Chapter

Twenty-Six

Leasing

© 2003 The McGraw-Hill Companies, Inc. All rights reserved.

26.1 Key Concepts and Skills

• Understand the basic lease terminology

• Understand the criteria for a capital lease vs.
an operating lease
• Understand the typical incremental cash flows
to leasing
• Be able to compute the net advantage to
leasing
• Understand the good reasons for leasing and
the dubious reasons for leasing

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26.2 Chapter Outline

• Leases and Lease Types

• Accounting and Leasing
• Taxes, the IRS and Leases
• The Cash Flows from Leasing
• Lease or Buy?
• A Leasing Paradox
• Reasons for Leasing

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

26.3 Lease Terminology

• Lease – contractual agreement for use of an

asset in return for a series of payments
• Lessee – user of an asset; makes payments
• Lessor – owner of the asset; receives payments
• Direct lease – lessor is the manufacturer
• Captive finance company – subsidiaries that
lease products for the manufacturer

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26.4 Types of Leases

• Operating lease
– Shorter-term lease
– Lessor is responsible for insurance, taxes and maintenance
– Often cancelable
• Financial lease (capital lease)
– Longer-term lease
– Lessee is responsible for insurance, taxes and maintenance
– Generally not cancelable
– Specific capital leases
• Tax-oriented
• Leveraged
• Sale and leaseback

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26.5 Lease Accounting

• Leases are governed primarily by FASB 13

• Financial leases are essentially treated as debt
financing
– Present value of lease payments must be included
on the balance sheet as a liability
– Same amount shown on the asset as the
“capitalized value of leased assets”
• Operating leases are still “off-balance-sheet”
and do not have any impact on the balance
sheet itself
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.
26.6 Criteria for a Capital Lease

• If one of the following criteria is met, then the

lease is considered a capital lease and must be
shown on the balance sheet
– Lease transfers ownership by the end of the lease
term
– Lessee can purchase asset at below market price
– Lease term is for 75 percent or more of the life of
the asset
– Present value of lease payments is at least 90
percent of the fair market value at the start of the
lease
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26.7 Taxes

• Lessee can deduct lease payments for income tax

purposes
– Must be used for business purposes and not to avoid taxes
– Term of lease is less than 80 percent of the economic life
of the asset
– Should not include an option to acquire the asset at the end
of the lease at a below market price
– Lease payments should not start high and then drop
dramatically
– Must survive a profits test
– Renewal options must be reasonable and consider fair
market value at the time of the renewal

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26.8 Incremental Cash Flows

• After-tax lease payment (outflow)

– Lease payment*(1 – T)
• Lost depreciation tax shield (outflow)
– Depreciation * tax rate for each year
• Initial cost of machine (inflow)
– Inflow because we save the cost of purchasing the
asset now
• May have incremental maintenance, taxes or
insurance depending on the type of lease and
whether the leased asset is replacing one
currently owned
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26.9 Example: Lease Cash Flows

• ABC, Inc. needs some new equipment. The

equipment would cost $100,000 if purchased and
would be depreciated straight-line over 5 years. No
salvage is expected. Alternatively, the company can
lease the equipment for $25,000 per year. The
marginal tax rate is 40%.
– What are the incremental cash flows?
• After-tax lease payment = 25,000(1 - .4) = 15,000
(outflow years 1 - 5)
• Lost depreciation tax shield = (100,000/5)*.4 = 8,000
(outflow years 1 – 5)
• Cost of machine = 100,000 (inflow year 0)

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

26.10 Lease or Buy?

• The company needs to determine whether it is

better off borrowing the money and buying the
asset or leasing
• Compute the NPV of the incremental cash
flows
• Appropriate discount rate is the after-tax cost
of debt since a lease is essentially the same
risk as a company’s debt

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

26.11 Net Advantage to Leasing

• The net advantage to leasing (NAL) is the

same thing as the NPV of the incremental cash
flows
– If NAL > 0, the firm should lease
– If NAL < 0, the firm should buy
• Consider the previous example. Assume the
firm’s cost of debt is 10%.
– After-tax cost of debt = 10(1 - .4) = 6%
– NAL = 3,116
• Should the firm buy or lease?
McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.
26.12 Work the Web Example

• Many people have to choose between buying

and leasing a car
• Click on the web surfer to go to Kiplinger’s
– Go to more calculators and chose the lease vs. buy
– Do the calculations for a $30,000 car, 5-year loan
at 7% with monthly payments and a $3000 down
payment. The available lease is for 3 years and
requires a $550 per month payment with a $1000
security deposit and $1000 other upfront costs.

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26.13 Good Reasons for Leasing

• Taxes may be reduced

• May reduce some uncertainty
• May have lower transaction costs
• May require fewer restrictive covenants
• May encumber fewer assets than secured
borrowing

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26.14 Dubious Reasons for Leasing

• Balance sheet, especially leverage ratios, may

look better if the lease does not have to be
accounted for on the balance sheet
• 100% financing – except leases normally do
require either a down-payment or security
deposit
• Low cost – some may try to compare the
“implied” rate of interest to other market rates,
but this is not directly comparable

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

26.15 Quick Quiz

• What is the difference between a lessee and a lessor?

• What is the difference between an operating lease
and a capital lease?
• What are the requirements for a lease to be tax
deductible?
• What are typical incremental cash flows and how do
you determine the net advantage to leasing?
• What are some good reasons for leasing?
• What are some dubious reasons for leasing?

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc. All rights reserved.