Corporate Financial Management, Third Edition

What Is a Lease?

A lease is a rental agreement that extends for one year or longer. Under a lease agreement, the owner of an asset (the lessor) grants another party (the lessee) the exclusive right to use the asset during the specified term of the lease in return for a specified series of payments, typically an annuity. In this way a lease resembles a secured loan.

Payments are typically made monthly, quarterly, or semiannually. The first lease payment is usually due when the lease agreement is signed. Payments are normally equal, like a mortgage or car payment. However, this time pattern can be altered. For example, a lease may provide for lower payments during the early years before the asset reaches its full potential to generate cash flow.

Often lease agreements also give the lessee the option to renew the lease or purchase the asset. Sometimes the purchase option specifies a fixed price, but usually it is the asset’s fair market value at the date the lessee exercises the option. If the purchase option is not exercised, the leased asset continues to belong to the lessor.

Lease Financing Alternatives

Most financial leases fall into one of three categories: direct leases, sale-and-lease-back arrangements, or leveraged leases (Figure 21-1).

Advantages of Leasing

Leasing offers a number of legitimate advantages.

• More-efficient use of tax deductions and tax credits of ownership.The main reason to choose lease financing is the lessor’s ability to use the tax deductions and tax credits associated with asset ownership more efficiently than the lessee can.
• Reduced risk.Short-term operating leases, in particular, provide a convenient way to use an asset for a relatively short period of time. Cancelable operating leases, such as computer leases, relieve the lessee of the risk of product obsolescence. This risk shifting is efficient. The lessor, such as the equipment manufacturer, is usually in a better position to assume the risk. This motivation for leasing reflects the Options Principle: The cancellation option is valuable.
• Reduced cost of borrowing.Lessors of assets that can be sold readily, such as vehicles, generally do not have to perform credit analyses quite as detailed as those conducted by general lenders. They are also more likely to be able to use “standardized” lease documentation. Both factors reduce transaction costs and thus result in a lower cost of borrowing for the lessee. This can especially benefit a smaller firm that may face restricted access to conventional sources of funds.
• Bankruptcy considerations.In the case of aircraft and vessels, special provisions of the bankruptcy law give a lessor greater flexibility than that of a secured lender to seize the asset in the event of bankruptcy because the lessor owns the asset. Suppliers of capital to smaller or less credit-worthy firms, for which the risk of financial distress is greater, often prefer to advance funds through a lease rather than a loan. Because the lessor retains ownership of the asset, it can seize it if the lessee defaults.
• An alternative source of financing.Lease financing may permit a lessee to access a new source of funds. For example, a finance company might not purchase the lessee’s securities, but might offer a lease. The new source is beneficial, of course, only if it results in a truly lower cost of borrowing.

Leasing also offers opportunities to circumvent restrictions. Managers sometimes cite these supposed benefits, but we are skeptical of whether these benefits are real.

• Circumventing restrictive debt covenants or other restrictions.A firm might be able to borrow funds through lease financing even when conventional debt financing is prohibited by its debt covenants.¹ The leases represent a disguised form of debt financing, so they may affect the lessee’s agency costs. However, recently drafted indentures and loan agreements usually contain limitations on leasing that close this loophole.

• Off-balance-sheet financing.Firms often go to great lengths to design leases that achieve off-balance-sheet treatment. Many firms also try to keep lease payments as low as possible during the early years of the lease term, in order to minimize the impact on reported earnings per share. Based on the Principle of Capital Market Efficiency, however, you would expect the leasing information disclosed in the footnotes to the firm’s financial statements to enable market participants to gauge the true financial impact of the leasing arrangements. In fact, evidence shows that investors correctly evaluate the financial impact of firms’ financial lease obligations. So the apparent income statement and balance-sheet benefits are of highly dubious value.

Of course, as you might also expect, a market imperfection can cause the accounting treatment to affect value. Off-balance-sheet treatment can prove beneficial to a regulated firm, such as a bank, in certain situations. Banks are required to maintain a minimum ratio of capital to total assets based on balance sheet figures. Given any particular amount of capital, the minimum required capital-to-assets ratio determines the maximum amount of assets, as reported in the bank’s balance sheet. But by leasing assets off balance sheet, a bank can increase its assets above the constrained amount. When a bank’s assets are already at the permitted maximum, the incremental after-tax cash flow the bank will realize by employing the leased assets in its business should be included in calculating the benefits of leasing.

