Chapter 6

1. Lease: A lease is a contractual agreement between a lessee and a lessor.

2. Lessee: The party that makes periodic payments in exchange for the right to use an asset.

3. Lessor: The party that lends the asset and is entitled to receive the lease payments.

1. Residual Value is the asset’s market value at the end of a lease.

2. The cost of a lease depends on the asset’s residual value.

3. At the end of the contract, the lease specifies who retains ownership of the asset and under what terms.

4. Most leases involve little or no upfront payment.

1. Short-term lease

2. Present value of lease payments is less than the asset's cost

3. Ownership remains with the lessor

4. Lessee reports payments as operating expenses

5. Asset is not on the balance sheet

6. No depreciation is recorded by the lessee

7. Lessee bears little or no risk

1. Long-term lease, usually lasting for the life of the asset

2. Present value of lease payments covers the full asset cost

3. Cannot be cancelled

4. Lessee assumes risks and benefits of ownership

5. Asset is recorded on the balance sheet

6. Lessee records depreciation and interest expense

7. Future lease payments are recorded as a liability

1. Sales-Type Lease: Lessor is the manufacturer of the asset (e.g., IBM, Xerox)

2. Direct Lease: Lessor is not the manufacturer but leases a purchased asset

3. Sale and Leaseback: A company sells an asset and then leases it back

4. Leveraged Lease: Lessor borrows money to finance the asset purchase

5. Tax-Oriented Lease: Lessor owns the asset primarily for tax advantages

1. The lessor buys the asset and leases it to the lessee

2. The lessor borrows part of the purchase cost from a lender

3. If the lessee defaults, the lender has first claim on the asset

4. If the lessor defaults, lease payments go directly to the lender

5. The lessor has no responsibility for the lender’s loan

6. Leveraged leases offer tax advantages and lower financing costs

1. Leasing spreads costs over time; a loan may require a larger upfront payment

2. Lease payments are usually lower than loan payments

3. Loans provide full ownership of the asset; leasing does not

1. Loans finance the entire cost of the asset

2. Leases finance only the asset's economic depreciation during the lease term

3. Thus, loan payments are higher than lease payments

4. For a fairly priced loan:

   PV(Loan Payments)=Purchase Price

1. Fair Market Value (FMV) Lease: Option to buy the asset at its market value at lease end

2. $1 Out Lease (Finance Lease): Ownership transfers to lessee for $1 at end (effectively a purchase)

3. Fixed Price Lease: Lessee can buy the asset at a pre-agreed fixed price

4. Fair Market Value Cap Lease: Lessee can purchase the asset at the lower of FMV or a fixed price ("cap")

1. Buying requires a large upfront cost, followed by depreciation tax shields

2. Leasing spreads the cost evenly over time, with tax savings from lease payments

3. Compare the present value of cash flows for both options

4. Discount lease payments at the firm's secured borrowing rate

5. Choose the option with the lower present value of outflows

• Leasing increases leverage, just like debt—it’s a fixed financial obligation

• It should be compared to borrowing, not just buying the asset outright

• Lease-Equivalent Loan: A loan that mimics lease cash flows for fair comparison

• The loan’s value equals the present value of lease free cash flows, discounted at the after-tax cost of debt

Loan Balance = PV [Lease FCFs discounted at rD (1−τc)]

1. Compute incremental cash flows:

   • Buying → Include depreciation tax shield

   • Leasing → Include tax-deductible lease payments

2. Calculate NPV of leasing vs. buying using the after-tax borrowing rate:

   • If NPV < 0 → Leasing is unattractive compared to debt financing

   • If NPV > 0 → Leasing has a financial advantage

1. Easier to evaluate than an operational lease

2. Lessee can still deduct depreciation

3. Only the interest portion of the lease payment is tax-deductible

4. It is similar to a loan

5. A lease is beneficial if its interest rate is lower than a comparable loan

6. To compare:

   • Discount lease payments at the firm’s pretax borrowing rate

   • Compare the result to the asset’s purchase price

Valid Reasons:

• Tax differences

• Reduces maintenance and resale hassle

• Reduced distress costs & increased debt capacity

• Transferring risk

• Improved cash flow management

⚠️ Suspect Reasons:

• Avoiding capital expenditure controls

• Preserving capital