Download - BASFIN2 Quiz 2 Reviewer
A. What is a LEASE?
• Rental agreement • With series of payments • That extends for a year or more
B. Parties Involved:
a) Lessor (Owner of Asset) b) Lessee (Borrower of Asset)
C. Types of Lease:
1. Operational Leases: • Short term and Cancelable • at the option of the lessee
2. Financial Leases: • Long-‐Term and Non-‐Cancelable • Long-‐Term: extends at the economical life of the
asset • Non-‐cancelable UNLESS Lessor is reimburse for any
loss D. Leases Differ in Service:
1. Full Service/Rental/Lease: • LESSOR promises to maintain and insure the
equipment and to pay property tax due on it 2. Net Lease:
• LESSEE promises to maintain and insure the equipment and to pay property tax due on it
3. Direct Lease: • LESSEE identifies the equipment, arranges for the
leasing company to buy it from the manufacturer, and signs a contract with the leasing company.
4. Sale and lease-‐back Arrangements: • The firm sells an asset it already owns and leases it
back from the buyer 5. Leveraged Lease:
• The lessor puts up some of the money required to purchase the asset and borrows the rest from a lender.
• The lender is given a senior secured interest on the asset and an assignment of the lease and lease payments. The lessee makes payments to the lessor, who makes payments to the lender.
E. Sensible Reasons for Leasing:
• Short-‐term leases are convenient
• Lower Monthly payment
• Protection against obsolescence
• Cancellation options are valuable o Some leases that appear expensive really are
fairly priced once the option to cancel is recognized.
• Maintenance is provided o Under a full-‐service lease, the user receives
maintenance and other services. • Standardization leads to low costs
o Standardization makes it possible to “lend” small sums of money without incurring large investigative, administrative, or legal costs.
• Leasing and financial distress
o LESSOR may fare better during Bankruptcy i. if asset is deemed “essential” by the court
then the court will AFFRIM the lease. The lessee must still continue to pay the lessor and continue to use the asset (1st scenario)
ii. If court REJECTS lease, then the lessor may recover asset (2nd scenario)
iii. If the LESSEE renegotiates with the lessor, lessor might be forced to accept lower lease payments (3rd scenario)
• Tax Shield can be used: o Lessor owns asset, and so deducts its
depreciation o If lessor can make better use of tax shield than
lessee, then lessor should own equipment and pass on some tax benefits to lessee
o So direct tax gain to lessor, indirect gain to lessee
F. Dubious Reasons for Leasing
• Leasing avoids capital expenditure controls o Leasing may enable an operating manager to avoid
the approval procedures needed to buy an asset • Leasing preserves capital
If Greymare Bus Lines leases a $100,000 bus rather than buying it, it does conserve $100,000 cash. It could also (1) buy the bus for cash and (2) borrow $100,000, using the bus as security. Its bank balance ends up the same whether it leases or buys and borrows. It has the bus in either case, and it incurs a $100,000 liability in either case.
• Leases may be off balance sheet financing
o In some countries financial leases are off-‐ balance-‐sheet financing; that is, a firm can acquire an asset, finance it through a financial lease, and show neither the asset nor the lease contract on its balance sheet.
• Leasing effects book income o Leasing can make the firm’s balance sheet and
income statement look better by increasing book income or decreasing book asset value, or both.
o A lease that qualifies as off-‐balance-‐sheet financing affects book income in only one way: The lease payments are an expense.
G. Financial accounting Standard Board(FASB) and Leases
The FASB defines capital leases as leases that meet any one of the following requirements:
• The lease agreement transfers ownership to the lessee before the lease expires.
• The lessee can purchase the asset for a bargain price when the lease expires.
• The lease lasts for at least 75% of the asset’s estimated economic life.
• The present value of the lease payments is at least 90% of the asset’s value.
