21

Leasing
Have you ever flown on General Electric (GE) Air- does. But why is GECAS in the business of buying
lines? Probably not; but with about 2,000 planes, GE assets, only to lease them out? And why don’t the
Capital Aviation Services (GECAS), part of GE, owns companies that lease from GECAS purchase the
one of the largest aircraft fleets in the world. In fact, assets themselves? This chapter answers these and
this financing arm of GE owns more than $45 billion other questions associated with leasing.
in assets, generated about $7.3 billion in profits dur-
ing 2017, and has more than 250 customers in 76
countries. Why does GECAS own so many planes? It Please visit us at rwjcorporatefinance.blogspot.com
turns out more than 40 percent of all commercial for the latest developments in the world of corporate
jetliners worldwide are leased, which is what GECAS finance.

21.1 Types of Leases

The Basics
A lease is a contractual agreement between a lessee and lessor. The agreement establishes
that the lessee has the right to use an asset and in return must make periodic payments
to the lessor, the owner of the asset. The lessor is either the asset’s manufacturer or an
independent leasing company. If the lessor is an independent leasing company, it must
buy the asset from a manufacturer. Then the lessor delivers the asset to the lessee, and
the lease goes into effect.
As far as the lessee is concerned, it is the use of the asset that is most important,
not who owns the asset. The use of an asset can be obtained by a lease contract. Because
the user also can buy the asset, leasing and buying involve alternative financing arrange-
ments for the use of an asset. This is illustrated in Figure 21.1.
The specific example in Figure 21.1 happens often in the computer industry. Firm U,
the lessee, might be a hospital, a law firm, or any other firm that uses computers. The
lessor is an independent leasing company that purchased the equipment from a manufac-
turer such as IBM or Apple. Leases of this type are called direct leases. In the figure, the
lessor issued both debt and equity to finance the purchase.
Of course, a manufacturer like Boeing could lease its own airplanes, though we do
not show this situation in the example. Leases of this type are called sales-type leasing.
In this case, Boeing would compete with the independent leasing company.

712

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 Chapter 21 Leasing  ■■■  713

Figure 21.1 Buying versus Leasing

Buy Lease
Firm U buys asset and uses asset; Firm U leases asset from lessor;
financing
cing raised by debt and equity. the lessor owns the asset.

Manufacturer Manufacturer
of asset of asset

Firm U buys asset

Lessor buys asset.
from manufacturer.
Firm U Lessor Lessee (Firm U) Firm U
1. Uses asset. 1. Owns asset. 1. Uses asset. leases asset
2. Owns asset. 2. Does not use asset. 2. Does not own asset.
Creditors and from lessor.
equity shareholdersrs
supply financing too Creditors and shareholders
m U.
Firm supply financing to lessor.

Equity Equity
Creditors Creditors
shareholders shareholders

Operating Leases
Years ago, a lease where the lessee received an operator along with the equipment was
called an operating lease. Though the operating lease defies an exact definition today, this
form of leasing has several important characteristics:
1. Operating leases are usually not fully amortized. This means that the payments
required under the terms of the lease are not enough to recover the full cost of the
asset for the lessor. This occurs because the term, or life, of the operating lease is
usually less than the economic life of the asset. The lessor expects to recover the
costs of the asset by renewing the lease or by selling the asset for its residual value.
2. Operating leases usually require the lessor to maintain and insure the leased assets.
3. Perhaps the most interesting feature of an operating lease is the cancellation option.
This option gives the lessee the right to cancel the lease contract before the expiration
date. If the option to cancel is exercised, the lessee must return the equipment to the
lessor. The value of a cancellation clause depends on whether future technological or
economic conditions are likely to make the value of the asset to the lessee less than
the value of the future lease payments under the lease.
To leasing practitioners, the preceding characteristics constitute an operating lease.
However, accountants use the term in a slightly different way, as we will see shortly.

Financial Leases
Financial leases are the exact opposite of operating leases, as is seen from their important
characteristics:

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 714  ■■■  Part V Long-Term Financing

1. Financial leases do not provide for maintenance or service by the lessor.

2. Financial leases are fully amortized.
3. The lessee usually has a right to renew the lease on expiration.
4. Generally, financial leases cannot be canceled. In other words, the lessee must make
all payments or face the risk of bankruptcy.
Because of these characteristics, particularly (2), this lease provides an alternative
method of financing to purchase. Hence, its name is a sensible one. Two special types of
financial leases are the sale and leaseback arrangement and the leveraged lease
arrangement.

Sale and Leaseback A sale and leaseback occurs when a company sells an asset
it owns to another firm and immediately leases it back. In a sale and leaseback, two things
happen:
1. The lessee receives cash from the sale of the asset.
2. The lessee makes periodic lease payments, thereby retaining use of the asset.
For example, in October 2017, grocer Albertsons announced that it had signed an
agreement with a real estate investor on the `720 million sale and leaseback of 71 com-
pany-owned stores. And, in January 2017, in an ironic twist, Finnish rental equipment
company Ramirent completed the €15 million sale and leaseback of its Norwegian
property.
In India, typically, companies going through a short-term liquidity crisis go in for
such a deal. State-owned carrier Air India had sold 9 of its 21 Dreamliner’s (Boeing B787)
to raise over `7,000 crores to fund new aircraft acquisition and repayment of bridge loans
availed to acquire these dream liners. The company would lease back these 9 aircraft
under operating lease for 12 months. In the past, the airline had sold the remaining 12
of the 21 dream liners and leased back. A similar pattern of sale and lease back was
adopted by SpiceJet Airlines during their early years.

Leveraged Leases A leveraged lease is a three-sided arrangement among the les-

see, the lessor, and the lenders:
1. As in other leases, the lessee uses the assets and makes periodic lease payments.
2. As in other leases, the lessor purchases the assets, delivers them to the lessee, and
collects the lease payments. However, the lessor puts up no more than 40 to 50 per-
cent of the purchase price.
3. The lenders supply the remaining financing and receive interest payments from the
lessor. The arrangement on the right side of Figure 21.1 would be a leveraged lease
if the bulk of the financing was supplied by creditors.
The lenders in a leveraged lease typically use a nonrecourse loan. This means that the
lessor is not obligated to the lender in case of a default. However, the lender is protected
in two ways:
1. The lender has a first lien on the asset.
2. In the event of loan default, the lease payments are made directly to the lender.

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 Chapter 21 Leasing  ■■■  715

The lessor puts up only part of the funds but gets the lease payments and all the tax
benefits of ownership. These lease payments are used to pay the debt service of the non-
recourse loan. The lessee benefits because, in a competitive market, the lease payment is
lowered when the lessor saves taxes. A case in point is a leveraged lease deal done by
IL&FS Limited recently. This cross-border leveraged lease involved a product tanker for
Chemplast Sanmar Limited.

21.2 Accounting and Leasing

Before November 1976, a firm could arrange to use an asset through a lease and not
disclose the asset or the lease contract on the balance sheet. Lessees needed to report
information on leasing activity only in the footnotes of their financial statements. Thus,
leasing led to off-balance sheet financing.
In November 1976, the Financial Accounting Standards Board (FASB) issued its
Statement of Financial Accounting Standards No. 13 (FAS 13), “Accounting for Leases.”
Under FAS 13, certain leases are classified as capital leases. For a capital lease, the pres-
ent value of the lease payments appears on the right side of the balance sheet. The identi-
cal value appears on the left side of the balance sheet as an asset. Operating leases are
not disclosed on the balance sheet except in the footnotes. Exactly what constitutes a
financial or operating lease for accounting purposes will be discussed in a moment.
Beginning in 2019, companies will be required to disclose operating leases on their
balance sheets, which is a major change. The implication is that most leases will be
reported on the balance sheet, so off-balance sheet financing will be largely eliminated
(at least from leasing activities).
The accounting implications of this distinction are illustrated in Table 21.1. Imagine
a firm that, years ago, issued `100,000 of equity to purchase land. It now wants to use a
`100,000 truck, which it can either purchase or lease. The balance sheet reflecting pur-
chase of the truck is shown at the top of the table assuming the truck is financed entirely
with debt. Alternatively, imagine that the firm leases the truck. If the lease is judged to
be an operating one, the middle balance sheet is created. Here, neither the lease liability