Disadvantages of Leasing

There are two main disadvantages to leasing. First, the lessee forfeits the tax deductions associated with asset ownership. Second, the lessee must usually forgo residual value. A prospective lessee should evaluate carefully the cost of losing these benefits. Only then can it decide if leasing is really cheaper than borrowing and buying.

Bear in mind the Principle of Two-Sided Transactions. The tax benefits of leasing to the lessor are offset to some extent by certain tax detriments. The lessor must recognize the full amount of each lease payment as taxable income. As we have pointed out, a lease is like a loan. However, it is a loan in which the entire debt service payment is tax deductible to the borrower/lessee and taxable to the lender/lessor. Leasing is only beneficial when the present value of the benefits of leasing exceeds the present value of the costs of leasing.

Tax Treatment of Financial Leases

The Internal Revenue Service (IRS) has established guidelines to distinguish true leases from installment sales agreements and secured loans. If the terms of the leasing arrangement satisfy the guidelines, the lessee can deduct for tax purposes the full amount of each lease payment, and the lessor is entitled to the tax deductions and tax credits of asset ownership. Here are the main guidelines:

• The term of the lease cannot exceed 80% of the useful life of the asset. The term includes all renewal or extension periods other than renewals or extensions that are (1) at the option of the lessee and (2) at the fair market rental prevailing at the time of renewal or extension.
• The lessor must maintain a minimum equity investment in the asset of no less than 20% of the asset’s original cost throughout the term of the lease.
• The lessor can grant the lessee a purchase option. However, the exercise price must equal the asset’s fair market value at the time the purchase option is exercised. Certain lease transactions do take place with a purchase option that provides for a fixed price equal to the estimated future fair market value, but such a lease in that case does not conform to the guidelines and therefore does not qualify for an advance IRS ruling that it is a valid lease for tax purposes.
• The lessee does not pay any portion of the purchase price of the asset. In addition, if the lease is a leveraged lease, the lessee does not lend the lessor funds with which to purchase the leased asset or guarantee loans from others to the lessor for this purpose.
• The lessor must hold title to the property, and it must demonstrate that it expects to earn a pretax profit from the lease transaction—that is, profit apart from any tax deductions and tax credits it will realize.

These and the other requirements the IRS establishes are subject to change from time to time. As we have said several times, it is important to review the applicable tax rules. It is important to verify that a proposed lease arrangement will qualify as a true lease and to confirm that it is advantageous to lease.

Accounting Treatment of Financial Leases

The accounting treatment accorded leases has undergone significant changes in recent decades. At one time, leases represented off-balance-sheet financing. That is, neither the leased asset nor the associated lease obligations were recorded on the face of the lessee’s balance sheet. However, generally accepted accounting principles did require a lessee to disclose certain details regarding lease transactions in the footnotes to its financial statements.

Financial Accounting Standards Board Statement No. 13 (FASB 13) requires lessees to capitalize on their balance sheets all leases that meet any one of the following requirements:

• The lease transfers ownership of the asset to the lessee before the lease expires.
• The lease agreement grants the lessee the option to purchase the asset at a bargain price.
• The term of the lease equals or exceeds 75% of the estimated useful economic life of the asset.
• The present value of the minimum lease payments, discounted to the beginning of the lease period at the smaller of (1) the lessee’s incremental borrowing rate or (2) the interest rate implicit in the lease payment stream (the lease rate), equals or exceeds 90% of the asset’s value (net of any investment tax credit claimed by the lessor).

Leases that “fail” all four tests are operating leases from an accounting standpoint. They do not have to be capitalized on the face of the balance sheet.

FASB 13 assumes that if one of the four conditions is met, the lease arrangement is like purchasing the asset with borrowed funds. Accordingly, FASB 13 requires the lessee to report the present value of the lease payments under capital leases next to long-term debt on the right-hand side of the balance sheet, with a corresponding amount reported as an asset on the left-hand side of the balance sheet. The lessee amortizes the leased asset over the term of the lease. Correspondingly, under the “interest” method, the lessee separates each lease payment into an interest component and a principal repayment component. The amortization amount and the interest component of the lease payment are deducted from income for financial reporting purposes. The principal repayment component reduces the amount of the capitalized lease obligation reported on the lessee’s balance sheet.

