Sadik Industries must install $1.75 million of new machinery in
its Texas plant.
It can get a
bank lease for 100% of the required amount.
A group of investors can
arrange a
lease with the following terms:
1)
equipment falls into 3 year MACRS
class
2)
maintenance is estimated at $75,000
a year.
3)
The firm tax rate is 40%.
4)
If money is borrowed, the loan rate
will be 13%, amortized in 3 equal installments at the end of each year.
5)
The tentative lease terms call for
payments of $375,000 at the end of each year for 3 years. It is a guideline (IRS) lease.
6)
Under proposed lease terms, the
lessee must pay for insurance, property taxes, and maintenance.
7)
Sadik must use the quipment if it
is to continue in business, so it will probably want to acquire the property
at the
end of the lease. If it does this, then it can purchase the
machinery at its fair market value at that time. The best
estimate of this market value is
$450,000, but it could be higher or lower depending on certain circumstances.
solve:
a)
Assumng the lease can be arranged.
Should the firm lease or borrow and buy the equipment? Explain.
(Hint:In this situation, the firm plans to use the asset beyond the
terms of the lease. Thus, the residual
value
becomes a cost to leasing in year
3. The firm will depreciate the
equipment it purchases under the purchase
option starting in year 3, using
the MACRS 3-year class schedule.
Depreciation will begin in the year in which
the equipment is purchase, which is
year 3).
b)
Consider the $450,000 residual
value. Is it appropriate to discount
it at the same rate as the other cash flows?
Are the other cash flows all
equally risky? (Hint: Riskier
cash flows are normally discounted at higher rates, but
when the cash flows are costs rather
than inflows, the normal procedure must be reversed).
Tool Kit
Chapter 19
12/9/2012
Lease Financing
19-2
Tax Effects
The full amount of the lease payments is a tax-deductible
expense for the lessee provided the Internal Revenue Service agrees that a
particular contract is a genuine lease and not simply a loan called a
lease. A lease that complies with all
IRS requirements is called a guideline, or tax-oriented, lease, and the tax
benefits of ownership (depreciation and any investment tax credits) belong to
the lessor.
Tax
effects of buying:
Equipment cost
2,000,000
Tax rate
40%
Discount
rate for tax savings
6%
Depreciation
Schedule
Year
1
2
3
4
Depreciation rate
33.33%
44.45%
14.81%
7.41%
Depreciation
666,600
889,000
296,200
148,200
Tax savings
266,640
355,600
118,480
59,280
PV of tax savings
714,463
Tax
effects of leasing
Suppose the entire purchase price could be paid as a single
lease payment with an option to purchase the asset for $1 at the end of the
year. (This wouldn’t satisfy the IRS requirements for a guideline lease, but
imagine it would just for this example).
Lease payment
2,000,000
Tax savings
800,000
19-3
Financial Statement Effects
Lease payments are shown as operating expenses on a firm’s
income statement. Under certain
conditions, neither the leased assets nor the liabilities under the lease
contract appears on the firm’s balance sheet. For these reasons, leasing is often called
“off balance sheet financing”.
This can be illustrated by looking at the hypothetical firms, B and L. These two firms are identical in every way,
except Firm B has decided to buy its new assets, while Firm L has chosen to
lease.
Before the increase in assets
Firms B and L
Curr. Assets
50
Debt
50
Debt Ratio
Fixed Assets
50
Equity
50
50%
Total Assets
100
Total D&E
100
After the increase in assets
Firm B
Curr. Assets
50
Debt
150
Debt Ratio
Fixed Assets
150
Equity
50
75%
Total Assets
200
Total D&E
200
Firm L
Curr. Assets
50
Debt
50
Debt Ratio
Fixed Assets
50
Equity
50
50%
Total Assets
100
Total D&E
100
From this simple example, we see that by leasing the assets Firm
L did not change its reported capital structure at all. In contrast, Firm B
would report an increase in the debt ratio from 50% to 75%. Thus, not capitalizing the lease
understates the true risk born by Firm L’s shareholders.
19-4
Evaluation by the Lessee
Any prospective lease must be evaluated by both the lessee and
the lessor. The lessee must determine
whether leasing the asset will be less costly than buying the asset, and the
lessor must determine if the lease provides an adequate return. Much like the capital budgeting decisions
we have seen previously, we must be concerned with incremental cash flows.
PROBLEM
Thompson-Grammatikos Company (TGC) requires the use of a
two-year asset that costs $100. TGC
can borrow $100 at an interest rate of 10%, with payments of $10 each year
and a principle payment of $100 at Year-2. For simplicity, assume
straight-line depreciation of $50 per year.
The tax rate is 40%. If TGC
leases the asset the lease payment is $55 due at the end of each year.
Input Data
(all dollar figures in
thousands)
New
Equipment cost
$100
KEY OUTPUT
New
Equipment life
2
Equip.
Salvage Value
$0
LEASE
Tax Rate
40%
because of the net
advantage of leasing is
$2.83
Loan interest rate
10%
Annual
rental charge
$55
Depreciation
$50
After-tax
cost of debt
6%
Figure 19-1
Analysis
of the TGC Lease versus Buy Decision (Millions of Dollars)
Cost of Owning
Year
0
1
2
Equipment cost
−$100
Loan amount
$100
Interest expense
−$10
−$10
Tax savings from interest
= (−Interest exp.)(Tax rate)
$4
$4
Principal
repayment
−$100
Tax
savings from depr.