Table 21.1 Balance Sheet

Examples of
Balance Sheets Truck is purchased with debt (the company owns a `100,000 truck):
under FAS 13 Truck `100,000 Debt `100,000
Land 100,000 Equity 100,000
Total assets `200,000 Total debt and equity `200,000
Operating lease (the company has an operating lease for the truck):
Truck ` 0 Debt ` 0
Land 100,000 Equity 100,000
Total assets `100,000 Total debt and equity `100,000
Capital lease (the company has a capital lease for the truck):
Assets under capital lease `100,000 Obligations under capital lease `100,000
Land 100,000 Equity 100,000
Total assets `200,000 Total debt and equity `200,000

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 716  ■■■  Part V Long-Term Financing

nor the truck appears on the balance sheet. The bottom balance sheet reflects a capital
lease. The truck is shown as an asset and the lease is shown as a liability.
Accountants generally argue that a firm’s financial strength is inversely related to the
amount of its liabilities. Because the lease liability is hidden with an operating lease, the
balance sheet of a firm with an operating lease looks stronger than the balance sheet of
a firm with an otherwise identical capital lease. Given the choice, firms would probably
classify all their leases as operating ones. Because of this tendency, FAS 13 states that a
lease must be classified as a capital one if at least one of the following four criteria is met:
1. 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.
2. The lease transfers ownership of the property to the lessee by the end of the term of
the lease.
3. The lease term is 75 percent or more of the estimated economic life of the asset.
4. The lessee can purchase the asset at a price below fair market value when the lease
expires. This is frequently called a bargain purchase price option.
These rules capitalize leases that are similar to purchases. The first two rules capital-
ize leases where the asset is likely to be purchased at the end of the lease period. The
last two rules capitalize long-term leases.
Some firms have tried to cook the books by exploiting this classification scheme.
Suppose a trucking firm wants to lease a `200,000 truck that it expects to use for 15 years.
A clever financial manager could try to negotiate a lease contract for 10 years with lease
payments having a present value of `178,000. These terms would get around Criteria 1
and 3. If Criteria 2 and 4 could be circumvented, the arrangement would be an operating
lease and would not show up on the balance sheet.
Does this sort of gimmickry pay? The semistrong form of the efficient capital markets
hypothesis implies that stock prices reflect all publicly available information. As we dis-
cussed earlier in this text, the empirical evidence generally supports this form of the
hypothesis. Though operating leases do not appear in the firm’s balance sheet, informa-
tion about these leases must be disclosed elsewhere in the annual report. Because of this,
attempts to keep leases off the balance sheet will not affect stock price in an efficient
capital market.

21.2a Indian Accounting Standard (Ind AS)

116 on Leases
In 2009, the Ministry of Corporate Affairs, Government of India, issued the converged
Indian Accounting Standards (Ind ASs), for leasing. It was Ind AS 17. In 2019, the Min-
istry of Corporate Affairs (MCA) notified Ind AS 116, the new leases accounting standard
replacing the earlier accounting guidance in Ind AS-17, ‘Leases’. The objectives of Ind
AS 116 are to prescribe, for lessees and lessors, the appropriate accounting policies and
disclosures in relation to finance leases and operating leases.
Unlike past practices, Ind AS 116 eliminated the classification of leases as a finance
lease or operating lease. It introduces a single on-balance sheet accounting model wherein
reporting of the operating leases on-balance sheet as if the company has borrowed funds
to purchase an interest in the leased asset. Hence, the assets taken on lease would be

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 Chapter 21 Leasing  ■■■  717

recognized as assets having a corresponding lease liability, claiming depreciation and

interest expense on the lease liability.
A lessor shall classify each of its leases as either an operating lease or a finance lease.
A lease is classified as a finance lease if it transfers substantially all the risks and rewards
incidental to ownership of an underlying asset. A lease is classified as an operating lease
if it does not transfer substantially all the risks and rewards incidental to ownership of an
underlying asset. Ind AS 116 applies to all leases including sub-lease. The standard is
applicable to hire purchase transactions as well.

21.3 Taxes, the Income Tax Authorities, and

Leases
The lessee can deduct lease payments for income tax purposes if the lease is qualified by
the Internal Revenue Service (in the U.S.A.) or the Income Tax Authority (in India).
Because tax shields are critical to the economic viability of any lease, all interested parties
generally obtain an opinion from the Income Tax Authorities before agreeing to a major
lease transaction. The opinion of the Income Tax Authorities will reflect the following
guidelines:
1. The term of the lease must be less than 30 years. If the term is greater than 30 years,
the transaction will be regarded as a conditional sale.
2. The lease should not have an option to acquire the asset at a price below its fair
market value. This type of bargain option would give the lessee the asset’s residual
scrap value, implying an equity interest.
3. The lease should not have a schedule of payments that is very high at the start of the
lease term and thereafter very low. Early balloon payments would be evidence that the
lease was being used to avoid taxes and not for a legitimate business purpose.
4. The lease payments must provide the lessor with a fair market rate of return. The profit
potential of the lease to the lessor should be apart from the deal’s tax benefits.
5. The lease should not limit the lessee’s right to issue debt or pay dividends while the
lease is operative.
6. Renewal options must be reasonable and reflect the fair market value of the asset.
This requirement can be met by granting the lessee the first option to meet a compet-
ing outside offer.
The reason the Income Tax Authorities is concerned about lease contracts is that
many times they appear to be set up solely to avoid taxes. To see how this could happen,
suppose a firm plans to purchase a `1 million bus that has a 5-year class life. Deprecia-
tion expense would be `200,000 per year, assuming straight-line depreciation. Now sup-
pose the firm can lease the bus for `500,000 per year for two years and buy the bus for
`1 at the end of the 2-year term. The present value of the tax benefits from acquiring the
bus would clearly be less than if the bus were leased. The speedup of lease payments
would greatly benefit the firm and give it a form of accelerated depreciation. If the tax
rates of the lessor and lessee are different, leasing can be a form of tax avoidance.

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 718  ■■■  Part V Long-Term Financing

In India, Central Board of Direct Taxes (CBDT) committee proposed Tax Accounting
Standards or TAS in 2013.While significant deviations have been proposed impacting the
computation of taxable income, one significant area is the arrangement of right to use
assets or lease. For finance lease, TAS-12 proposes that the classification should be based
on the substance of the lease rather than the form. The lessee would be entitled to tax
depreciation on the leased asset if a joint confirmation on the lease classification has been
executed. The finance income component, both in the case of the lessor and the lessee,
should be apportioned over the lease tenure. For operating lease, in line with AS-19,
TAS-12 recommends that income/ expense be recognized on a straight-line basis. Tax
depreciation would be claimed by the lessor, subject to execution of joint confirmation
on classification.

21.4 The Cash Flows of Leasing

In this section, we identify the basic cash flows used in evaluating a lease. Consider the
decision confronting the Wadia Company, which manufactures pipe. Business has been
expanding, and Wadia currently has a 5-year backlog of pipe orders for the Barauni-Malda
Pipeline.
The International Boring Machine Corporation (IBMC) makes a pipe-boring machine
that can be purchased for `10,000. Wadia has determined that it needs a new machine,
and the IBMC model will save Wadia `6,000 per year in reduced electricity bills for the
next five years. These savings are known with certainty because Wadia has a long-term
electricity purchase agreement with State Power Distribution Firms.
Wadia has a corporate tax rate of 21 percent. For simplicity, we assume that 5-year
straight-line depreciation is used for the pipe-boring machine and the machine will be
worthless after five years.
Falguni Leasing Corporation has offered to lease the same pipe-boring machine to
Wadia for `2,500 per year for five years. With the lease, Wadia would remain responsible
for maintenance, insurance, and operating expenses.1
Sanjay Surana, a recently hired MBA, has been asked to calculate the incremental
cash flows from leasing the IBMC machine in lieu of buying it. He has prepared Table 21.2,
which shows the direct cash flow consequences of buying the pipe-boring machine and
also signing the lease agreement with Falguni Leasing.
To simplify matters, Sanjay Surana has prepared Table 21.3, which subtracts the direct
cash flows of buying the pipe-boring machine from those of leasing it. Noting that only
the net advantage of leasing is relevant to Wadia, he concludes the following from his
analysis:
1. Operating costs are not directly affected by leasing. Wadia will save `4,740 (after
taxes) from use of the IBMC boring machine regardless of whether the machine is
owned or leased. This cash flow stream does not appear in Table 21.3.
2. If the machine is leased, Wadia will save the `10,000 it would have used to purchase
the machine. This saving shows up as an initial cash inflow of `10,000 in Year 0.
3. If Wadia leases the pipe-boring machine, it will no longer own this machine and must
give up the depreciation tax benefits. These lost tax benefits show up as an outflow.