Leasing Displaces Borrowing

Lease analysis is similar to bond refunding analysis (Chapter 20). Just as one bond issue displaces another, so lease financing displaces debt. A firm that leases a piece of equipment reduces its borrowing capacity because it must meet its lease payment obligations on time in order to have uninterrupted use of the leased asset. If the lessee misses a lease payment, the lessor can reclaim the asset (which it legally owns) and sue the lessee for the missed lease payment. The consequences of failing to make a lease payment are the same as the consequences of failing to pay interest or repay principal on outstanding debt. The lessor becomes a creditor who can force the lessee into bankruptcy. Consequently, for purposes of financial analysis, a firm’s lease payment obligations belong in the same risk category as the firm’s interest and principal repayment obligations.

Only when the alternatives of leasing, or borrowing and buying, are placed on a comparable basis can we make an accurate choice. Such a comparable basis includes the firm’s capital structure. Whether the firm will in fact have the same capital structure after implementing either alternative is a separate decision and should be evaluated on its own merits. The important point is to isolate the decision under consideration and not to confuse a lease versus borrow-and-buy decision with a capital structure decision.

Basic Analytic Framework

We have pointed out how the cash flow stream associated with a financial lease is similar in financial effect to the cash flow stream of a secured loan. This suggests an appropriate starting point for analyzing a financial lease: Compare it to the alternative of borrowing to finance the purchase price of the asset and repaying this loan over the lease term.

Using Debt Service Parity

The debt service parity (DSP) approach is useful for this purpose. It applies to leasing analysis much as it does to bond refunding. As we have said, the principal tenet of the DSP approach is that the two alternatives must be evaluated as though the firm’s total after-tax obligation (either lease payments or debt service payments) will be exactly the same under either alternative. Maintaining such parity is important. Evaluating the lease-versus-borrow-and-buy decision must avoid the complications associated with other possible simultaneous decisions. These complications could bias the calculation of the net advantage to leasing.

When you apply the DSP approach, you ask the question, “How much money can I raise today by selling the debt stream promised by the lease?” If this amount is greater than the purchase price of the financed asset, then the lease will not increase shareholder wealth. You could buy the asset more economically using borrowed funds.

First, we determine the amount of debt the firm can issue today. We assume the after-tax period-by-period debt service payments for the borrow-and-buy alternative are identical to the lease alternative. Here is how you might view the amount of debt the firm could issue today. Think of the after-tax lease payments as a set of promised future cash flows that could be “auctioned off” in the capital market. The amount of debt the firm can issue today is then the amount it would receive in exchange for that set of promised future cash flows. If the proceeds of the debt are not enough to purchase the equipment, then the leasing alternative has a positive NPV and should be undertaken. Of course, if the debt proceeds are greater, then leasing would decrease shareholder wealth and should not be undertaken.

Analyzing a Lease-or-Buy Decision

Let us apply the DSP approach to NACCO’s lease-or-buy decision. First, we must specify current capital market conditions. NACCO can borrow 10-year secured installment debt in the amount of 80% of the value of each electric shovel at a pretax interest rate of 11.5% per year. NACCO can borrow unsecured installment debt in the amount of the remaining 20% of the value of each electric shovel at a pretax interest rate of 14.0% per year. Finally, the after-tax required return (weighted average cost of capital) for this project is 15% per year. NACCO’s marginal tax rate is 40%.

Leasing and Capital Budgeting

As we saw in the case of capital structure, taxes affect asset value. Lease financing can affect the value of an investment by enabling a lessee to take advantage of any potential tax asymmetry. It is possible for a project that would have a negative NPV if the firm financed it on a conventional basis to have a positive NPV if it is lease financed. If the lessor can benefit from tax deductions and credits and their timing but the lessee cannot, leasing can increase the investment value.

Note that the project’s residual value could also play an important role in the economics of leasing. Suppose the residual value in the example just given were, say, $10 million. The net present value of the project when financed on a conventional basis would be $1.10 million, and the net advantage to leasing would be −$0.77 million. The sponsor should finance the project in that case on a conventional basis even though it does not expect to be able to use any of the tax deductions associated with asset ownership.

When Is Lease Financing Advantageous?

As you would expect, leasing would be a zero-sum game between lessor and lessee in a perfect capital market environment. Even with taxes, in an otherwise-perfect capital market environment, it will be a zero-sum game if both parties have the same marginal tax rate.

