23-1 copyright 2007 mcgraw-hill australia pty ltd ppts t/a fundamentals of corporate finance 4e, by...
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23-1Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Chapter Twenty-three
Leasing
23-2Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
23.1 The Nature of Leases
23.2 Types of Leases
23.3 A Brief Look at Accounting for Leases
23.4 Taxation and Leases
23.5 An Evaluation of Leasing
23.6 The Role of the Residual Value
23.7 Setting Lease Premiums
23.8 Alleged Advantages and Disadvantages of Leasing
Summary and Conclusions
Chapter Organisation
23-3Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Chapter Objectives• Understand the characteristics of the different types
of leases.• Explain how leases are recorded in a firm’s
accounting records.• Identify the tax implications of leases.• Evaluate a lease by calculating the net advantage of
leasing (NAL).• Explain the calculation of lease premiums.• Discuss the advantages and disadvantages of
leases.
23-4Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Leasing• What is a lease?
– A lessee (user) enters an agreement in which they make lease payments to the lessor (owner) in return for the use of the leased property/asset.
• Who are the major providers of lease finance in Australia?– Finance companies and banks.
• What assets are leased?– Any asset including photocopiers, cars, construction
equipment, computers, shop/office fittings and equipment.
23-5Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Leasing versus Buying
Manufacturerof asset
Manufacturerof asset
Sass arranges financing and buys asset from manufacturer
Sass 1. Uses asset 2. Owns asset
Lessor 1. Owns asset 2. Does not use asset
Lessee (Sass) 1. Uses asset 2. Does not own asset
Sass buys asset and uses asset; financing raised by debt
Sass leases asset from lessor; the lessor owns the asset
Sass leases asset from lessor
LeaseBuy
23-6Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Types of Leases
• Operating leases (service leases)
• Finance leases (capital leases)
• Two special types of finance leases are:– Sale and leaseback agreement– Leveraged lease.
23-7Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Operating Leases• Short-term lease.
• Cancellable prior to the expiry date at little or no cost.
• Lessor is responsible for maintenance and upkeep of asset.
• The sum of the lease payments does not provide for full recovery of the asset’s costs.
• Includes telephones, televisions, computers, photocopiers, cars.
23-8Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Financial Leases• Long-term lease.
• Non-cancellable (without penalty) prior to expiry date.
• Lessee is responsible for the maintenance and upkeep of the asset.
• Lease period approximates asset’s economic life.
• The sum of the lease payments exceeds the asset’s purchase price.
• Includes specialist equipment, heavy industrial equipment.
23-9Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Residual Value Clause
• Lease continues for its full term– Lessee can purchase the asset for its residual value, return
the asset to the lessor (paying any shortfall from residual value) or renew the lease.
• Lease is cancelled during its initial term– Lessee must pay outstanding premiums (less interest
component) plus residual value of asset.
23-10Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Types of Financial Leases• Sale and leaseback agreements
– Companies sell an asset to another firm and immediately lease it back. Enables the company to receive cash and yet maintain use of the asset.
– Commonly used by banks and large retailers in relation to branch property.
• Leveraged leases– The lessor arranges for funds to be contributed by one or
more parties—form of risk-sharing and transferring tax benefits.
– Often used to finance large-scale projects.
23-11Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
A. Balance Sheet with Purchase (company finances $100 000 truck with debt)
Truck $100 000 Debt $100 000
Other assets 100 000 Equity 100 000Total assets $200 000 Debt plus equity $200 000
B. Balance Sheet with Operating Lease (co. finances truck with an operating lease)
Truck $ 0 Debt $ 0
Other assets 100 000 Equity 100 000Total assets $100 000 Debt plus equity $100 000
C. Balance Sheet with Financial Lease (co. finances truck with a financial lease)
Assets under financial Obligations under lease $100 000 financial lease $100 000
Other assets 100 000 Equity 100 000Total assets $200 000 Debt plus equity $200 000
Leasing and the Balance Sheet
23-12Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Criteria for a Financial Lease• AAS17 ‘Accounting for Leases’ states that a financial
lease occurs where substantially all risks and benefits pass to the lessee.
• A financial lease must be disclosed on the Balance Sheet if at least one of the following criteria is met:– the lease term is 75 per cent or more of the estimated
economic life of the asset– the present value of the lease payments is at least 90 per
cent of the fair market value of the asset at the start of the lease.
23-13Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Leasing and Taxation• Lease premiums paid under a lease contract are tax
deductible.
• Any payment relating to the ultimate purchase of the asset is not deductible.
• The residual payment does not qualify as a tax deduction.
• Any profit made on the asset previously leased is subject to capital gains tax.
