-Lease – A contractual agreement establishing that the lessee has the right to use the asset and
in return must make period payments to the lessor, the owner of the asset.
-Lessor – individual who owns the property and rents it out.
-Lessee – the user of the property.
-Service lease – usually a short term cancelable lease. Service is normally responsibility of
-These leases are not fully amortized.
-Capital lease – Also called a ‘direct financing’ or ‘financial’ lease financing arrangement for
lessee to buy equipment. Generally longer term. Often non-cancelable. Lessee usually
responsible for maintenance. “Opposite” of a service lease.
-Leveraged lease – A 3 sided arrangement. The lessor borrows money to purchase asset.
-Sale and leaseback – owner of asset sells asset to another party and then leases it back – Ex.
When is a Lease a Capital Lease?
-The lease transfers ownership of the property to the lessee by the end of the term of the
-The lessee has the option to purchase the asset at a price below fair market value when
the asset matures
-The lease term is at least 75% of the estimated economic life of the asset
-The present value of the lease payments is at least 90% of the asset’s fair market value
-These leases have to be recorded on firm’s balance sheet
When is a Lease a Capital/Financial Lease?
-When the government says it is:
-The lessee automatically acquires ownership after payment of a specified amount in the
form of rentals
-Lessee is obligated to purchase asset at or before maturity
-The lessee can purchase asset at maturity for price less than fair market value of asset
-The same rules apply to sale and leaseback agreements
-If the government rules a lease is a capital lease, then in this case:
-Only interest portion of lease payment is tax deductible
-Lessee claims CCA
Should a Firm Lease of Buy?
Good Reasons Bad Reasons
-Tax benefits – if the lessor has a higher -Conservation of capital
marginal tax rate than the lessee, the lessor -Protection of debt capacity
can earn higher CCA tax shields than can the -Impact on accounting income
lessee. Some of these savings are passed on -Less restrictive than debt
to the lessee through a lower lease rate covenants
-Transaction costs may be higher for buying
and reselling an asset opposed to leasing
-Increase flexibility; ability to expand or shut
-Reduction of uncertainty in salvage values NPV Analysis
-Should the firm buy the asset or undertake an operating lease?
-Look at incremental cash flows!
-Do not look at cash flows that accrue because firm has use of asset
-We’re not interested in the full capital
budgeting decision, just the lease vs. buy
NAL = Benefits to leasing – Cost of leasing
-As with every other budgeting decision,
lease if the present value of the benefits of leasing exceeds the cost of leasing:
-Appropriate discount rate for NPV calculations is the after tax cost of debt: r =ir (b-T ) c
Why? Leasing imposes same sort of commitment (Ex. leverage) as does a long term debt
NAL = CLA – 0 (1-T )(1Cr) i ¿−n – CLA 0 -
NAL = -CLA + 0 (1-T )(1Cr) i ¿−n + CLA 0