Of course, in an imperfect capital market environment, there is a possibility that a tax asymmetry, information asymmetries, or transaction costs may cause leasing to be favorable for both lessor and lessee. Therefore, if the lessor and the lessee have different marginal income tax rates, the CFATs can have different present values to the two parties. Leasing may also offer a better way to allocate the risk connected with an asset. Certain parties may have a comparative advantage in dealing with certain kinds of uncertainty. Finally, still other parties may have a comparative advantage in dealing with particular transaction costs connected with an asset.

Project Structure

Each project is unique in some respects. Project financing arrangements are designed to suit the project’s special characteristics and to resolve potential agency problems.

Project Financing

Financial engineering is crucial in project financing. It is necessary to design contractual arrangements to allocate project risks among the entities involved with the project, to allocate the economic rewards among them, to convey the credit strength of creditworthy firms to support project debt, and to minimize total agency costs. Typical credit support arrangements include the following:

• Completion undertaking.Such an undertaking obligates the sponsors or other creditworthy entities either (1) to assure that the project will pass certain performance tests by some specified date, or (2) to repay the debt. As an example of the former, the coal mine mentioned earlier might be required to produce a certain number of tons of coal per month for a certain specified number of months prior to some specified date. Completion undertakings are designed to control the equityholders’ tendency to pursue high-risk projects at the expense of lenders. They also prevent the equityholders from abandoning a project without fully compensating lenders if a project becomes unprofitable.
• Purchase, throughput, or tolling agreements.These obligate one or more creditworthy entities to purchase the project’s output or use its facilities. Purchase agreements that are capable of supporting project financing take the form of take-or-pay contracts or hell-or-high-water contracts. Take-or-pay contracts obligate the purchaser to take the project’s output or else pay for it if the product is offered for delivery (but normally only if the product is available for delivery). Hell-or-high-water contracts obligate the purchaser to pay in all events, that is, whether or not any output is available for delivery. The latter is, of course, stronger and therefore provides greater credit support. Throughput agreements are often used in pipeline financing. They require shippers to put some specified minimum amount of a product (for example, oil) through the pipeline each month (or interest period) in order to enable the pipeline to generate sufficient cash to cover its operating expenses and debt service requirements. They can take the form of either ship-or-pay (similar to take-or-pay obligations) or hell-or-high-water undertakings. Tolling agreements are often used in financing processing facilities, such as an aluminum smelter, where the user retains ownership of the item throughout the production process. Such arrangements require users to process a certain specified minimum amount of raw material each month (or interest period).
• Cash deficiency agreements.Unless the purchase, throughput, or tolling agreement is of the hell-or-high-water variety, interruptions in availability or deliverability can result in the project realizing insufficient cash to meet its debt service obligations. Sponsors may therefore have to provide supplemental credit support in the form of a cash deficiency agreement. It obligates the sponsor to invest additional cash as required by the project to meet its debt service obligations.

Advantages of Project Financing

Project financing can provide significant advantages in certain situations.

• Risk sharing.A sponsor can enlist one or more joint venture partners to share the equity risk. Such risk sharing is beneficial in the presence of significant costs of financial distress. It should be considered whenever a capital investment project is so large relative to a firm’s existing asset portfolio that pursuing it alone would increase the firm’s risk of bankruptcy to an unacceptable level. Under some circumstances, a project sponsor can transfer risks to suppliers, purchasers, and, to a limited degree, lenders through contractual arrangements like those just discussed. Risks can be allocated to parties who are willing to bear them at the lowest cost.
• Expanded debt capacity.By financing on a project basis rather than on its general credit, a firm may be able to achieve a higher degree of leverage than would be consistent with its senior debt rating objective if it financed the project entirely on its own. Project-related contractual arrangements transfer portions of the business and financial risk to others. This permits greater leverage.
• Lower cost of debt.Suppose the purchasers of the project’s output have a higher credit standing than project sponsors. In that case, financing on the purchasers’ credit rather than on the sponsors’ credit can lead to a lower cost of debt. This benefit is more likely to occur when the output of the project will create a positive NPV for the purchaser that can be realized only if the sponsor undertakes the project. The project sponsor is effectively realizing a portion of the purchaser’s positive NPV through the lower cost of borrowing it achieves.

