Lecture09 - FIN2101 FIN2101 BUSINESS FINANCE II Module 8...

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Unformatted text preview: FIN2101 FIN2101 BUSINESS FINANCE II Module 8 Analysis of Leases Student Activities Student Activities Reading Text, Chapter 18 (pp. 652­61 only) Text Study Guide, Chapter 18 (part only) Study Book, Module 8 Tutorial Activities Self Assessment Activity 8.1 Text Study Guide, Chapter 18, T/F 1­2, M/C 1­4, Problem 1 Lease Finance Providers Lease Finance Providers Lease finance commitments, by type of lessor Source 1999-2000 2000-2001 2001-2002 Banks $3 135m $2 062m $1 905m Finance companies $2 556m $1 571m $1 812m General financiers $1 472m $1 580m $1 625m Other $ 744m $ 849m $1 271m Totals $7 908m $6 061m $6 613m Source: ABS, Year Book Australia 2003, Table 26.26 Assets Leased Assets Leased Lease finance commitments, by type of goods leased Type of Asset 1999-2000 2000-2001 2001-2002 MV & other transport $3 639m $2 529m $2 844m Construction & earth moving equipment $ 319m $ 217m $ 232m Agricultural machinery & equipment $ 328m $ 212m $ 220m Automatic data processing equipment & office machinery $1 996m $1 944m $2 124m Shop and office furniture, fittings & equipment $ 454m $ 343m $ 340m Other goods $1 171m $ 815m $ 857m Totals $7 907m $6 060m $6 617m Source: ABS, Year Book Australia 2003, Table 26.27 Definitions Definitions LEASE ­ A contract which grants a lessee the right to use an asset in return for periodic payments to the lessor. LESSOR ­ The owner of the asset. LESSEE ­ The party leasing the asset from its owner. Lease Document Lease Document Terms of the lease. Asset to be leased. Payments ­ when and how much? Obligations of lessee and lessor ­ who pays for insurance, maintenance, etc. Whether lessee may acquire the asset at the end of the lease. Cancellation provisions. Types of Leases Types of Leases Operating lease ­ short­term (5 years or less). The term of the lease is usually less than the economic life of the asset. Financial lease ­ more long­term. The economic life of the asset and the term of the lease are approximately equal. Basic characteristics of each covered in text, pp. 652­4. Operating Lease Operating Lease Risks and rewards rest with lessor. Generally cancellable at virtually no cost. Sum of lease payments less than the initial cost to the lessor. May have a separate or inclusive maintenance contract whereby the lessor assumes responsibility for maintenance of the asset ­ service or maintenance lease. Equipment reverts back to the lessor when lease is terminated. Finance Lease Finance Lease Lessee incurs most of the risks and enjoys most of the benefits. Lessee normally responsible for maintenance, etc. Non­cancellable by either party. Sum of lease payments exceeds the value of the leased asset. Lessee guarantees the residual value. Residual Value Residual Value An option for the lessee to purchase the asset cannot be explicitly provided for in the lease agreement. However, the lessee indemnifies the lessor for any loss resulting from the sale at the end of the lease term. Usually through the lessee purchasing the asset for the original residual value (usually between 10% and 40% of the original cost). Australian Case Australian Case Term generally less than economic life. Cancellable (by the lessee). Total of lease payments usually less than purchase price. Types of Financial Leases Types of Financial Leases Sale and Lease­Back Agreement text, pp. 653 Leveraged Lease text, pp.653­4 Sale and Lease­Back Agreement Sale and Lease­Back Agreement The owner of the asset sells it to another party (for an amount usually equal to its market value) who becomes the lessor by leasing it back to the former owner. Quite common in real estate. A way of generating cash without having to part with use of the asset. Leveraged Lease Leveraged Lease Often used to finance large­scale projects (typically in excess of $15 million). Lessor borrows most of the funds. Common where it is difficult to find a lessor who is able to finance the acquisition and able to absorb the full benefits of the tax deductibility of depreciation and interest costs. Parties to a Leveraged Lease Parties to a Leveraged Lease Broker ­ organises and manages the lease. Lender(s) ­ debt participants lending between 70% and 80% to the lessor. Lessor(s) ­ provide the balance of the funds. Lessee Advantages of Leases Advantages of Leases TO LESSOR: Cheap way of acquiring asset. Residual value. Retains ownership in case of default. Receives tax shields. Advantages of Leases Advantages of Leases TO LESSEE: Use of asset but avoids big cash outlay. Flexible way of acquiring use of an asset for a short period of time. For an operating lease, the burden rests with lessor who is responsible for maintenance, etc. Relatively low lease payments. Flexible finance. Disadvantages of Leases Disadvantages of Leases FOR LESSOR: Burden of maintenance, operating costs, etc (for operating lease). Loss of tax benefits advantage. Risk of obsolescence. Disadvantages of Leases Disadvantages of Leases FOR LESSEE: Burden of operating and maintenance costs (for financial lease). Risk of obsolescence. No direct access to tax benefits associated with ownership. Accounting