1
We have assumed that lease payments are made at the end of each year. In practice, most leases require lease payments to be
made at the beginning of the year.

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 Chapter 21 Leasing  ■■■  719

Table 21.2 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cash Flows to
Wadia from Buy
Using the Cost of machine −`10,000
IBMC Pipe- Aftertax operating savings
Boring   [`4,740 = `6,000
Machine: Buy    × (1 − .21)] `4,740 `4,740 `4,740 `4,740 `4,740
versus Lease Depreciation tax
  benefit* 420 420 420 420 420
Total −`10,000 `5,160 `5,160 `5,160 `5,160 `5,160
Lease
Lease payments −`2,500 −`2,500 −`2,500 −`2,500 −`2,500
Tax benefits of
  lease payments
  (`525 = `2,500 × .21) 525 525 525 525 525
Aftertax operating savings 4,740 4,740 4,740 4,740 4,740
Total `2,765 `2,765 `2,765 `2,765 `2,765

*Depreciation is straight-line. Because the depreciable base is `10,000, depreciation expense per year is `10,000/5
= `2,000.
The depreciation tax benefit per year is equal to:
Tax rate × Depreciation expense per year = .21 × `2,000 = `420

Table 21.3 Lease Minus Buy Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Incremental
Cash Flow Lease
Consequences Lease payments −`2,500 −`2,500 −`2,500 −`2,500 −`2,500
for Wadia from Tax benefits of
Leasing Instead   lease payments 525 525 525 525 525
of Purchasing Buy (minus)
Cost of machine −(−`10,000)
Lost depreciation
  tax benefit −420 −420 −420 −420 −420
Total `10,000 −`2,395 −`2,395 −`2,395 −`2,395 −`2,395

The bottom line presents the cash flows from leasing relative to the cash flows from purchase. The cash flows would
be exactly the opposite if we considered the purchase relative to the lease.

4. If Wadia chooses to lease the machine, it must pay `2,500 per year for five years.
The first payment is due at the end of the first year. (This is a break: Often the first
payment is due immediately.) The lease payments are tax deductible and, as a con-
sequence, generate tax benefits of `525 (= .21 × `2,500).
The net cash flows have been placed in the bottom line of Table 21.3. These numbers
represent the cash flows from leasing relative to the cash flows from the purchase. It is

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 720  ■■■  Part V Long-Term Financing

arbitrary that we express the cash flows in this way. We could have expressed the cash
flows from the purchase relative to the cash flows from leasing. These cash flows would
look like this:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Net cash flows from
 purchase alternative relative
to lease alternative −`10,000 `2,395 `2,395 `2,395 `2,395 `2,395

Of course, the cash flows here are the opposite of those in the bottom line of Table 21.3.
Depending on our purpose, we may look at either the purchase relative to the lease or
vice versa. You should become comfortable with either viewpoint.
Now that we have the cash flows, we can make our decision by discounting the cash
flows properly. However, because the discount rate is tricky, we take a detour in the next
section before moving back to the Wadia case. In this next section, we show that cash
flows in the lease-versus-buy decision should be discounted at the aftertax cost of debt.

A NOTE ABOUT TAXES

Sanjay Surana has assumed that Wadia can use the tax benefits of the depreciation allow-
ances and the lease payments. This may not always be the case. If Wadia were losing
money (or had loss carryforwards), it would not pay taxes, and the tax shelters would be
worthless (unless they could be shifted to someone else). As we mentioned before, this is
one circumstance under which leasing may make a great deal of sense. If this were the
case, the relevant entries in Table 21.2 would have to be changed to reflect a zero tax rate.

21.5 A Detour for Discounting and Debt

Capacity with Corporate Taxes
The analysis of leases is difficult, and both financial practitioners and academics have
made conceptual errors. These errors revolve around taxes. We hope to avoid their mis-
takes by beginning with the simplest type of example: a loan for one year. Though this
example is unrelated to our lease-versus-buy situation, principles developed here will apply
directly to lease-buy analysis.

Present Value of Riskless Cash Flows

Consider a corporation that lends `100 for a year. If the interest rate is 10 percent, the
firm will receive `110 at the end of the year. Of this amount, `10 is interest and the
remaining `100 is the original principal. A corporate tax rate of 21 percent implies taxes
on the interest of `2.10 (= .21 × `10). The firm ends up with `107.90 (= `110 − 2.10)
after taxes on a `100 investment.
Now consider a company that borrows `100 for a year. With a 10 percent interest
rate, the firm must pay `110 to the bank at the end of the year. However, the borrowing
firm can take the `10 of interest as a tax deduction. The corporation pays `2.10 (= .21
× `10) less in taxes than it would have paid had it not borrowed the money at all. Con-
sidering this reduction in taxes, the firm must repay `107.90 (= `110 − 2.10) on a `100
loan. The cash flows from both lending and borrowing are displayed in Table 21.4.

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 Chapter 21 Leasing  ■■■  721

Table 21.4 Date 0 Date 1

Lending and
Borrowing in a Lending example
World with Lend `100 Receive `100.00 of principal
Corporate Receive ` 10.00 of interest
Taxes (interest 7.9%
rate is
lending Pay ` 2.10 (= .21 × `10) in taxes
10 percent and
rate `107.90
corporate tax
rate is 21 Aftertax lending rate is 7.9%.
percent) Borrowing example
Borrow `100
Pay `100.00 of principal
Pay ` 10.00 of interest
7.9%
borrowing Receive ` 2.10 (= .21 × `10) as a tax rebate
rate `107.90
Aftertax borrowing rate is 7.9%.

General principle: In a world with corporate taxes, riskless cash flows should be discounted at the aftertax riskless
interest rate.

The previous two paragraphs show a very important result: The firm could not care
less whether it received `100 today or `107.90 next year.2 If it received `100 today, it
could lend it out, thereby receiving `107.90 after corporate taxes at the end of the year.
Conversely, if it knows today that it will receive `107.90 at the end of the year, it could
borrow `100 today. The aftertax interest and principal payments on the loan would be
paid with the `107.90 that the firm will receive at the end of the year. Because of this
interchangeability, we say that a payment of `107.90 next year has a present value of `100.
Because `100 = `107.90/1.079, a riskless cash flow should be discounted at the aftertax
interest rate of .079 [= .10 × (1 − .21)].
Of course, the preceding discussion is a specific example. The general principle is this:
In a world with corporate taxes, the firm should discount riskless cash flows at the aftertax
riskless rate of interest.

Optimal Debt Level and Riskless Cash Flows

In addition, our simple example can illustrate a related point concerning optimal debt
level. Consider a firm that has determined that the current level of debt in its capital
structure is optimal. Immediately following that determination, it is surprised to learn
that it will receive a guaranteed payment of `107.90 in one year from a tax-exempt
government lottery. This future windfall is an asset that, like any asset, should raise
the firm’s optimal debt level. How much does this payment raise the firm’s optimal
level?