H. International Financial Reporting Standards (IFRS) and Lease
A lease is classified as a finance lease if it transfers substantially all the risks and rewards incident to ownership. All other leases are classified as operating leases. Classification is made at the inception of the lease.
I. Situations that would normally lead to a lease being classified as a finance lease include the following:
i. the lease transfers ownership of the asset to the lessee by the end of the lease term
ii. the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than fair value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain that the option will be exercised
iii. the lease term is for the major part of the economic life of the asset, even if title is not transferred
iv. at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset
v. the lease assets are of a specialized nature such that only the lessee can use them without major modifications being made
J. Other situations that might also lead to classification as a finance lease are:
i. if the lessee is entitled to cancel the lease, the lessor's losses associated with the cancellation are borne by the lessee
ii. gains or losses from fluctuations in the fair value of the residual fall to the lessee (for example, by means of a rebate of lease payments)
iii. the lessee has the ability to continue to lease for a secondary period at a rent that is substantially lower than market rent
K. Evaluation of Leases
◆ Lease rentals
– Allowable deduction for lessee
– taxable income for lessor
◆ Depreciation
– Allowable deduction for lessor
– Not allowed for lessee
◆ Tax payable on gain from sale of underlying asset
– Payable by lessor
– Avoided by lessee
L. Evaluation of LESSEE
• Add cost of asset • Subtract lease payments • Add tax shield from lease payments • Subtract depreciation tax shield • Subtract residual value of asset • Add/ subtract tax gain/loss on sale of asset
M. Evaluation of LESSOR
• Subtract Cost of asset • Add lease payments • Subtract tax shield from lease payments • Add depreciation tax shield • Add residual value of asset • Subtract/ Add tax loss/gain on sale of asset
EVALUATION
LESSEE LESSOR
COST OF ASSET + -‐
LEASE PAYMENT -‐ +
TAX SHIELD FROM LEASE PAYMENT
+ -‐
DEPRICIATION TAX SHIELD
-‐ +
RESIDUAL VALUE OF ASSET
-‐ +
LOSS ON SALES OF ASSET
+ -‐
GAIN ON SALE OF ASSET
-‐ +
v Acme has branched out to rentals of office furniture to start up companies. Consider a $3000 desk. Desks last for six years and can be depreciated on a five-‐ year MACRS schedule. What is the break-‐even operating lease rate for a new desk? Assume that lease rates for old and new desks are the same and that Acme’s pre-‐tax administrative costs are $400 per desk per year. The cost of capital is 9% and the tax rate is 35%. Lease payments are made inn advance, that is, at the start of each year. The inflation rate is zero. The table below provides the depreciation schedule:
Given:
• Initial Cost: $3000 • Pre Tax Admin Cost= $400 • Cost of Capital/ Discount Rate: 9% • Tax Rate: 35%
CASH FLOWS
-‐3260 -‐50 +76 -‐58.40 -‐139.04 -‐139.04 +60.48
Break Even Lease Rate =𝐵𝑟𝑒𝑎𝑘 𝑒𝑣𝑒𝑛 𝑙𝑒𝑎𝑠𝑒 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 (𝐶)
(1 + 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)
Present Value = C !!− !
!(!!!)1 + 𝑟
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 = 𝐶! +𝐶!
(1 + 𝑟)!+
𝐶!(1 + 𝑟)!
+⋯+ 𝐶!
(1 + 𝑟)!
Solution:
𝑃𝑉 = −3260 −50
1 + 0.09 ! +76
1 + 0.09 ! −58.40
1 + 0.09 !
−139.04
(1 + 0.09)!−
139.04(1 + 0.09)!
+ 60.48
(1 + 0.09)!
