Economics of Lease

Financing
Chapter 03
Course Code: FIN 403
Management of Financial Services

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Agenda
• Financial analysis for lease transaction: lessee’s
perspective
• Lessor’s perspective- Investment decision
• Pricing of lease facility and fixation of lease rental
• Buy or lease decision.

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The economics of leasing
(i) Leasing is an attractive method of financing the
acquisition of assets, especially for persons who have
limited capital.
(ii) It is a device for minimizing the risks that either
lessees or lessors associate with owning assets.
(iii) By dividing the rights to an asset between lessor and
lessee, leasing permits the parties to specialize in
different functions and to solve various impediments to
contracting that would be difficult to overcome among
separate owners.

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Sources/Scope of leasing
• Today, leases are used to acquire the rights to a very wide
variety of assets.
• Resources that are commonly leased include agricultural
land, mineral and timber rights, office buildings, shopping
centers, industrial and commercial equipment such as
ships, aircraft, farm machinery and computers, residences
including both freestanding houses and apartments, autos
and other motor vehicles, and furniture, among other
things.
• Other than ownership, the lease is probably the most
common legal form of holding assets throughout the world.

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 The World Practice of Leasing
• Modern legal systems recognize variations on the full-blown
agricultural lease, such as leases limited to the pasturing of animals.
• Private landowners frequently enter into timber, mineral, or oil and
gas leases (Brown, Fitzgerald, & Weber 2016).
• Extractive leases are especially important with respect to
government-controlled land.
• Leases of space for commercial offices, retail space in shopping
centres, and for warehouse and light industrial space.
• Leases of space for residential occupancy, including apartments,
townhouses, and freestanding homes are familiar and obviously
economically important.
• A large industry has emerged providing self-storage units, which are
leased, for persons and businesses in transition from one place or
situation in life to another.
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The Lease as a Financing Device
• The first function of leases is as a financing device.
• One can think of a lease as an arrangement in which one
party—the lessor—loans some asset to the other party—
the lessee—in return for payment.
• The payment is designed to compensate the lessor for
the opportunity cost of the resource, just as in the case
of any type of commercial loan.
• In a loan of money, we call the charge for the opportunity
cost of the funds “interest.”
• In a lease of physical assets, we call it “rent.”
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The Irrelevance Theorem
• Borrowing from the Modigliani–Miller theorem in
corporate finance (Modigliani & Miller,1958), the costs to
a firm of leasing an asset will be the same as the cost
of borrowing money to purchase the asset.
• According to the irrelevance proposition theorem, the
valuation of the company will remain the same
regardless of the net amounts of cash, debt, or equity
that it holds.
• Their theorem is also referred to as the capital structure
irrelevance principle or the Modigliani-Miller theorem.
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Why the Modigliani–Miller theorem
is irrelevance?
• Since the value of the firm
depends neither on its dividend
policy nor its decision to raise
capital by issuing shares or
selling debt,
• The Modigliani–Miller theorem is
often called the capital structure
irrelevance principle.

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The assumptions that yield the irrelevance
theorem in the lease-or-purchase context

• Capital markets are accessible to all lessors and lessees

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Get Less/Pay less
• The major advantage of leases as a financing device is
that they allow assets to be acquired at lower cost.
• Leases have always been, a type of financing device
preferred by persons who are constrained by their lack
of access to capital markets.
• This can be either because they have not accumulated
enough savings or investment capital to purchase the
asset outright, to satisfy the conditions required to obtain
a purchase-money loan.

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How does a lessor protect their
interests in lease negotiations?
• Lease Agreement Terms and Conditions
• Credit and Background Checks (e.g., CRR, KYC)
• Security Deposit and Insurance Requirements
• Guarantees and Co-signers
• Regular Property Inspections and Maintenance Clauses

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Leases as a Risk Management Device
• A second function of leases is to manage risk.
• Leasing can be used to reduce certain risks associated
with owning assets, but it also creates risks relative to
ownership.
• It’s a tool by both lessors and lessees to reduce the risk
associated with ownership of assets.
• It can be used to mitigate the risks created by leasing
itself.

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How Leases Can Reduce the Risks of
Ownership
• For lessors, an important feature of leases is that they
transfer the residual rights (sometimes called residual
claims) associated with an asset from the lessor to the
lessee for the duration of the lease (Barzel 1997, p. 38–
39).
• This was perceived by courts as early as the foundational
case of Paradine v. Jane.
• The lessee captures the upside gains associated with the
asset—high crop prices, increased demand for the
output of a machine, the rising value of occupancy of an
apartment due to a housing shortage.