2
For simplicity, assume that the firm received `100, or `107.90 after corporate taxes. The pretax inflows would be `126.58 [=
`100/( 1 − .21)] or `136.58 [= `107.90/(1 − .21)], respectively.

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 722  ■■■  Part V Long-Term Financing

Our analysis implies that the firm’s optimal debt level must be `100 more than
it previously was. That is, the firm could borrow `100 today, perhaps paying the
entire amount out as a dividend. It would owe the bank `110 at the end of the year.
Because it receives a tax rebate of `2.10 (= .21 × `10), its net repayment will be
`107.90. The borrowing of `100 today is fully offset by next year’s government lottery
proceeds of `107.90. In other words, the lottery proceeds act as an irrevocable trust
that can service the increased debt. Note that we need not know the optimal debt
level before the lottery was announced. We are merely saying that whatever this pre-
lottery optimal level was, the optimal debt level is `100 more after the lottery
announcement.
Of course, this is just one example. The general principle is:3
In a world with corporate taxes, we determine the increase in the firm’s optimal debt level
by discounting a future guaranteed aftertax inflow at the aftertax riskless interest rate.
Conversely, suppose that a second, unrelated firm is surprised to learn that it must
pay `107.90 next year to the government for back taxes. Clearly, this additional liability
impinges on the second firm’s debt capacity. By the previous reasoning, it follows that
the second firm’s optimal debt level must be lowered by exactly `100.

21.6 NPV Analysis of the Lease‐versus‐Buy

Decision
Our detour leads to a simple method for evaluating leases: Discount all cash flows at the
aftertax interest rate. From the bottom line of Table 21.3, Wadia’s incremental cash flows
from leasing versus purchasing are:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Net cash flows from lease

alternative relative to
purchase alternative `10,000 −`2,395 −`2,395 −`2,395 −`2,395 −`2,395

Let us assume that Wadia can either borrow or lend at the interest rate of 6.329114 percent.
If the corporate tax rate is 21 percent, the correct discount rate is the aftertax rate of
5 percent [= .06329114 × (1 − .21)]. When 5 percent is used to compute the NPV of the
lease, we have:
NPV = `10,000 − `2,395 × ​PVIFA​  5%, 5​​ = − `369.10 (21.1)
Because the net present value of the incremental cash flows from leasing relative to pur-
chasing is negative, Wadia prefers to purchase. The NPV we have computed here is often
called the net advantage to leasing (NAL). Surveys indicate that the NAL approach is the
most popular means of lease analysis in the real world.
Equation 21.1 is the correct approach to lease-versus-buy analysis. Students are often
bothered by two things. First, they question whether the cash flows in Table 21.3 are truly
riskless. We examine this issue next. Second, they feel that this approach lacks intuition.
We address this concern a little later.

3
This principle holds for riskless or guaranteed cash flows only. Unfortunately, there is no easy formula for determining the
increase in optimal debt level from a risky cash flow.

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 Chapter 21 Leasing  ■■■  723

The Discount Rate

Because we discounted at the aftertax riskless rate of interest, we have implicitly assumed
that the cash flows in the Wadia example are riskless. Is this appropriate?
A lease payment is like the debt service on a secured bond issued by the lessee, and
the discount rate should be the same as the interest rate on such debt. In general, this
rate will be slightly higher than the riskless rate considered in the previous section. The
various tax shields could be somewhat riskier than the lease payments for two reasons.
First, the value of the depreciation tax benefits depends on the ability of Wadia to gener-
ate enough taxable income to use them. Second, the corporate tax rate may change in
the future, just as it fell in 1986, increased in 1993, and fell again in 2018. For these two
reasons, a firm might be justified in discounting the depreciation tax benefits at a rate
higher than that used for the lease payments. Our experience is that real-world companies
discount both the depreciation shield and lease payments at the same rate. This implies
that financial practitioners view these two risks as minor. We adopt the real-world conven-
tion of discounting the two flows at the same rate. This rate is the aftertax interest rate
on secured debt issued by the lessee.
At this point, some students still question why we do not use WACC as the discount
rate in lease-versus-buy analysis. Of course, WACC should not be used for lease analysis
because the cash flows are more like debt service cash flows than operating cash flows
and, as such, the risk is much less. The discount rate should reflect the risk of the incre-
mental cash flows.

21.7 Debt Displacement and Lease Valuation

The Basic Concept of Debt Displacement
The previous analysis allows us to calculate the right answer in a simple manner. This
clearly must be viewed as an important benefit. However, the analysis has little intuitive
appeal. To remedy this, we hope to make lease-buy analysis more intuitive by considering
the issue of debt displacement.
A firm that purchases equipment will generally issue debt to finance the purchase.
The debt becomes a liability of the firm. A lessee incurs a liability equal to the present
value of all future lease payments. Because of this, we argue that leases displace debt. The
balance sheets in Table 21.5 illustrate how leasing might affect debt.
Suppose a firm initially has `100,000 of assets and a 150 percent optimal debt-equity
ratio. The firm’s debt is `60,000 and its equity is `40,000. As in the Wadia case, suppose
the firm must use a new `10,000 machine. The firm has two alternatives:
1. The firm can purchase the machine. If it does, it will finance the purchase with a
secured loan and with equity. The debt capacity of the machine is assumed to be the
same as for the firm as a whole.
2. The firm can lease the asset and get 100 percent financing. That is, the present value
of the future lease payments will be `10,000.
If the firm finances the machine with both secured debt and new equity, its debt will
increase by `6,000 and its equity by `4,000. Its optimal debt-equity ratio of 150 percent
will be maintained.

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 724  ■■■  Part V Long-Term Financing

Table 21.5 Assets Liabilities

Debt
Displacement Initial situation
Elsewhere in Current ` 50,000 Debt ` 60,000
the Firm When Fixed 50,000 Equity 40,000
a Lease Is Total `100,000 Total `100,000
Instituted
Buy with secured loan
Current ` 50,000 Debt ` 66,000
Fixed 50,000 Equity 44,000
Machine 10,000
Total `110,000 Total `110,000
Lease
Current ` 50,000 Lease ` 10,000
Fixed 50,000 Debt 56,000
Machine 10,000 Equity 44,000
Total `110,000 Total `110,000

This example shows that leases reduce the level of debt elsewhere in the firm. Though the example illustrates a point,
it is not meant to show a precise method for calculating debt displacement.

Conversely, consider the lease alternative. Because the lessee views the lease payment
as a liability, the lessee thinks in terms of a liability-equity ratio, not a debt-equity ratio.
As mentioned, the present value of the lease liability is `10,000. If the leasing firm is to
maintain a liability-equity ratio of 150 percent, debt elsewhere in the firm must fall by
`4,000 when the lease is instituted. Because debt must be repurchased, net liabilities rise
by only `6,000 (= `10,000 − 4,000) when `10,000 of assets are placed under lease.4
Debt displacement is a hidden cost of leasing. If a firm leases, it will not use as much
regular debt as it would otherwise. The benefits of debt capacity will be lost—particularly
the lower taxes associated with interest expense.

Optimal Debt Level in the Wadia Example

The previous section showed that leasing displaces debt. Though the section illustrated a
point, it was not meant to show the precise method for calculating debt displacement.
Here we describe the precise method for calculating the difference in optimal debt levels
between purchase and lease in the Wadia example.
From the last line of Table 21.3, we know these cash flows from the purchase alterna-
tive relative to the cash flows from the lease alternative:5
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Net cash flows from

 purchase alternative relative
to lease alternative −`10,000 `2,395 `2,395 `2,395 `2,395 `2,395

4
Growing firms in the real world will not generally repurchase debt when instituting a lease. Rather, they will issue less debt in
the future than they would have without the lease.
5
The last line of Table 21.3 presents the cash flows from the lease alternative relative to the purchase alternative. As we pointed
out earlier, our cash flows are reversed because we are now presenting the cash flows from the purchase alternative relative to
the lease alternative.