Disadvantages of Project Financing

Project financing can involve significant transaction costs. The contractual arrangements mentioned earlier are often complex. Consequently, arranging project financing usually involves significant legal fees. In addition, lenders generally require a yield premium in return for accepting credit support in the form of contractual undertakings rather than a firm’s direct promise to pay because of the higher agency costs.

When to Use Project Financing

A project should be financed on a project basis only if that method of financing maximizes shareholder wealth. This will generally be the case when (1) project financing facilitates a higher degree of leverage than conventional financing and (2) the tax effects owing to the higher degree of leverage exceed the sum of the costs associated with the yield premium lenders require plus the higher after-tax transaction costs.

Characteristics of Limited Partnerships

A limited partnership is a special form of partnership. Certain partners, called limited partners, enjoy limited liability. They are passive investors like the stockholders of a corporation. But a limited partnership, like partnerships generally, does not pay income taxes. Income or loss for tax purposes is passed through to the partners. So suppose a firm plans a capital-intensive investment, such as oil and gas drilling, but believes it will not have sufficient taxable income to fully use the tax deductions and tax credits of the venture. It could form a limited partnership in order to direct the tax benefits through to the investors.⁴ Particularly in risky projects like oil exploration, these tax benefits can offer a substantial inducement to individual investors to share the investment risks inherent in such projects.

The limited partnership is operated by a general partner. The general partner is responsible for the liabilities of the limited partnership (except for those liabilities specifically assumed or guaranteed by the limited partners). Income, losses, tax credits, and distributions are allocated among the partners in accordance with a sharing formula specified at the time the limited partnership is formed.

Measuring the Cost of Limited Partner Capital

A firm that sets up a limited partnership and serves as general partner effectively experiences the following cash flow benefits and costs:

• Initial cash inflow equal to the net proceeds from the sale of units of limited partnership interest
• Annual cash inflows equal to the taxes payable on the portion of partnership taxable income allocated to the limited partners
• Initial cash outflow equal to the amount of the investment tax credit, if any, allocated to the limited partners
• Annual cash outflows equal to (1) the cash distributions to the limited partners plus (2) the tax shields resulting from the portion of partnership losses for tax purposes allocated to the limited partners
• Terminal cash outflow equal to the residual value of the limited partnership’s assets allocated to the limited partners

The cost of limited partner capital depends importantly on the limited partners’ tax position and on the asset’s residual value. The higher the tax rate on the limited partners’ income, the greater the value of the tax credits transferred to them. Hence, the lower is likely to be the firm’s cost of raising funds through limited partnership financing. In addition, the lower the portion of residual value that needs to be allocated to limited partners, the lower the cost of funds, as was the case with lease financing.

Advantages and Disadvantages of Limited Partnership Financing

Limited partnership financing provides an alternative means of “selling” the tax deductions and tax credits associated with asset ownership. As in the case of lease financing, limited partnership financing can be mutually beneficial to the firm and to the investor when the investor pays income tax at a higher marginal rate than the firm.

Also as in the case of lease financing, the firm must sacrifice a portion of the asset’s residual value. When the forgone residual value is taken into account, limited partnership financing may prove to be more expensive than conventional equity financing.

In contrast to lease financing, limited partnership financing can also be advantageous to profitable firms. A partnership is nontaxable. Organizing a project (or a business) as a limited partnership, rather than having a corporation own it, eliminates a layer of taxation.

Level A (Basic)

A1.

(Net advantage to leasing) Arkansas Instruments (AI) can purchase a sonic cleaner for $1,000,000. The machine has a five-year life and would be depreciated straight line to a $100,000 salvage value. Hibernia Leasing will lease the same machine to AI for five annual $300,000 lease payments paid in arrears (at the end of each year). AI is in the 40% tax bracket. The before-tax cost of borrowing is 10%, and the after-tax cost of capital for the project would be 12%. What cash flows does AI realize if it leases the machine instead of buying it? What is the net advantage to leasing (NAL)?

A2.

(Net advantage to leasing) Allied Metals, Inc., is considering leasing $1 million worth of manufacturing equipment under a lease that would require annual lease payments in arrears for five years. The net cash flows to lessee over the term of the lease (with zero residual value) are given here. Allied’s cost of secured debt is 12%, and its cost of capital is 16%. Allied pays taxes at a 34% marginal rate. Calculate the net advantage to leasing. Should Allied lease, or borrow and buy? Year 0 1 2 3 4 5 Net cash flow ($000) 1,000 −300 −275 −250 −225 −200

A3.

