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Wilfrid Laurier University
S I Li

Leasing Terminology -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. Lease Types -Service lease – usually a short term cancelable lease. Service is normally responsibility of lessor. -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. Air Canada When is a Lease a Capital Lease? -From CICA: -The lease transfers ownership of the property to the lessee by the end of the term of the lease -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 down -Obsolescence risk -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 decision -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 - ri 1+¿ 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 - 1−(¿¿ri¿) ¿ri ¿ 1+¿ contract ¿ NAL = -CLA + 0 (1-T )(1Cr) i ¿−n + CLA 0
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