* 21.1 Types of Leases
* The Basics
* A lease is a contractual agreement between a lessee and lessor. * The lessor owns the asset and for a fee allows the lessee to use the asset. * Buying versus Leasing
* Operating Leases
* Usually not fully amortized
* Usually require the lessor to maintain and insure the asset * Lessee enjoys a cancellation option
* Financial Leases
* Essentially opposite of an operating lease.
* Do not provide for maintenance or service by the lessor. * Financial leases are fully amortized.
* The lessee usually has a right to renew the lease at expiry. * Generally, financial leases cannot be cancelled. * Sale and Lease-Back
* A particular type of financial lease
* Occurs when a company sells an asset it already owns to another firm and immediately leases it from them. * Two sets of cash flows occur:
* The lessee receives cash today from the sale.
* The lessee agrees to make periodic lease payments, thereby retaining the use of the asset. * Leveraged Leases
* A leveraged lease is another type of financial lease. * A three-sided arrangement between the lessee, the lessor, and lenders: * The lessor owns the asset and for a fee allows the lessee to use the asset. * The lessor borrows to partially finance the asset. * The lenders typically use a nonrecourse loan. This means that the lessor is not obligated to the lender in case of a default by the lessee.
* 21.2 Accounting and Leasing
* In the old days, leases led to off-balance-sheet financing. * Today, leases are either classified as capital leases or operating leases. * Operating leases do not appear on the balance sheet. * Capital leases appear on the balance sheet—the present value of the lease payments appears on both sides. * Accounting and Leasing (Balance Sheet)
* Consider a firm with two assets: a truck and some land. * Capital Lease
* A lease must be capitalized if any one of the following is met: * The present value of the lease payments is at least 90 percent of the fair market value of the asset at the start of the lease. * The lease transfers ownership of the property to the lessee by the end of the term of the lease. * The lease term is 75 percent or more of the estimated economic life of the asset. * The lessee can buy the asset at a bargain price at expiry. * 21.3 Taxes, the IRS, and Leases
* The principal benefit of long-term leasing is tax reduction. * Leasing allows the transfer of tax benefits from those who need equipment but cannot take full advantage of the tax benefits of ownership to a party who can. * Naturally, the IRS seeks to limit this, especially if the lease appears to be set up solely to avoid taxes. * Taxes, the IRS, and Leases
* The lessee can deduct lease payments if the lease is qualified by the IRS. * The term must be less than 30 years.
* There can be no bargain purchase option.
* The lease should not have a schedule of payments that is very high at the start of the lease and low thereafter. * The lease payments must provide the lessor with a fair market rate of return. * The lease should not limit the lessee’s right to issue debt or pay dividends. * Renewal options must be reasonable and reflect fair market value of the asset. * 21.4 The Cash Flows of Leasing
* Consider a firm, ClumZee Movers, that wishes to acquire a delivery truck. * The truck is expected to reduce costs by $4,500 per year. * The truck costs $25,000 and has a useful life of 5 years. * If the firm...