PV= 3,439.80
3,439.80 = C1
0.09−
10.09 1 + 0.09
1 + 0.09
3,439.804.889651263
= C
C = 703.49
Break Even Lease Rate =703.49
(1 + 0.35)
Break Even Lease Rate = 1,082.29
v If a firm can borrow at 9% , what discount rate should the firm use to discount lease cash flows? (The marginal tax rate for the firm is 35%) Tax Shield= 0.09(1-‐0.35) Tax Shield =5.85%
v Nodhead College needs a new computer. It can either buy it for $250,000 or lease it from Compulease. The lease terms requires Nodhead to make six annual payments (prepaid) of $62,000. Nodhead pays no tax. Compulease pays tax at 35%. Compulease can depreciate the computer for tax purposes over five years. The computer will have no residual value at the end of year 5. The interest rate is 8%.
a. What is the NPV of the lease for Nodhead College?
Given:
𝑃𝑉 =62,000
(1 + 0.08)!
!
!!!
NPV cash flow of Nodhead is:
250,000 – value of PV = -‐59,500
b. What is the NPV for Compulease?
- Adjusted discount rate= rD(1 -‐ Tc) - The after tax interest rate is:
(1 − 0.35)× 0.08 = 0.052 = 5.2% - The NPV cash flow of Compulease is 40.0 or
$40,000
c. What is the overall gain(loss) from leasing?
40,000 − 59,500 = −19,500
v Suppose that National Waferonics has before it a proposal for a four-‐year financial lease. The table below summarizes the lease cash flows of the proposal:
These flows reflect the cost of machine, depreciation tax shields, and the after-‐tax lease payments. Ignore salvage value. Assume the firm could borrow at 10% and faces a 35% marginal tax rate.
a. What is the value of the equivalent loan?
– Adjusted discount rate= rD(1 -‐ Tc)
– 0.10 × (1 – 0.35) = 0.065 = 6.5%
– The value of the equivalent loan is the present value of the cash flows for years 1, 2 and 3: $59,307.30
b. What is the value of the lease?
- The value of the lease is: $62,000 – $59,307.30 = $2,692.70
c. Suppose the machine’s NPV under normal financing is
($5,000). Should Thor Inc. invest?
- National Waferonics should not invest. The lease’s value of +$2,692.70 does not offset the machine’s negative NPV. On the other hand, the company would be happy to sign the same lease on a more attractive asset.
EQUATIONS:
Break Even Lease Rate =𝐵𝑟𝑒𝑎𝑘 𝑒𝑣𝑒𝑛 𝑙𝑒𝑎𝑠𝑒 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 (𝐶)
(1 + 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)
Present Value = C1𝑟−
1𝑟(1 + 𝑟)
1 + 𝑟
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 = 𝐶! +𝐶!
(1 + 𝑟)!+
𝐶!(1 + 𝑟)!
+⋯+ 𝐶!
(1 + 𝑟)!
𝐴𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒 = 𝑟!"#$%&'((1 − 𝑇!"#$"#%&'"()
𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑 𝑜𝑓 𝐿𝑒𝑎𝑠𝑒 𝑃𝑎𝑦𝑚𝑒𝑛𝑡= 𝐴𝑛𝑛𝑢𝑎𝑙 𝐿𝑒𝑎𝑠𝑒 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 × 𝑇𝑎𝑥 𝑟𝑎𝑡𝑒
𝐷𝑒𝑝𝑟𝑖𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑= 𝑑𝑒𝑝𝑟𝑖𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑚𝑜𝑢𝑛𝑡 𝑐𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒
𝐷𝑒𝑝𝑟𝑐𝑖𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝐴𝑚𝑜𝑢𝑛𝑡 = 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 × 𝑑𝑒𝑝𝑟𝑖𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒
𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 = 𝑃𝑟𝑒 𝑇𝑎𝑥 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒
𝐵𝑒𝑓𝑜𝑟𝑒 𝑇𝑎𝑥 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 =𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑝𝑎𝑦𝑚𝑒𝑛𝑡
(1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)
𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 = 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 + 𝑑𝑒𝑝 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑+ 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑎𝑑𝑚𝑖𝑛 𝑐𝑜𝑠𝑡