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 Chapter 21 Leasing  ■■■  725

An increase in the optimal debt level at Year 0 occurs because the firm learns at that
time of guaranteed cash flows beginning at Year 1. Our detour into discounting and debt
capacity told us to calculate this increased debt level by discounting the future riskless
cash inflows at the aftertax interest rate.6 The additional debt level of the purchase alter-
native relative to the lease alternative is:
`2,395 `2,395 `2,395 `2,395 `2,395
​`10,369.10 = _____
​  1.05 ​ + _____
​   ​ + _____
​   ​ + _____
​   ​ + _____
​   ​​
1​ .05​​  2​ 1​ .05​​  3​ 1​ .05​​  4​ 1​ .05​​  5​
That is, whatever the optimal amount of debt would be under the lease alternative, the
optimal amount of debt would be `10,369.10 more under the purchase alternative.
This result can be stated in another way. Imagine there are two identical firms except
that one firm purchases the boring machine and the other leases it. From Table 21.3, we
know that the purchasing firm generates `2,395 more cash flow after taxes in each of the
five years than does the leasing firm. Further imagine that the same bank lends money
to both firms. The bank should lend the purchasing firm more money because it has a
greater cash flow each period. How much extra money should the bank lend the purchas-
ing firm so that the incremental loan can be paid off by the extra cash flows of `2,395
per year? The answer is exactly `10,369.10—the increase in the optimal debt level we
calculated earlier.
To see this, let us work through the example year by year. Because the purchasing
firm borrows `10,369.10 more at Year 0 than does the leasing firm, the purchasing firm
will pay interest of `656.27 (= `10,369.10 × .06329114) at Year 1 on the additional
debt. The interest allows the firm to reduce its taxes by `137.82 (= `656.27 × .21),
leaving an aftertax outflow of `518.45 (= `656.27 − 137.82) at Year 1.
We know from Table 21.3 that the purchasing firm generates `2,395 more cash at
Year 1 than does the leasing firm. Because the purchasing firm has the extra `2,395
coming in at Year 1 but must pay interest on its loan, how much of the loan can the firm
repay at Year 1 and still have the same cash flow as the leasing firm? The purchasing
firm can repay `1,876.55 (= `2,395 − 518.45) of the loan at Year 1 and still have the
same net cash flow that the leasing firm has. After the repayment, the purchasing firm
will have a remaining balance of `8,492.55 (= `10,369.10 − 1,876.55) at Year 1. For
each of the five years, this sequence of cash flows is displayed in Table 21.6. The outstand-
ing balance goes to zero over the five years. The annual cash flow of `2,395, which
represents the extra cash from purchasing instead of leasing, fully amortizes the loan of
`10,369.10.
Our analysis of debt capacity has two purposes. First, we want to show the additional
debt capacity from purchasing. We just completed this task. Second, we want to determine
whether the lease is preferred to the purchase. This decision rule follows easily from our
discussion. By leasing the equipment and having `10,369.10 less debt than under the
purchase alternative, the firm has exactly the same cash flows in Years 1 to 5 that it would
have through a levered purchase. We can ignore cash flows beginning in Year 1 when
comparing the lease alternative to the purchase-with-debt alternative. However, the cash
flows differ between the alternatives at Year 0:
1. The purchase cost at Year 0 of `10,000 is avoided by leasing. This should be viewed as
a cash inflow under the leasing alternative.
6
Though our detour considered only riskless cash flows, the cash flows in a leasing example are not necessarily riskless. As we
explained earlier, we adopt the real-world convention of discounting at the aftertax interest rate on secured debt issued by the
lessee.

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 726  ■■■  Part V Long-Term Financing

Table 21.6 Calculation of Increase in Optimal Debt Level if Wadia Purchases Instead of Leases
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Outstanding balance of loan `10,369.10 ` 8,492.55* `6,522.18 `4,453.29 `2,280.95 ` 0

Interest 656.27 537.50 412.80 281.85 144.36
Tax deduction on interest 137.82 112.88 86.69 59.19 30.32
Aftertax interest expense ` 518.45 ` 424.63 ` 326.11 ` 222.66 ` 114.05
Extra cash that purchasing firm
generates over leasing firm
(from Table 21.3) ` 2,395.00 `2,395.00 `2,395.00 `2,395.00 `2,395.00
Repayment of loan ` 1,876.55† `1,970.37 `2,068.89 `2,172.34 `2,280.95

Assume that there are two otherwise identical firms: one leases and the other purchases. The purchasing firm can borrow `10,369.10 more
than the leasing firm. The extra cash flow each year of `2,395 from purchasing instead of leasing can be used to pay off the loan in five
years.
*`8,492.55 = `10,369.10 − 1,876.55.
†`1,876.55 = `2,395 − 518.45.

2. The firm borrows `10,369.10 less at Year 0 under the lease alternative than it can under
the purchase alternative. This should be viewed as a cash outflow under the leasing
alternative.
Because the firm borrows `10,369.10 less by leasing but saves only `10,000 on the equip-
ment, the lease alternative requires an extra cash outflow at Year 0 relative to the purchase
alternative of −`369.10 (= `10,000 − 10,369.10). Because cash flows in later years from
leasing are identical to those from purchasing with debt, the firm should purchase.

Two Methods for Calculating Net Present Value

of Lease Relative to Purchase*
Method 1: Discount all cash flows at the aftertax interest rate:
​− `369.10 = `10,000 − `2,395 × ​PVIFA​  5%, 5​​​
Method 2: Compare purchase price with reduction in optimal debt level under leasing
alternative:
− `369.10 = `10,000 − 10,369.10
Purchase Reduction in
​​     
    
    
​  ​  ​  ​  ​  ​  ​ ​​ ​​
price optimal debt
level if leasing
*Because we are calculating the NPV of the lease relative to the purchase, a negative value indicates that the purchase
alternative is preferred.

This is exactly the same answer we got when, earlier in this chapter, we discounted
all cash flows at the aftertax interest rate. Of course, this is no coincidence: The increase
in the optimal debt level also is determined by discounting all cash flows at the aftertax
interest rate. The accompanying box presents both methods. The numbers in the box are
in terms of the NAL of the lease relative to the purchase. A negative NAL indicates that
the purchase alternative should be taken.

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 Chapter 21 Leasing  ■■■  727

21.8 Does Leasing Ever Pay? The Base Case

We previously looked at the lease-buy decision from the point of view of the potential
lessee, Wadia. Let’s now look at the decision from the point of view of the lessor, Falguni
Leasing. This firm faces three cash flows, which are displayed in Table 21.7. First, Friendly
purchases the machine for `10,000 at Year 0. Second, because the asset is depreciated
straight-line over five years, the depreciation expense at the end of each of the five years
is `2,000 (= `10,000/5). The yearly depreciation tax shield is `420 (= `2,000 × .21).
Third, because the yearly lease payment is `2,500, the aftertax lease payment is `1,975
[= `2,500 × (1 − .21)].
Now examine the total cash flows to Falguni Leasing displayed in the bottom line
of Table 21.7. Those of you with a healthy memory will notice something interesting.
These cash flows are exactly the opposite of those of Wadia displayed in the bottom line
of Table 21.3. Those of you with a healthy sense of skepticism may be thinking something
interesting: “If the cash flows of the lessor are exactly the opposite of those of the lessee,
the combined cash flow of the two parties must be zero each year. There does not seem
to be any joint benefit to this lease. Because the net present value to the lessee was
−`369.10, the NAL to the lessor must be `369.10. The joint NAL is `0 (= −`369.10
+ 369.10). There does not appear to be any way for the NAL of both the lessor and
the lessee to be positive at the same time. Because one party would inevitably lose money,
the leasing deal could never fly.”
This is one of the most important results of leasing. Though Table 21.7 concerns one
particular leasing deal, the principle can be generalized. As long as (1) both parties are
subject to the same interest and tax rates and (2) transaction costs are ignored, there can
be no leasing deal that benefits both parties. However, there is a lease payment for which
both parties would calculate an NAL of zero. Given that payment, Wadia would be indif-
ferent to whether it leased or bought, and Falguni Leasing would be indifferent to whether
it leased or not.7
A student with an even healthier sense of skepticism might be thinking, “This text-
book appears to be arguing that leasing is not beneficial. Yet we know that leasing occurs
frequently in the real world. Maybe, just maybe, the textbook is wrong.” Although we will
not admit to being wrong (what authors would?!), we freely admit that our explanation is
incomplete at this point. The next section considers factors that give benefits to leasing.

