MAF334 University of the Western Cape
MANAGERIAL ACCOUNTING AND FINANCE 334
(MAF 334)
2018
Financing and Leasing
Contents:
1. Required readings
2. Module Objectives
3. Introduction
4. Module notes
Tutorial questions:
1. QU 15.4
2. QU 15.7
3. QU 15.9
4. QU 15.10
5. QU 15.13
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1. Required readings
th
Correia, Flynn, Uliana & Wormald; Financial Management 8 edition: Chapter 15
2. Module objectives
1. Outline the various types of leases and how each type of lease provides the right
to use an asset.
2. Identify the differences in treatment of leases for financial reporting, taxation and
finance.
3. Describe a direct lease, sale and lease-back and a leveraged lease.
4. Identify the advantages of leasing.
5. Evaluate the leasing decision and alternative sources of finance using
discounted cash flows by being able to:
- select and justify an appropriate discount rate, and
- calculate the net present cost of the various financing alternatives and the
net advantage of leasing
3. Introduction
A lease is a contract providing a right to the use of assets, legally owned by the lessor, in
exchange for a specified rental paid by the lessee.
It is important to notice the importance of leasing, as leasing is a source of finance. Refer
back to work covered in capital structure.
Lease rentals are normally paid at the beginning of the month in the period covered by the
lease. It is included in the gross taxable income of the lessor. The lessee can deduct the lease
payment when calculating his gross income. It enables the transfer of tax breaks to the lessor.
Options specified in original lease agreement: choice of renewing lease, acquiring the asset,
or returning the asset.
Leasing is a widespread form of medium-term financing and long term financing.
We explore the use of DCF using Kd as the relevant discount rate.
EXERCISE: Briefly discuss why financing cash flows should be discounted at the after-
tax cost of debt rather than the weighted average cost of capital (WACC).
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4. Module notes
Types of leases
Leasing is an important source of finance for South African companies:
i. Leasing = 50% of all capital equipment financing
ii. Hire purchase and other finance = the other 50%
There are different types of leases and the treatment varies between financial reporting,
taxation and finance. From a finance perspective only the cash flows (direct and as a result of
taxation) are important. The new IFRS 16 on leases have different terminology and treatment
of leases than the Income Tax Act. It is therefore important to make sure that you understand
the differences and how this affects the cash flows.
Structuring of leases
i. Direct lease: Lessor acquires asset from manufacturer to lease to lessee.
ii. Sale and lease-back: A company sells an asset it owns under an agreement to lease it
back.
iii. Leveraged lease: Financial institution provides financing and lessor obtains right to
lease payments after paying loan costs.
Advantages of leasing
The advantages of leasing extend beyond possible tax benefits of leasing. The following are
some of the advantages of leasing.
Taxation
The full lease payment is deductible whilst for debt; only the interest component is tax
deductible. If a firm has an assessed loss or has inadequate taxable income against which to
claim depreciation deductions, then by leasing the plant from a profitable lessor, the lessee
can transfer tax shields to the lessor. The lessor would then lower the required interest
resulting in lower lease instalments, thus sharing the savings with the lessee.
Technology
If the industry is subject to rapid technological changes, then leases may be structured
whereby the lessor will take on the risk of technological obsolescence and the lessee will be
able to upgrade to a newer model or version. This is particularly true in the IT sector.
100% debt financing
Often, the lessee will be able to obtain 100% financing as no deposit will be required. Often,
with a loan or hire-purchase agreement, the lessee will need to offer an initial deposit. The
equipment will form the security for the lessor who is able to efficiently dispose of equipment
and make a market in leased equipment.
Operating flexibility
The use of operating leases will enable the firm to react quickly to changes in market
conditions. The example used in the textbook relates to the leasing of airplanes for specific
routes which are no longer profitable. The current leased planes were right for those routes
but not for other profitable routes. The lessee can arrange to swap its leased planes for other
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better suited planes with the lessor, whilst if owned, the sale and purchase of aircraft would
result in significant costs and time delays.