(Net advantage to leasing) A firm is considering leasing a computer system that costs $1,000,000 new. The lease requires annual payments of $135,000 in arrears for 10 years. The lessee pays income taxes at a 35% marginal rate. If it purchased the computer system, it could depreciate it to its expected residual value over 10 years. The lessee’s cost of similarly secured debt is 10% and its WACC is 15%. Calculate the net advantage to leasing assuming zero residual value. Should the firm lease the computer system? Calculate the net advantage to leasing assuming $250,000 residual value. Should the firm lease the computer system?

A4.

(Cost of limited partner capital) Suppose the cable television limited partnership example in the text instead enabled the limited partners to receive 90% of partnership income, losses, tax credits, and cash distributions for the life of the limited partnership. Calculate the cost of limited partner capital.

A5.	(Cost of limited partner capital) What is the cost of limited partner capital if a limited partner invests $50 million at time zero and receives net distributions of $8 million for the next 10 years?

A6.	(Calculating a lease discount rate) U.S. Aluminum overcollateralizes its secured debt by 25%. If U.S. Aluminum’s secured borrowing rate is 9%, and its unsecured borrowing rate is 11%, what is the proper discount rate to use when computing the net advantage to leasing?

A7.

(Net advantage to leasing) You want to lease a car that costs $25,000 new. You can lease it with zero down for $500 per month at the start of each month for the next five years, and then buy the car for $8,000 at the end of the lease. Your rich uncle thinks leases are a bad deal and offers to loan you the $25,000 at a 9% APR interest rate. You cannot deduct interest expense or car depreciation on your tax return. What do you tell your uncle?

Level B

B1.	(Time value of money) Show how to modify Equation (21.2) to reflect the timing of lease payments when the lease calls for payments at the beginning of each year.

B2.

(Net advantage to leasing) New Horizon Natural Foods is considering whether to lease a delivery truck. A leasing company has offered to lease the truck. It costs $35,000. New Horizon has proposed a five-year lease that calls for annual payments of $7,850 at the beginning of each year. New Horizon could depreciate the truck to $5,000 at the end of five years on a straight-line basis and claim depreciation tax deductions at the beginning of each year. Its marginal tax rate is 34%, its cost of five-year secured debt is 10%, and its required return for the project is 12% after tax and 16% pretax. Should New Horizon lease the truck, or borrow and buy? Suppose instead that New Horizon does not expect to pay income taxes in the foreseeable future. Should New Horizon lease the truck, or borrow and buy?

B3.

(Net advantage to leasing) Neighborhood Savings Bank is considering leasing $100,000 worth of computer equipment. A four-year lease would require payments in advance of $22,000 per year. The bank does not currently pay income taxes and does not expect to have to pay income taxes in the foreseeable future. If the bank purchased the computer equipment, it would depreciate the equipment on a straight-line basis down to an estimated salvage value of $20,000 at the end of the fourth year. The bank’s cost of secured debt is 14%, and its cost of capital is 20%. Calculate the net advantage to leasing.

B4.

(Net advantage to leasing) Brown Toyota is considering leasing $120,000 worth of computer equipment. A four-year lease would require payments in advance of $33,000 per year. Brown does not currently pay income taxes and does not expect to have to pay income taxes in the foreseeable future. If Brown purchased the computer equipment, it would depreciate the equipment on a straight-line basis down to an estimated salvage value of $30,000 at the end of the fourth year. Brown’s cost of secured debt is 14%, and its cost of capital is 20%. Calculate the net advantage to leasing.

B5.

(Net advantage to leasing) Rashid Singh, the president of Surf-Side Beer Distributors of Salina, Kansas, has decided that his firm must acquire a new machine that costs $800,000. The firm’s corporate borrowing rate is 12%. The machine can be leased for $110,000 per year for its 10-year life. If the firm leases, it gets no salvage value. If it owns, the expected salvage value is $50,000. Maintenance costs will be the same whether Surf-Side leases or buys. The firm uses straight-line depreciation (to the salvage value), and its tax rate is 40%. Can you demonstrate which would be better for Rashid, leasing or buying?

B6.