Table 21.7 Cash Flows to Falguni Leasing as Lessor of IBMC Pipe-Boring Machine
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cash for machine −`10,000

Depreciation tax benefit
(`420 = `2,000 × .21) ` 420 ` 420 ` 420 ` 420 ` 420
Aftertax lease payment
[`1,975 = `2,500 × (1 − .21)] 1,975 1,975 1,975 1,975 1,975
Total −`10,000 `2,395 `2,395 `2,395 `2,395 `2,395

These cash flows are the opposite of the cash flows to Wadia, the lessee (see the bottom line of Table 21.3).
7
The break-even lease payment is `2,392.09 in our example. Both the lessor and lessee can solve for this as follows:

`10,000 = `420 × ​​PVIFA​  5%, 5​​​ + L × (1 − .21) × ​​PVIFA​  5%, 5​​​

In this case, L = `2,392.09.

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 728  ■■■  Part V Long-Term Financing

21.9 Reasons for Leasing

Proponents of leasing make many claims about why firms should lease assets rather than
buy them. Some of the reasons given to support leasing are good, and some are not. Here
we discuss good reasons for leasing and those we think are not good.

Good Reasons for Leasing

Leasing is a good choice if at least one of the following is true:
1. Taxes will be reduced by leasing.
2. The lease contract will reduce certain types of uncertainty.
3. Transaction costs will be higher for buying an asset and financing it with debt or
equity than for leasing the asset.

Tax Advantages The most important reason for long-term leasing is tax reduction.
If the corporate income tax were repealed, long-term leasing would probably disappear.
The tax advantages of leasing exist because firms are in different tax brackets.
Should a user in a low tax bracket purchase, he will receive little tax benefit from
depreciation and interest deductions. Should the user lease, the lessor will receive the
depreciation shield and the interest deductions. In a competitive market, the lessor must
charge a low lease payment to reflect these tax shields. The user is likely to lease rather
than purchase.
In our example with Wadia and Falguni Leasing, the value of the lease to Friendly
was `369.10:
`369.10 = −`10,000 + `2,395 × PVIFA5%, 5
However, the value of the lease to Wadia was exactly the opposite (−`369.10).
Because the lessor’s gains came at the expense of the lessee, no deal could be arranged.
However, if Wadia pays no taxes and the lease payments are reduced to `2,393 from
`2,500, both Friendly and Wadia will find positive NPVs in leasing. Wadia can rework
Table 21.3 with TC = 0, finding that its cash flows from leasing are now these:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cost of machine `10,000

Lease payment −`2,393 −`2,393 −`2,393 −`2,393 −`2,393

The NAL to Wadia is:

NAL = `10,000 − `2,393 × ​PVIFA​  6.329114%, 5​​
​​ ​       
​  ​  ​​ ​
​ = `9.43
Notice that the discount rate is the interest rate of 6.329114 percent because tax rates
are zero. In addition, the full lease payment of `2,393—and not some lower aftertax num-
ber—is used because there are no taxes. Finally, note that depreciation is ignored, also
because no taxes apply.
Given a lease payment of `2,393, the cash flows to Falguni Leasing look like this:

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 Chapter 21 Leasing  ■■■  729

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cost of machine −`10,000

Depreciation tax shield
(`420 = `2,000 × .21) ` 420 ` 420 ` 420 ` 420 ` 420
Aftertax lease payment
 [`1,890.47 = `2,393 ×
(1 − .21)] 1,890.47 1,890.47 1,890.47 1,890.47 1,890.47
Total `2,310.47 `2,310.47 `2,310.47 `2,310.47 `2,310.47

The NAL to Friendly is:

NAL = − `10,000 + `2,310.47 × ​PVIFA​  5%, 5​​
​​ ​     
     
​  =​  − `10,000 + 10,003.13​ ​​ ​
= `3.13
As a consequence of different tax rates, the lessee (Wadia) gains `9.43 and the lessor
(Friendly) gains `3.13. Both the lessor and the lessee can gain if their tax rates are dif-
ferent because the lessor uses the depreciation and interest tax shields that cannot be used
by the lessee. The Income Tax Authorities loses tax revenue and some of the tax gains
of the lessor are passed on to the lessee in the form of lower lease payments.
Because both parties can gain when tax rates differ, the lease payment is agreed upon
through negotiation. Before negotiation begins, each party needs to know the reservation
payment of both parties. This is the payment that will make one party indifferent to
whether it enters the lease deal. In other words, this is the payment that makes the NAL
equal to zero. These payments are calculated next.
Reservation Payment of Lessee We now solve for LMAX, the payment that makes the value
of the lease to the lessee zero. When the lessee is in a zero tax bracket, its cash flows,
in terms of LMAX, are as follows:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cost of machine `10,000
Lease payment −LMAX −LMAX −LMAX −LMAX −LMAX

This table implies that:

Value of lease = `10,000 − LMAX × PVIFA6.329114%, 5
The value of the lease equals zero when:
`10,000
​​L​  MAX​​ = ___________
  
​  P VIFA​  6.329114%, 5 ​​​ = `2,395.26​
​  
After performing this calculation, the lessor knows that the maximum payment the lessee
will accept is `2,395.26.
Reservation Payment of Lessor We now solve for LMIN, the payment that makes the value
of the lease to the lessor zero. The cash flows to the lessor, in terms of LMIN, are these:

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 730  ■■■  Part V Long-Term Financing

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cost of machine −`10,000

Depreciation tax shield
(`420 = `2,000 × .21) `420 `420 `420 `420 `420
Aftertax lease payment
(TC = .21) LMIN × .79 LMIN × .79 LMIN × .79 LMIN × .79 LMIN × .79

This table implies that:

Value of lease = −`10,000 + `420 × PVIFA5%, 5 + LMIN × .79 × PVIFA5%, 5
The NAL equals zero when:
`10,000
___________ `420
____
​L​  MIN​​ =    .79 × ​PVIFA​  5%,5 ​​​ − ​  .79 ​
​    
​​​     
   ​  ​   ​​ ​ ​
​ = `2,923.73 − 531.65
​ = `2,392.09
After performing this calculation, the lessee knows that the lessor will never agree to a
lease payment below `2,392.09.

A Reduction of Uncertainty We have noted that the lessee does not own the
property when the lease expires. The value of the property at this time is called the
residual value, and the lessor has a firm claim to it. When the lease contract is signed,
there may be substantial uncertainty about what the residual value of the asset will be.
Under a lease contract, this residual risk is borne by the lessor. Conversely, the user bears
this risk when purchasing.
It is common sense that the party best able to bear a particular risk should do so. If
the user has little risk aversion, she will not suffer by purchasing. However, if the user is
highly averse to risk, she should find a third-party lessor more capable of assuming this
burden.
This latter situation frequently arises when the user is a small or newly formed firm.
Because the risk of the entire firm is likely to be quite high and because the principal
stockholders are likely to be undiversified, the firm desires to minimize risk wherever
possible. A potential lessor, such as a large, publicly held financial institution, is far more
capable of bearing the risk. Conversely, this situation is not expected to happen when the
user is a blue chip corporation. That potential lessee is more able to bear risk.

Transaction Costs The costs of changing an asset’s ownership are generally greater
than the costs of writing a lease agreement. Consider the choice that confronts a person
who lives in Kanpur but must do business in Chennai for two days. It would clearly be
cheaper to rent a hotel room for two nights than it would be to buy a condominium for
two days and then to sell it.
Leases generate agency costs, as well. For example, the lessee might misuse or overuse
the asset because she has no interest in the asset’s residual value. This cost will be implic-
itly paid by the lessee through a high lease payment. Although the lessor can reduce these
agency costs through monitoring, monitoring itself is costly. Leasing is most beneficial
when the transaction costs of purchase and resale outweigh the agency costs and monitor-
ing costs of a lease.