Increases in demand
If demand increases quickly, the firm will be able to increase its services or production levels
more quickly by leasing the equipment rather than by outright purchase. Further, if an
industry is subject to a huge increase in demand in a short space of time, then there will be a
shortage of the relevant equipment and equipment suppliers will tend to first supply its large
customers, being the leasing companies. Therefore, to reduce time delays and protect its
market share, it may be preferable to be linked to a leasing company for the supply of capital
equipment.
Specialisation effects
Leasing companies are able to negotiate more effectively with equipment manufacturers and
are able to negotiate quantity discounts. Further, leasing companies become specialists in
relation to maintenance and will often be able to organise higher resale values for used
equipment.
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Standardisation of contracts
Leasing agreements are standardised which reduce the administrative work required as
compared to customised loan agreements.
Fewer restrictions
There will be fewer restrictions on the general operating decisions of the company as the
lessor is looking to the asset as security for the lease. The firm may be required to undertake
certain maintenance work on the asset.
Off-balance sheet financing
In certain industry sectors, such as the airline industry and other industry sectors with long-
lived asset lives, the structuring of leases may occur such that the leases are classified as
operating leases and thereby do not have to be disclosed as assets on the company’s balance
sheet. This will result in a lower reported level of financial leverage.
Avoidance of capital expenditure controls and budgetary constraints
Companies often impose strict controls on capital expenditure decisions which may not
extend to the entering of operating leases to acquire the same equipment. Management will
then enter into agreements to acquire such equipment using leasing structures to overcome
such controls or other limitations such as budgetary constraints.
Evaluating the Leasing Decision
i. Lease vs. borrow & purchase.
ii. Leasing is an alternative to borrowing.
iii. Evaluation of leasing usually takes place once the investment decision has been made.
iv. Evaluation = comparison of PV of lease cash flows to PV of borrow and purchase
cash flows.
v. What is the appropriate discount rate? The after tax cost of Debt. If company has
assessed losses, it will defer tax shields.
Investment decision
Assets = WACC
Finance decision
Equity = Ke
Debt = Kd(1-t)
vi. Remember: Investment decisions – use the firm’s WACC to evaluate the project’s
cash flows.
vii. Leasing is a financing decision – the correct discount rate is the after-tax cost of debt.
viii. Principle = financing cash flows are discounted at the after-tax cost of debt.
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EXAMPLE
Cost of plant: R500 000. Loan at interest rate of 9.7222% or plant can be leased at R125 000
per year, payable annually in advance. Lease includes maintenance but if purchased, repairs
will amount to R25 000 per year. Residual value is R70 000. Before tax cost of debt is
9.7222% and WACC is 12%.
What is the NPC of the LEASE OPTION?
What is the NPC of the borrow-and-purchase alternative?
Therefore lease the plant.
We can do the above using an incremental analysis.
Please note: By leasing we save the cost of R500 000 and the other costs of ownership but we
lose the residual value and depreciation deductions.
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Conclusion
It is estimated that about $450 billion of assets in the USA are financed with leases.
In South Africa, taxation effects are probably the reason for initial growth of leasing in South
Africa.
However, leasing also provides flexibility, focus and specialisation.
Sources: Financial Management , Carlos Correia et al, Juta
Gripping GAAP – (2012 Edition) - CL Sowden-Service Lexis Nexis
Combining the investment and financing decision where there is asset-specific finance:
(Source: Financial Management, page 15-17, Carlos Correia et al, Juta)
YES Is the net present NO
value positive?
Is the net advantage of Is the net advantage of the
leasing positive? asset-specific lease
positive?
YES NO YES NO
Ignore
Is the NPV plus
Lease the Borrow and
NAL positive?
asset purchase the
asset
YES NO
Lease the
Ignore
asset
Do 15-17 as a class example.
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