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Sources of Risks Created by
Leasing
• Lessors face the risk of lessees failing to pay rent or
engaging in misconduct that damages the asset or
alienates other lessees.
• Lessees face the risk of lessors interfering with their
possession and use of the asset, perhaps by selling the
reversion to a third party.
• Another source of risk is created by the very division of
rights between the lessor and lessee.
• The lessee has present possession and use of the asset;
the lessor has the right to receive rent and to reclaim
possession after the lease has ended.
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Reasons Not to Lease
• Leasing creates conflicts of interest and problems of opportunism
that do not exist when one person is the sole owner of something.
• Because of the division of rights, leasing will in many cases provide
inferior incentives to make potentially valuable long-term
improvements.
• Leasing inevitably creates end-point problems, especially at the
termination of the lease.
• At the inception of the lease, both the lessee and the lessor typically
have market alternatives, which limits the bargaining power of each.
• Ownership invariably conveys greater discretion on the holder of an
asset than leasing; in other words, ownership does more to
promote autonomy.
• From the perspective of the lessee, ownership allows the
accumulation of assets that contribute to net worth in a way that
leasing does not.
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Financial analysis for lease
transaction: lessee’s perspective-
• Calculate the rent
• Calculate the operating expenses
• Calculate the income tax
• Calculate the cash flow
• Calculate the return on investment
• Calculate the break-even point

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Buy or lease decision
a. How to calculate the cost of leasing (Lease Depreciation
+ Lease Interest + Lease Sales tax) = Total cash outlay for
the lease
b. How to calculate the cost of purchasing (Sales tax +
Loan term and interest + Depreciation) = Total cash outlay
for the purchase.
c. Comparing both options and making a decision.

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Lessor’s perspective- Investment
decision
• Future Revenue Potential
• Company’s Financial Health
• Availability of Investment Alternatives
• Market Conditions
• Risk Appetite of the Investors

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What are three capital investment
decisions?
• Three types of capital investment decisions are:
-financing decisions, which deal with how funds are
raised;
-investment appraisal decisions, concerning how to
maximize profits on an investment; and
-dividend decisions, which centre on the amount of
earnings to be paid to shareholders.

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The Tactical Goal of Lease Pricing:
Lessor
• − Economics: achieve a defined, targeted rate of return.
• − Accounting: mirror the economics (generally capital lease
accounting).
[In a capital lease, the lessee (or the company renting the asset)
is treated as if they purchased the asset using borrowed funds.]
[Mirrors of the Economy shows how actors themselves change
norms and adopt new institutional solutions as more
appropriate to changed circumstances.]
• − Tax: maximize the available tax benefits while minimizing
re-characterization risk (passing true lease tests).
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The Tactical Goal of Lease Pricing:
Lessee
• Economics: net advantage to lease-vs-borrow or
lease-vs-buy, both quantitatively and qualitatively.
• Accounting: differentiate based on the substance or
the form of risk/reward shifting.

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Pricing Methods: Cost-Plus Pricing
• Identify & sum the costs Add profit margin
– Cost of funds – Credit rating as the basis
• Market benchmark: US – Interest Rate Floor
Treasury (Like-Maturity or • Target to achieve all-in rate &
Average) other measures
• Plus incremental borrowing – Yield: Implicit, IRR
cost
– Cash: Average pretax cash,
• Adjust based on market after-tax cash, or net present
instability value.
– Expected credit loss
– Administrative setup costs.

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Pricing Methods: Cost-Plus Pricing
Price to Market
• Obtain current market benchmarks
– Credit spreads
– Residuals: What’s hot, what’s not
– Tax capacity (active players)
• “Deals won, deals lost” analysis
• Target using active market assumptions
– Top line: Preferred yield based on product offering
– Residuals: Orderly liquidation value (published sources)
– Tax line: Generic (35%)
– Ignore cost of funds, explicit credit & administrative cost loads

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Pricing Throughout the Lease
Lifecycle
• Origination – provide multiple quotes
• Documentation – acceptance of one quote
• Mid-term changes
- Alteration of payment structure
- Swap out of asset
• Termination changes
-Early buy-out
-Asset replacement
-Like-kind exchange
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MACRS Depreciation
• “Modified Accelerated Cost Recovery System.”
• The formula to calculate MACRS Depreciation is as
follows:
= Cost basis of the asset X Depreciation rate
• MACRS is the primary depreciation method used for tax
purposes. It allows you to take a larger tax deduction in
the early years of an asset and less in later years.
• Depreciation is an important element of fixed asset
accounting, and many very small businesses use MACRS
to record depreciation on their books and tax returns.

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Practical problems
• The equipment costs $1,000,000, and, if it were purchased, Lewis could obtain a term loan
for the full purchase price at a 10 percent interest rate. Although the equipment has a six-
year useful life, it is classified as a special-purpose computer, so it falls into the MACRS 3-
year class. If the system were purchased, a 4-year maintenance contract could be obtained
at a cost of $20,000 per year, payable at the beginning of each year. The equipment would be
sold after 4 years, and the best estimate of its residual value at that time is $200,000.
However, since real-time display system technology is changing rapidly, the actual residual
value is uncertain.
• As an alternative to the borrow-and-buy plan, the equipment manufacturer informed Lewis
that Consolidated Leasing would be willing to write a 4-year guideline lease on the
equipment, including maintenance, for payments of $260,000 at the beginning of each year.
Lewis’s marginal federal-plus-state tax rate is 40 percent. You have been asked to analyze
the lease-versus-purchase decision, and in the process, to answer the following questions:
• 1. What is the present value cost of owning the equipment? (Hint: Set up a timeline that
shows the net cash flows over the period t = 0 to t = 4, and then find the PV of these net cash
flows or the PV cost of owning.)
• 2. Explain the rationale for the discount rate you used to find the PV.
• 3. What is Lewis’s present value cost of leasing the equipment? (Hint: again, construct a
timeline.)
• 4. What is the net advantage to leasing (NAL)? Does your analysis indicate that Lewis should
buy or lease the equipment? Explain.

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Thanks!
Question?

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