23-14Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Lease versus Buy
Macca Co. has to decide whether to borrow the $15 000 needed to purchase a new gadget machine (with a borrowing cost of 10 per cent) or to lease the machine for $4 000 per annum. If purchased, the asset could be depreciated using the straight-line method over the three-year life. The company tax rate is 30 per cent.
Under the lease agreement, Macca Co. would be responsible for maintaining the machine.
23-15Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Lease versus Buy: Repayment Schedule
6032$
100 /101 / 1 - 1 / 00015 Repayment 3
..
23-16Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Lease versus Buy:Tax Subsidises Borrowing
23-17Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Lease versus Buy:Tax Subsidises Leasing
23-18Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Lease versus Buy:Net Advantage of Leasing
514 $3
5052$ 538 $1 -
052 $5 - 522 $4 - 984 $2
costy Opportunit - savingsNet tax NAL
052) ($5
000 $15 - 2.4869 000 $4
cost Borrowing - payments lease of PV cost y Opportunit
The advantage is greater than zero so Macca Co. should lease.
23-19Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Residual Value• The residual value is the amount for which the asset
may be purchased by the lessee from the lessor at the end of the lease term.
• The salvage value is the amount the asset can be sold for in the market place by the lessee (once they have acquired the asset).
• In the previous example, assume a residual value of $2,000 and a salvage value of $1500.
23-20Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Lease the Asset with Residual Value
23-21Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Borrow to Purchase the Asset with Residual Value
23-22Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Net Advantage of Leasing
576 $2
550 $3 - $974
costy Opportunit - savingsNet tax NAL
550) ($3
000 $15 -1.10 / 000 $2 2.4869 000 $4
cost Borrowing - valueresidual PV pay. lease PV cost Opp3
23-23Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Setting Lease Premiums
• Commercial practice in Australia is for lease premiums to be paid in advance.
payments 1- tforfactor annuity PV 1
valueresidual PV - eAsset valu advancein premium Lease
23-24Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Example—Lease Premiums
KAZ Co. has started a four-year lease of a photocopier which has a $70 000 purchase price. Had the company purchased the copier, the interest rate quoted on borrowings was 1.5 per cent per month. KAZ has agreed with the lessor to a residual value of $10 000 at the end of four years.
What will be the amount of the lease premiums?
23-25Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Solution—Lease Premiums
221884$
553233 1 / 10665
0150 / 0151 / 1 - 1 1
0151 00010 - 00070
payments 1- tforfactor annuity PV 1
valueresidual PV - eAsset valu premium Lease
47
48
.
.
..
.
23-26Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Alleged Advantages of Leases• Financial:
– No restrictions on future borrowing.– Can be tailored to suit firm’s needs.– Eliminates the need to raise extra capital.– No unnecessary financial outlay.– May be excluded from the Balance Sheet.– Facilitates financing capital additions on a piecemeal
basis.– Is an allowable cost under government contracting.– Offers tax advantages.
23-27Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Alleged Advantages of Leases• Operating:
– Frees up capital for alternative uses.– Increases the company’s working capital.– Provides greater control due to greater certainty in future
outlays.– Assures more competent upkeep of asset.
• Risk:– Avoids the risk of obsolescence.– Avoids the equipment disposal problem.– Future outlays cost less in real terms due to inflation.
23-28Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Alleged Disadvantages of Leasing• Interest cost often higher.• May not offer the right to the residual value of the
asset.• Allows the acquisition of assets without submitting
formal capital expenditure procedures.• May cause distortions in the evaluation of interfirm
and interdivision performance.• Lacks the prestige associated with ownership.
23-29Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Good Reasons for Leasing• Taxes may be reduced by leasing due to differential
tax rates or deductions.• The lease contract may reduce certain types of
uncertainty that might otherwise decrease the value of the firm.
• Leasing reduces the impact of obsolescence of an asset on a firm (but there is a cost for this).
• Transaction costs may be lower for a lease contract than for buying the asset.
• Leasing may require fewer (if any) restrictive covenants than secured borrowing.
23-30Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Bad Reasons for Leasing• The perception of 100 per cent financing.
• The apparent low cost.
• Using leasing to artificially enhance accounting income.
23-31Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
Summary and Conclusions• Leases can be separated into two types: financial and
operating.
• Financial leases must be reported on a firm’s Balance Sheet; operating leases are not.
• Taxes are an important consideration in leasing.
• A long-term financial lease is a source of financing much like long-term borrowing and can be evaluated using NPV.
• The lease premium is set by the lessor to recover the principal that is tied up in the asset and a component for interest on that principal.
• Three elements may create economic advantages for the parties to a lease: differential taxation rates, reducing uncertainty, and avoiding transaction costs.