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 Chapter 21 Leasing  ■■■  731

Bad Reasons for Leasing

Leasing and Accounting Income Leasing can have a significant effect on the
appearance of the firm’s financial statements. If a firm is successful at keeping its leases
off the books, the balance sheet and, potentially, the income statement can be made to
look better. As a consequence, accounting-based performance measures such as return on
assets, or ROA, can appear to be higher. As we have mentioned, changes in lease account-
ing coming in 2019 will make keeping leases off the books much more difficult.
Because an operating lease does not appear on the balance sheet under current (2018)
rules, total assets (and total liabilities) will be lower with an operating lease than they
would be if the firm were to borrow the money and purchase the asset. From Chapter 3,
we know that ROA is computed as net income divided by total assets. With an operating
lease, net income is usually bigger and total assets are smaller, so ROA will be larger. In
addition, debt covenants often do not consider operating leases as debt, which may allow
a firm to obtain debtlike financing without a covenant violation.

One Hundred Percent Financing It is often claimed that leasing provides

100 percent financing, whereas secured equipment loans require an initial down payment.
However, we argued earlier that leases tend to displace debt elsewhere in the firm. Our
earlier analysis suggests that leases do not permit a greater level of total liabilities than
do purchases with borrowing.

Other Reasons There are, of course, many special reasons that some companies
find advantages in leasing. In one celebrated case, the U.S. Navy leased a fleet of tankers
instead of asking Congress for appropriations. Thus, leasing may be used to circumvent
capital expenditure control systems set up by bureaucratic firms. This is alleged to be a
relatively common occurrence in hospitals. Likewise, many school districts lease buses
and modular classrooms and pay for them out of their operating budgets when they are
unable to gain approval for a bond issue to raise funds.

Some Indian Examples of Leasing

1. Tata Steel Limited, India’s second largest steel firm, wanted to replace its mining
equipment for its West Bokaro mines. The cost of the equipment was around `100
crores. Tata Steel opted for leasing. GE Capital, SREI Intl. and IL&FS bid for the lease
deal. Finally, Tata Steel decided to give the deal to IL&FS. The leasing period was
60 months, and the EMI came out to be `2.296 crores. The advance payment made
to the supplier was `5 crores and `1 crore was also paid upfront as lease manage-
ment fees.
2. Air India invited global tenders for five aircraft on lease which would enable it to sell
its four old aircraft. This was structured as a ‘dry lease’ for 2 years, with monthly
payments and involved 15% upfront advance payment to Singapore Airlines. ‘Dry
lease’ is the lease of the aircraft only, without crew. ‘Wet lease’ means a lease of an
aircraft including its crew. The lessor provides the aircraft, one of more complete
crews (including engineers) including their salaries and allowances, all Maintenance
for the aircraft itself and, usually, third-party liability cover. The deal involved the les-
sor to charge for the aircraft by the hour but will want a minimum number of hours
per month guaranteed from the lessee. For example, the lessor may charge US$
1000 per hour, but will want a minimum of 100 hours per month paid, whether you
actually reach 100 hours of travel in that month or not.

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 732  ■■■  Part V Long-Term Financing

21.10 Some Unanswered Questions

Our analysis suggests that the primary advantage of long-term leasing results from the
differential tax rates of the lessor and the lessee. Other valid reasons for leasing are lower
contracting costs and risk reduction. There are several questions our analysis has not
specifically answered.

Are the Uses of Leases and Debt Complementary?

Ang and Peterson find that firms with high debt tend to lease frequently, as well.8 This
result should not be puzzling. The corporate attributes that provide high debt capacity
also may make leasing advantageous. Even though leasing displaces debt (i.e., leasing and
borrowing are substitutes) for an individual firm, high debt and high leasing can be posi-
tively associated when we look at a number of firms.

Why Are Leases Offered by Both Manufacturers

and Third-Party Lessors?
The offsetting effects of taxes can explain why both manufacturers and third-party lessors
offer leases.
1. For manufacturer lessors, the basis for determining depreciation is the manufacturer’s
cost. For third-party lessors, the basis is the sales price that the lessor paid to the
manufacturer. Because the sales price is generally greater than the manufacturer’s cost,
this is an advantage to third-party lessors.
2. The manufacturer must recognize a profit for tax purposes when selling the asset to
the third-party lessor. The manufacturer’s profit for some equipment can be deferred
if the manufacturer becomes the lessor. This provides an incentive for manufacturers
to lease.

Why Are Some Assets Leased More Than Others?

Certain assets appear to be leased more frequently than others. Smith and Wakeman have
looked at nontax incentives affecting leasing.9 Their analysis suggests many asset and firm
characteristics that are important in the lease-versus-buy decision. The following are
among the things they mention:
The more sensitive the value of an asset is to use and maintenance decisions, the
more likely it is that the asset will be purchased instead of leased. They argue that owner-
ship provides a better incentive to minimize maintenance costs than does leasing.
Price discrimination opportunities may be important. Leasing may be a way of cir-
cumventing laws against charging too low a price.

8
James Ang and Pamela P. Peterson, “The Leasing Puzzle,” Journal of Finance 39 (September 1984).
9
Clifford W. Smith Jr. and L. M. Wakeman, “Determinants of Corporate Leasing Policy,” Journal of Finance 40 (July 1985).

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 Chapter 21 Leasing  ■■■  733

Summary and Conclusions

A large fraction of America’s equipment is leased rather than purchased. This chapter both
described the institutional arrangements surrounding leases and showed how to evaluate leases
financially.
1. Leases can be separated into two types: financial and operating. Financial leases are gen-
erally longer-term, fully amortized, and not cancelable without a hefty termination pay-
ment. Operating leases are usually shorter-term, partially amortized, and cancelable.
2. When a firm purchases an asset with debt, both the asset and the liability appear on the
firm’s balance sheet. If a lease meets at least one of a number of criteria, it must be
capitalized. This means that the present value of the lease appears as both an asset and
a liability. A lease escapes capitalization if it does not meet any of these criteria. Leases
not meeting the criteria are called operating leases, though the accountant’s definition
differs somewhat from the practitioner’s definition. Operating leases will begin to be
reported on the balance sheet in 2019.
3. Firms generally lease for tax purposes. To protect its interests, the IRS allows financial
arrangements to be classified as leases only if a number of criteria are met.
4. We showed that risk-free cash flows should be discounted at the aftertax risk-free rate.
Because both lease payments and depreciation tax shields are nearly riskless, all relevant
cash flows in the lease-versus-buy decision should be discounted at a rate near this after-
tax rate. We use the real-world convention of discounting at the aftertax interest rate on
the lessee’s secured debt.
5. We presented an alternative method in the hopes of increasing the reader’s intuition.
Relative to a lease, a purchase generates debt capacity. This increase in debt capacity can
be calculated by discounting the difference between the cash flows of the purchase and
the cash flows of the lease by the aftertax interest rate. The increase in debt capacity
from a purchase is compared to the extra outflow at Year 0 from a purchase.
6. If the lessor is in the same tax bracket as the lessee, the cash flows to the lessor are
exactly the opposite of the cash flows to the lessee. Thus, the sum of the value of the
lease to the lessee plus the value of the lease to the lessor must be zero. Although this
suggests that leases are never advantageous, there are actually at least three good reasons
for leasing:
a. Differences in tax brackets between the lessor and lessee.
b. Shift of risk bearing to the lessor.
c. Minimization of transaction costs.

Concept Questions
1. Leasing vs. Borrowing What are the key differences between leasing and borrowing? Are
they perfect substitutes?
2. Leasing and Taxes Taxes are an important consideration in the leasing decision. Which
is more likely to lease: A profitable corporation in a high tax bracket or a less profitable
one in a low tax bracket? Why?
3. Leasing and IRR What are some of the potential problems with looking at IRRs when
evaluating a leasing decision?