(Net advantage to leasing) Empire Excavation Corporation plans to acquire a fleet of 10 dump trucks. Each truck costs $75,000. Empire can borrow $750,000 on a secured basis at a pretax cost of 14%. The dump trucks can be depreciated for tax purposes on a straightline basis to zero over a five-year useful life. Truck Leasing Corp. has offered to lease the fleet of trucks to Empire under a five-year lease that calls for lease payments of $190,000 at the end of each year. Empire estimates that forgone residual value would be $10,000 per truck (net of taxes). Empire’s tax rate is 34%. Its cost of capital is 16%. Calculate the stream of net cash flows to Empire under the lease financing. Calculate the net advantage to leasing.

B7.

(Net advantage to leasing) A three-year lease entails the following stream of net cash flows (in millions of dollars) to the lessee: $10.5, −$3.0, −$5.0, −$5.0. The lessee’s pretax cost of secured debt is 13%. The lessee does not pay taxes, and it does not expect to become a taxpayer in the near future. The item will have zero residual value at the end of the lease term. Calculate the net advantage to leasing.

B8.

(Net advantage to leasing) Carrion Luggage, Ltd. is considering leasing $50 million worth of warehousing equipment under a lease that would require annual lease payments in arrears for five years. The net cash flows to the lessee over the term of the lease (with zero residual value) are given here. Carrion’s cost of secured debt is 11%, and its cost of capital is 14%. Carrion pays taxes at a 40% marginal rate. Calculate the net advantage to leasing. Calculate the IRR for the lease. Should Carrion lease, or borrow and buy? Year 0 1 2 3 4 5 Net cash flow ($ millions) 50 −15 −15 −15 −15 −15

B9.

(Net advantage to leasing) Lake Trolley Company is considering whether to lease or buy a new trolley that costs $25,000. The trolley can be depreciated straight line over an eight year period to an estimated residual value of $5,000. Lake Trolley’s cost of eight-year secured debt is 12%. Its required return for the project is 16% after tax and 20% pretax. National Trolley Leasing Corporation has offered to lease the trolley to Lake Trolley in return for annual payments of $5,000 payable at the end of each year. Specify the incremental cash flow stream associated with the lease, assuming Lake Trolley’s marginal income tax rate is 40%. Calculate the net advantage to leasing, assuming Lake Trolley’s tax rate is 40%. Should Lake Trolley lease, or borrow and buy? Calculate the net advantage to leasing, assuming Lake Trolley’s tax rate is zero. Should Lake Trolley lease, or borrow and buy? How would your answers to parts b and c change if the residual value at the end of eight years is $500, but the trolley is depreciated to $5,000?

B10.

(Net advantage to leasing) A lease calls for payments of $1 million at the end of each of the next five years and payments of $2 million at the end of each of the following five years. The asset to be leased costs $10 million. The 10-year depreciation schedule to a residual value of $500,000 at the end of the lease term is given here. The lessee’s marginal income tax rate is currently 40%. Its cost of 10-year secured debt is 12.5%. Its required return for the project is 15% after tax and 17.5% pretax. Calculate the net advantage to leasing. How would your answer to part a change if the lessee did not expect to pay any income taxes for the next three years but to pay income taxes each year thereafter at a 40% rate? (Hint: Any tax losses in years 1 to 3 can be carried forward and realized in year 4.) Year 1 2 3 4 5 6 7 8 9 10 Depreciation ($000) 2,000 1,750 1,500 1,250 1,000 400 400 400 400 400

B11.

(Negotiating a lease rate) Amalgamated Leasing Corp. would like to submit a leasing proposal to the Sandoval Hardware Manufacturing Company. Sandoval has asked to lease $5 million worth of equipment under a six-year lease. Amalgamated can depreciate the equipment for tax purposes on a straight-line basis over the six-year term to an estimated residual value of $250,000. The leasing firm’s income tax rate is 40%. Amalgamated has estimated Sandoval’s six-year cost of funds to be 10% for secured debt (83.33% financing) and 12% for unsecured debt. It has also estimated the required after-tax return for an investment in the assets to be 15%. At what lease rate would Amalgamated be indifferent to making the lease? Assume Sandoval pays income taxes at a 30% rate. Calculate Sandoval’s net advantage to leasing at Amalgamated’s indifference lease rate. At what lease rate would Sandoval be indifferent? Is it possible for Amalgamated and Sandoval to find a mutually beneficial lease rate?

B12.

