firms

Reasons for leasing Less cash required upfront Better protection against obsolescence Quicker approvals Fewer restrictive covenants

Expensive reasons High interest cost Loss of tax benefits

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Term Loan

Maturity

Sources

Less expensive

Better suited

Working capital

Default provisions

Amortization

Interest costs

Loan agreements

Warrants

Security provisions

Covenants

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Computing the annual payment

PVAN0 = PMT (PVIFAi, n)

PMT = PVAN0

PVIFAi, n

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Sources of Term Loans

Banks

Insurance companies

Pension funds

Government agencies

Equipment suppliers Conditional sales contracts

Chattel mortgages

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Government Agencies

SBA

http://www.sba.gov/

Participation loans

SBICs

IDAs

Municipal bonds

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Security Provisions

Dependent on the borrower’s credit standing

Provisions Assignment of payments due from a particular

contract Assignment or pledging of inventories, A/R or

securities Floating lean Mortgage Life insurance Pledge of marketable securities

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Covenants

Affirmative

Negative

Restrictive