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Introduction
Lease is a contractual agreement between two parties: the lessee and the lessor. Lessee is the party
that has the right to use an asset and makes period payments to the assets owner whereas a Lessor
is owner of the asset.
Leasing versus buying decision involves a comparison of the alternative financing methods employed
to secure the use of the asset. In both cases, the company ends up using the asset.
Types of Leases
2. Leveraged leases lessor borrows a substantial portion of the purchase price on a non-
recourse basis
3. Sale and leaseback agreements lessee sells the asset to the lessor and leases it back
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The Cash Flows from Leasing
Leasing is advantageous if the implied after-tax interest rate on the lease is less than the companys
after-tax cost of borrowing.
Example
A florist can purchase a delivery truck from her local GM dealer for $25,000. The GM dealer will also
lease the truck for $6,100 per year over five years. The truck has an expected life of seven years. The
truck is expected to be worth $2,500 in five years and the florist has the option to buy it at fair market
value at that time. If the florist wants to purchase the truck, she must borrow the money from Boone
National Bank at a current rate of 10%. Which financing option is better?
First, if we ignore taxes, the implied interest rate of these payments is (assuming lease payments are
end of year) 9.5%. This implies that the GM dealer is willing to loan money to the florist at 9.5%
instead of the conventional 10% loan being offered by the bank. The decision appears clear lease
the truck.
Unfortunately, lease versus buy decisions are not this simple. Taxes are very important. In this lease,
the entire lease payment is tax deductible since the lease term is less than 80 percent of the assets
life and the option to purchase at the end is for fair market value. If she purchases the truck, the
purchase price is deductible only through depreciation. Lease contracts also often include
maintenance, insurance, etc. Consider the following after-tax cash flows when making the decision.
The florists tax rate is 34% and for simplicity assumes straight-line depreciation.
Year 0 1 2 3 4 5
Purchase Savings 25,000
After-tax lease payment -4,026 -4,026 -4,026 -4,026 -4,026
6100(1-.34)
Lost depreciation tax shield -1,700 -1,700 -1,700 -1,700 -1,700
(25,000/5)(.34)
Purchase truck -2,500
Incremental Cash Flows 25,000 -5,726 -5,726 -5,726 -5,726 -8,226
b. NPV = -547.50, she should purchase now instead of leasing. The savings of 25,000 today is not
supported by the future after-tax costs.
c. The after-tax loan rate (compute the IRR) would have to be 7.37% to be indifferent between the
two options. This corresponds to a pre-tax loan rate of 11.16%.
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borrowing over leasing (reverse all the signs), then you are back to conventional cash flows, and
you would lease if the IRR is higher than the after-tax cost of borrowing. The implied rate is based
on the net cash flows of leasing instead of borrowing you have to use incremental cash flows.
A Misconception
The present value of the loan payments, if we borrow and buy, is the cost of the equipment
regardless of the loan repayment schedule. So, it doesnt really matter if we pay cash to purchase
the asset or we borrow and buy the asset; the initial cost is the same either way.
A Leasing Paradox
It is important to recognize that the cash flows to the lessee are exactly the opposite of the cash
flows to the lessor when they have the same tax rate and cost of debt. As a result, a lease
arrangement is often a zero-sum game. Since, in this situation, either one party wins and one party
loses, or both parties break even, why would leasing take place?
1. Taxes may be reduced by leasing. A potential tax shield that cannot be used effectively by one firm
can be transferred to another firm through a leasing arrangement. The firm in the higher tax bracket
would act as the lessor and then utilize the majority of the tax shields. (The loser is the IRS.)
2. Leasing may reduce uncertainty regarding the assets residual value. This uncertainty may reduce
firm value.
1. The balance sheet may appear stronger when operating leases are used (since they are considered
off-balance sheet financing).
2. A firm may secure a lease arrangement when additional debt would violate existing loan
agreements.
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3. Basing the lease decision on the interest rate implied by the lease payments and not on the
incremental after-tax cash flows.
Summary
This topic has described different lease types which are financial lease and operating leases. We also
discuss/ illustrate the evaluation of financial lease as well as the reasons why a corporation might
decide to lease an asset rather than buying it.
Questions
1. What are the differences between an operating lease and a financial lease?
3. An asset costs $48,000, has a 3-year life and will be worthless after the 3 years. The firm uses
straight-line depreciation, has a cost of borrowing of 12 percent, and a tax rate of 34 percent. The
asset can be leased for $17,500 a year. What is the net present value to leasing?