LeasingLease Financing

Corporate Finance

ANSWERS CLASS ASSIGNMENTS

Shanghai Session 2 FINC 5880-2014

Class assignment Leasing:Assume the following case;

A company considers and investment of $100; the asset is depreciated over 2 years straight line; no residual value and tax rate 40%; if the company borrow the money the interest is 10% per year

A guideline lease requires a yearly lease fee of $55 Estimate the cash flows under the 2 scenarios; which

has the lower present value? (assume dcf=6% this is the after tax cost of debt: 10%*(1-40%))

Answer: Buy and borrow…cash flows

Cash flows Year 0 Year 1 Year 2

Cost -$100

Loan +$100

Interest -$10 -$10

Tax saving +$4 +$4

Repay loan -$100

Tax saving depreciation

+$20 +$20

Total $0 +$14 -$86

Answer: Lease cash flows

Cash flow Year 0 Year 1 Year 2

Lease payment

-$55 -$55

Tax saving lease payment

$22 $22

Total $0 -$33 -$33

So calculate the PV (at 6%)

Buy/Borrow PV(6%): $ 63.33 Lease PV(6%): $60.50

The PV of the cost of Financing is lower under leasing…so…LEASE!

Class Assignment: Leasing

Consider a $10 M investment (10 year life) to be discontinued after 5 year

Borrow at 10% interest per year (before tax) if you Buy the Equipment

After 5 years residual value $2 M

A 5 year lease would trigger annual lease payments of $ 2,6M starting immediately in t=0

Under the lease the lessor maintains the equipment

If the company buy/borrow this equipment the maintenance cost will need to be paid additionally at $0.5M per year at the beginning of each year starting immediately (t=0)

Tax rate of the Lessee is 35%

Modified Accelerated Cost Recovery System (MACRS) depreciation: over the 5 years is resp. 20%, 32%, 19%, 12% and 11%

Compare the PV of the cost of owning (buy/borrow) with the PV of the cost of leasing….which one is lower?

Answer: cash flows (in $ 1000) if you Borrow and Buy…

MUSD Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5After tax loan payments -650 -650 -650 -650 -10,650

Maintenance costs -500 -500 -500 -500 -500

Maintenance Tax savings 175 175 175 175 175

DepreciationTax savings 700 1,120 665 420 385

Residual Value 2,000

Tax on residual value

-490

Total Cash Flow -325 -275 145 -310 -555 -8,755

Answer: Leasing

MUSD Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5

Lease payment -2,600 -2,600 -2,600 -2,600 -2,600

Payment Tax savings 910 910 910 910 910

Net Cash Flow -1,690 -1,690 -1,690 -1,690 -1,690

Comparing…

In 1,000 USD Borrow & Buy Leasing

Present Value at 6.5% (10% after tax 35%)

- 7,534 - 7,480

So: leasing is beneficial

Disadvantage Advantage (54)

Class assignment: From the Lessor’s point of view

Assuming: Lessor’s tax rate is 40% Lessor’s alternative investment is a 5 year bond with an after tax yield

of 9%(1-40%)=5.4% Asset will be depreciated to book value of $600,000 after 5 years and

the before tax residual value is $ 2M This implies that Lessor can expect to receive $2M –

40%*$1.4M=$1,440,000 after the lease expires selling the asset directly…

Develop the cash flows and determine the IRR% of this investment Is 5.4%>,< or= IRR%? So what would the lessor invest his money in in

the Lease or the Bonds…?

Answer: Lessor’s cash flow (IRR%=5.8% > 5.4% on the Bond….)

Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5

purchase price asset

-10,000

Maintenance from t=0

-500 -500 -500 -500 -500

Maintenance tax savings 40%

200 200 200 200 200

Depreciation tax savings

800 1280 760 480 440

Lease payment

2,600 2,600 2,600 2,600 2,600

Tax on lease payment 40%

-1,040 -1,040 -1,040 -1,040 -1,040

Residual value 2,000

Tax on residual value(2000-600)*40%

-560

Cash flow -8740 2,060 2,540 2,020 1,740 1,880

IRR% calculation in Excel

0 1 2 3 4 5 YEAR-8740 2,060 2,540 2,020 1,740 1,880 CASH FLOW 5.75% IRR%