for Operating Leases Accounting for Operating Leases Operating leases need not be capitalised. The basic features of an operating lease must be disclosed in a footnote to the firm’s financial statements. Accounting for Financial Leases Accounting for Financial Leases AAS17 requires explicit disclosure of financial lease obligations on the firm’s balance sheet. Lease payments under a financial lease must be capitalised, ie the PV of all lease payments is included as an asset and a corresponding liability on the balance sheet. Operating vs Financial Lease Operating vs Financial Lease The classification of a lease should depend on the economic substance of the transaction rather than a literal application of the guidelines in AAS17. Provided that substantially all of the risks and benefits associated with ownership are effectively transferred to the lessee, the lease is then a financial lease and should be capitalised. Tax Implications Tax Implications LESSOR: Benefit of depreciation tax savings (DTS). Lease payments received are taxable. LESSEE: Lease payments under a ‘genuine lease’ are tax deductible if the leased asset is used to generate taxable income. Setting Lease Rentals Setting Lease Rentals Manning Leasing wants to set a lease rate that provides it with a satisfactory risk­adjusted return. Manning’s after­tax return on leases is 6%, and its marginal tax rate is 30%. The cost of the asset involved is $150 000, and it will be depreciated over its 6­year life using the straightline method. Assume lease payments are in advance. Calculate the minimum annual lease payment that Manning should quote. Solution Solution Step 1 – Calculate PV of Ownership $150 000 PV = - $150 000 + × 0.30 × PVIFA0.06,6 6 = - $150 000 + ( $7 500 × 4.917 ) = - $150 000 + $36 877.50 = - $113 122.50 Step 2 – Calculate Minimum After-tax LPs $113 122.50 = LP + ( LP × PVIFA0.06,5 ) $113 122.50 = LP + 4.212 LP $113 122.50 LP = 5.212 LP = $21 704.24 Step 3 – Calculate Minimum Before-tax LPs LPB- tax LPA - tax = 1- T $21 704.24 = 1 - 0.30 = $31 006.06 Financial Evaluation of Leases Financial Evaluation of Leases Lease vs borrow and purchase. NPV of lease option must be cheaper than cost of an equivalent loan. Use the after­tax cost of debt as discount rate. Discount Rate Discount Rate Financial leases have the same characteristics of secured debt finance: the security is the leased asset; the lessor is the provider of the finance. Lease contract is considered to be the same as debt ­ impacts on the debt capacity and gearing ratio of the firm. Compare lease finance to debt finance. Leasing Example Leasing Example Purchase price $180 000 Depreciation ­ straightline to zero Annual lease payments $50 000 Before­tax cost of debt 10% p.a. Life (and lease period) 4 years Tax rate 30% Assumptions Assumptions All operating, maintenance and insurance costs are borne by the lessee. Lease payments are made at the end of the year (in arrears). Tax is in the same year. The company will be profitable over the 4 years of the lease. Option 1 ­ Purchase the Asset Option 1 ­ Purchase the Asset Time Period 0 1 2 3 4 Initial Outlay -180 000 DTS (Note 1) 13 500 13 500 13 500 13 500 NCF -180 000 13 500 13 500 13 500 13 500 DCF @ 7% (Note 2) 1 0.935 0.873 0.816 0.763 NPV = Present Value -180 000 12 623 11 786 11 016 10 301 -$134 274 Option 2 ­ Lease the Asset Option 2 ­ Lease the Asset Time Period 0 1 2 3 4 B-tax Tax Savings Lease on LP Payments (See Note 3) -50 000 -50 000 -50 000 -50 000 15 000 15 000 15 000 15 000 NCF DCF (@ 7%) Present Value -35 000 -35 000 -35 000 -35 000 0.935 0.873 0.816 0.763 NPV = -32 725 -30 555 -28 560 -26 705 -$118 545 Conclusion: Leasing is the lower cost alternative by $15 729. Incremental Analysis Approach Incremental Analysis Approach What is the advantage of leasing, if any? Time Period 0 1 2 3 4 Initial Cost Avoided 180 000 A-tax LP -35 000 -35 000 -35 000 -35 000 DTS Foregone -13 500 -13 500 -13 500 -13 500 NCF 180 000 -48 500 -48 500 -48 500 -48 500 DCF Present (@ 7%) Value 1 0.935 0.873 0.816 0.763 NPV = 180 000 -45 348 -42 341 -39 576 -37 006 $15 729 Conclusion: NPV > 0, lease. The NAL is $15 729. Lease Payments in Advance Lease Payments in Advance Time Period 0 1 2 3 4 Initial Cost Avoided 180 000 A-tax LP -35 000 -35 000 -35 000 -35 000 DTS Foregone -13 500 -13 500 -13 500 -13 500 NCF 145 000 -48 500 -48 500 -48 500 -13 500 DCF Present (@ 7%) Value 1 0.935 0.873 0.816 0.763 NPV = 145 000 -45 348 -42 341 -39 576 -10 301 $7 434 Conclusion: NPV > 0, lease. The NAL is $7 434. Salvage Value $40 000 End Year 4 Salvage Value $40 000 End Year 4 Time Period Initial Cost Avoided A-tax LP 0 1 2 3 4 180 000 -35 000 -35 000 -35 000 -35 000 DTS Foregone -13 500 -13 500 -13 500 -13 500 A-tax Salvage Value Foregone -28 000 NCF DCF (@ 7%) Present Value 145 000 -48 500 -48 500 -48 500 -41 500 1 0.935 0.873 0.816 0.763 NPV = 145 000 -45 348 -42 341 -39 576 -31 665 -$13 930 Conclusion: NPV < 0, borrow and purchase. ...
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This note was uploaded on 12/06/2011 for the course BUSINESS Finance taught by Professor Qilei during the Summer '11 term at Tianjin University.

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