$20
$20
Net
cash flow (NCF)
$0
$14
−$86
PV
ownership NCF @ 6%
−$63.33
Cost of Leasing
Year
0
1
2
Lease payment
−$55
−$55
Tax savings from lease
= (−Lease pmt)(Tax rate)
$22
$22
Net
cash flow (NCF)
$0
−$33
−$33
PV
of leasing NCF @ 6%
−$60.50
Net advantage to leasing (NAL)
NAL =PV of leasing − PV of owning
$2.83
PROBLEM
Anderson Company plans to acquire equipment, with a 5-year MACRS
life (but a 10-year useful life), at a cost of $10 million (delivery and
installation included). Anderson can
borrow the $10 million at 10%, interest only until the repayment in 5 years. Alternatively, Anderson can lease
the equipment for five years at a rental charge of $2.6 million per year, at
the beginning of the year. The equipment, when used, will have an estimated
net salvage value of $2 million. If
Anderson buys, it will own the
equipment at the end of five years. If
Anderson leases, it will not exercise the option to buy the equipment. The lease includes maintenance service,
whereas if bought, the equipment would require maintenance provided by a
service contract for $500,000 per year, at the beginning of the year. The
equipment falls into the MACRS five-year class life, and the depreciable
basis is the original cost. Anderson’s
tax rate is 35%.
Input Data
(all
dollar figures in thousands)
New
Equipment cost
$10,000
KEY OUTPUT
New
Equipment MACRS life
5
Equip.
Salvage Value at end of MACRS
$2,000
LEASE
Annual
Maintenance
$500
because of the net
advantage of leasing is
$54.04
Tax Rate
35%
Loan interest rate
10%
Annual
rental charge
$2,600
Useful life
10
Scrap
Value at end of useful life
$50
After-tax
cost of debt
6.5%
Now,
we will use the MACRS 5-year depreciation schedule to calculate the annual
depreciation charges.
MACRS
5-year Depreciation Schedule
Year
1
2
3
4
5
6
Depr. Rate
20.00%
32.00%
19.20%
11.52%
11.52%
5.76%
Depr. Exp.
$2,000
$3,200
$1,920
$1,152
$1,152
$576
Starting
book value
$10,000
$8,000
$4,800
$2,880
$1,728
$576
Remaining
book value
$8,000
$4,800
$2,880
$1,728
$576
$0
Figure 19-2
Anderson
Company: Lease Analysis (Thousands of Dollars)
Part
A: Cost of Owning
Year
0
1
2
3
4
5
1. After-tax loan payments
−$650
−$650
−$650
−$650
−$10,650
2. Maintenance cost
−$500
−$500
−$500
−$500
−$500
3. Maintenance tax savings
$175
$175
$175
$175
$175
4. Depreciation tax savings
$700
$1,120
$672
$403
$403
5. Residual value
$2,000
6. Tax on residual value
−$498
7. Net cash flow
−$325
−$275
$145
−$303
−$572
−$8,745
8. PV ownership CF @ 6.5%
−$7,534
Part
B: Cost of Leasing
Year
0
1
2
3
4
5
9. Lease payment
−$2,600
−$2,600
−$2,600
−$2,600
−$2,600
10.
Tax savings from lease
$910
$910
$910
$910
$910
11. Net cash flow
−$1,690
−$1,690
−$1,690
−$1,690
−$1,690
$0
12.
PV of leasing CF @ 6.5%
−$7,480
Part
C: Net advantage to leasing (NAL)
13.
NAL = PV of leasing − PV of owning =
$54
Suppose Anderson decides to use the equipment for 10 years and
will purchase the equipment at the residual value at Year 5 if it leases the
equipment. The equipment will be worthless at Year 10.
Anderson Company: Lease and Purchase at
Residual Value (Thousands of Dollars)
Year
0
1
2
3
4
5
6
7
8
9
10
I. Cost of Owning
1.
After-tax loan payments
($650)
($650)
($650)
($650)
($10,650)
$0
$0
$0
$0
$0
2.
Maintenance cost
($500)
(500)
(500)
(500)
(500)
3.
Maintenance tax savings
175
175
175
175
175
4.
Depreciation tax savings
700
1,120
672
403
403
202
0
0
0
0
5. Residual value
0
0
0
0
0
0
6.
Tax on residual value
0
0
0
0
0
0
7. Net cash flow
($325)
($275)
$145
($303)
($572)
($10,247)
$202
$0
$0
$0
$0
8.
PV ownership CF @
6.5%
($8,491)
II. Cost of Leasing
9. Lease payment
($2,600)
($2,600)
($2,600)
($2,600)
($2,600)
10.
Tax savings from lease
910
910
910
910
910
10.a. Purchase
(2,000)
10.b
Depreciation tax savings
140
224
134
81
81
10.c Tax impact on selling
for zero when book
value is not zero
40
11. Net cash flow
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