(Cost of limited partner capital) A limited partnership would expect the net cash flows given here from a project. Calculate the cost of limited partner capital. Suppose the firm’s unleveraged cost of equity is 15% and the limited partnership has no debt. Should the firm employ limited partnership financing? Year 0 1 2 3 4 5 6 7 Net cash flow ($ millions) 125.0 −10.5 −12.0 −14.5 −16.5 −19.5 −22.5 −112.5

B13.

(Lease versus buy) Suppose you can either purchase a new Honda Civic for $20,000 cash or lease it from Honda for $2,000 down and $360 per month for 48 months. At the end of the lease, you will be able to purchase the car for $6,000, which is your estimate of its residual value. Your cost of borrowing the funds to buy the car is 12% APR. You cannot depreciate the car for tax purposes. Nor can you deduct the lease payments or interest expense. Should you lease the car, or borrow to buy it? Honda can depreciate the car straight-line to $6,000 over four years. Honda’s required return on the lease is 12% pretax APR. Honda’s marginal income tax rate is 40%. Is leasing advantageous to Honda? Explain why leasing a car can be mutually advantageous to the manufacturer and the customer.

B14.

(Excel: net advantage to leasing) Brown Storage Technology is planning to buy a propanefueled truck for $100,000. Brown expects to use the truck for eight years, after which it has an expected salvage value of $8,000. Brown’s before-tax cost of borrowing is estimated to be 8.0% and its marginal tax rate is 40%. McLeavey Leasing will lease this same truck to Brown for eight beginning-of-year lease payments of $16,000. The tax savings from depreciation occur at the end of the year, and the tax savings from the lease payments occur at the time they are paid. Assuming that the truck is depreciated straight-line to a zero salvage value over eight years, what is Brown’s net advantage to leasing? Assuming that the truck is depreciated as five-year property under MACRS, what is the net advantage to leasing? (Refer to Table 10-7 for the MACRS depreciation schedule.) Why does your answer differ from part a? Still using the five-year MACRS depreciation schedule, what is the maximum lease payment that McLeavey could charge Brown? That is, what lease payment would result in a zero net advantage to leasing?

B15.

(Excel: net advantage to leasing) Purdue Systems can purchase a commercial DVD burner for $3,000,000. The equipment will be depreciated as three-year MACRS property (refer back to Table 10-7 for the MACRS depreciation schedule). The depreciation tax savings will be realized at the end of each year. The equipment will have a five-year life and will have a before-tax salvage value of $700,000. Purdue Systems has a before-tax cost of debt of 9% and a cost of capital of 12%. Lafayette Leasing will purchase this DVD burner and lease it to Purdue Systems for five years, charging a lease payment of $550,000 payable at the beginning of each year. The tax saving on a lease payment is realized at the time the payment is made. Purdue will have no rights to purchase or use the equipment at the end of the five-year lease period. Purdue has a 30% marginal tax rate. What is the net advantage to leasing for Purdue Systems?

Level C (Advanced)

C1.

(Excel: Break-even lease payment) The break-even tax rate is the income tax rate for the lessee that would make the lessee indifferent between leasing an asset on the one hand and borrowing and buying it on the other. Calculate the break-even lease payment for Lake Trolley in problem B9 under the assumption that the residual value is $500.

C2.

(Leasing, taxes, and the time value of money) The lessor can claim the tax deductions associated with asset ownership and realize the leased asset’s residual value. In return, the lessor must pay tax on the rental income. Explain why a financial lease represents a secured loan in which the lender’s entire debt service stream is taxable as ordinary income to the lessor/lender. In view of this tax cost, what tax condition must hold in order for a financial lease transaction to generate positive net-present-value tax benefits for both the lessor and lessee? Suppose the lease payments in Table 21-2 must be made in advance, not arrears. (Assume that the timing of the lease payment tax deductions/obligations changes accordingly but the timing of the depreciation tax deductions does not change). Show that the net advantage to leasing for NACCO must decrease as a result. Explain why this reduction occurs. Show that if NACCO is nontaxable, the net advantage to leasing is negative and greater in absolute value than the net advantage of the lease to the lessor. Either find a lease rate that will give the financial lease a positive net advantage for both lessor and lessee, or show that no such lease rate exists. Explain what your answer to part e implies about the tax costs and tax benefits of the financial lease when lease payments are made in advance.