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 734  ■■■  Part V Long-Term Financing

4. Leasing Comment on the following remarks:

a. Leasing reduces risk and can reduce a firm’s cost of capital.
b. Leasing provides 100 percent financing.
c. If the tax advantages of leasing were eliminated, leasing would disappear.
5. Accounting for Leases Discuss the accounting criteria for determining whether a lease
must be reported on the balance sheet. In each case, give a rationale for the criterion.
6. IRS Criteria Discuss the IRS criteria for determining whether a lease is tax deductible.
In each case, give a rationale for the criterion.
7. Off-Balance Sheet Financing What is meant by the term “off-balance sheet financing”?
When do leases provide such financing and what are the accounting and economic con-
sequences of such activity?
8. Sale and Leaseback Why might a firm choose to engage in a sale and leaseback transac-
tion? Give two reasons.
9. Leasing Cost Explain why the aftertax borrowing rate is the appropriate discount rate
to use in lease evaluation.
Refer to the following example for Questions 10–12. In July 2017, Cargo Aircraft Man-
agement announced a deal to lease three Boeing 767-300 freighters to Northern Air Cargo.
The freighters would be operated by Northern Air Cargo subsidiaries in Hawaii, Alaska, and
Florida.
10. Leasing vs. Purchase Why wouldn’t Northern Air Cargo purchase the planes if they were
obviously needed for the company’s operations?
11. Reasons to Lease Why would Cargo Aircraft Management be willing to buy planes from
Boeing and then lease the planes to Northern Air Cargo? How is this different from lend-
ing money to Northern Air Cargo to buy the planes?
12. Leasing What do you suppose happens to the plane at the end of the lease period?

Questions and Problems

Use the following information to work Problems 1–6. You work for a nuclear research labora-
tory that is contemplating leasing a diagnostic scanner (leasing is a common practice with
expensive, high-tech equipment). The scanner costs $5.2 million and would be depreciated
BASIC straight-line to zero over four years. Because of radiation contamination, it will actually be
(Questions 1–8) completely valueless in four years. You can lease it for $1.51 million per year for four years.
1. Lease or Buy Assume that the tax rate is 21 percent. You can borrow at 8 percent before
taxes. Should you lease or buy?
2. Leasing Cash Flows What are the cash flows from the lease from the lessor’s viewpoint?
Assume a 21 percent tax rate.
3. Finding the Break-Even Payment What would the lease payment have to be for both the
lessor and the lessee to be indifferent about the lease?
4. Taxes and Leasing Cash Flows Assume that your company does not contemplate paying
taxes for the next several years. What are the cash flows from leasing in this case?
5. Setting the Lease Payment In the previous question, over what range of lease payments
will the lease be profitable for both parties?

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 Chapter 21 Leasing  ■■■  735

6. MACRS Depreciation and Leasing Rework Problem 1 assuming that the scanner will
be depreciated as 3-year property under MACRS (see Chapter 6 for the depreciation
allowances).
7. Lease or Buy Witten Entertainment is considering buying a machine that costs $545,000.
The machine will be depreciated over five years by the straight-line method and will be
worthless at that time. The company can lease the machine with year-end payments of
$140,000. The company can issue bonds at an interest rate of 7 percent. If the corporate
tax rate is 21 percent, should the company buy or lease?
8. Setting the Lease Payment Quartz Corporation is a relatively new firm. Quartz has
experienced enough losses during its early years to provide it with at least eight years of
tax loss carryforwards, so Quartz’s effective tax rate is zero. Quartz plans to lease equip-
ment from New Leasing Company. The term of the lease is five years. The purchase cost
of the equipment is $680,000. New Leasing Company is in the 23 percent tax bracket.
Each firm can borrow at 9 percent.
a. What is Quartz’s reservation price?
b. What is New Leasing Company’s reservation price?
c. Explain why these reservation prices determine the negotiating range of the lease.
INTERMEDIATE Use the following information to work Problems 9–11. The Wildcat Oil Company is trying to
(Questions 9–16)
decide whether to lease or buy a new computer-assisted drilling system for its oil exploration
business. Management has decided that it must use the system to stay competitive; it will
provide $2.7 million in annual pretax cost savings. The system costs $9.4 million and will be
depreciated straight-line to zero over five years. Wildcat’s tax rate is 23 percent and the firm
can borrow at 9 percent. Lambert Leasing Company has offered to lease the drilling equipment
to Wildcat for payments of $2.05 million per year. Lambert’s policy is to require its lessees to
make payments at the start of the year.
9. Lease or Buy What is the NAL for Wildcat? What is the maximum lease payment that
would be acceptable to the company?
10. Leasing and Salvage Value Suppose it is estimated that the equipment will have an
aftertax residual value of $700,000 at the end of the lease. What is the maximum lease
payment acceptable to Wildcat now?
11. Deposits in Leasing Many lessors require a security deposit in the form of a cash pay-
ment or other pledged collateral. Suppose Lambert requires Wildcat to pay a $1.5 million
security deposit at the inception of the lease. If the lease payment is still $2.05 million,
is it advantageous for Wildcat to lease the equipment now?
12. Debt Capacity Gatto Manufacturing is considering leasing some equipment. The annual
lease payment would be $325,000 per year for six years. The appropriate interest rate is
6 percent and the company is in the 21 percent tax bracket. How would signing the lease
affect the debt capacity for the company?
13. Setting the Lease Price An asset costs $780,000 and will be depreciated in a straight-line
manner over its 3-year life. It will have no salvage value. The corporate tax rate is
22 percent and the appropriate interest rate is 7 percent.
a. What set of lease payments will make the lessee and the lessor equally well off?
b. Show the general condition that will make the value of a lease to the lessor the nega-
tive of the value to the lessee.
c. Assume that the lessee pays no taxes and the lessor is in the 22 percent tax bracket.
For what range of lease payments does the lease have a positive NPV for both parties?
14. Lease or Buy Wolfson Corporation has decided to purchase a new machine that costs
$2.4 million. The machine will be depreciated on a straight-line basis and will be worthless

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 736  ■■■  Part V Long-Term Financing

after four years. The corporate tax rate is 24 percent. The Sur Bank has offered Wolfson
a 4-year loan for $2.4 million. The repayment schedule is four yearly principal repayments
of $600,000 and an interest charge of 9 percent on the outstanding balance of the loan
at the beginning of each year. Both principal repayments and interest are due at the end
of each year. Cal Leasing Corporation offers to lease the same machine to Wolfson. Lease
payments of $710,000 per year are due at the beginning of each of the four years of the
lease.
a. Should Wolfson lease the machine or buy it with bank financing?
b. What is the annual lease payment that will make Wolfson indifferent to whether it
leases the machine or purchases it?
15. Setting the Lease Price An asset costs $640,000 and will be depreciated in a straight-line
manner over its 3-year life. It will have no salvage value. The lessor can borrow at 7 percent
and the lessee can borrow at 9 percent. The corporate tax rate is 21 percent for both
companies.
a. How does the fact that the lessor and lessee have different borrowing rates affect the
calculation of the NAL?
b. What set of lease payments will make the lessee and the lessor equally well off?
c. Assume that the lessee pays no taxes and the lessor is in the 21 percent tax bracket.
For what range of lease payments does the lease have a positive NPV for both parties?
16. Automobile Lease Payments Automobiles are often leased, and there are several terms
unique to auto leases. Suppose you are considering leasing a car. The price you and the
dealer agree on for the car is $38,000. This is the base capitalized cost. Other costs that
may be added to the capitalized cost price include the acquisition (bank) fee, insurance,
or extended warranty. Assume these costs are $550. Capitalized cost reductions include
any down payment, credit for a trade-in, or dealer rebate. Assume you make a down pay-
ment of $4,000 and there is no trade-in or rebate. If you drive 10,000 miles per year, the
lease-end residual value for this car will be $20,000 after three years.
The lease or “money” factor, which is the interest rate on the loan, is the APR of
the loan divided by 2,400. The money factor of 2,400 is the product of three numbers:
2, 12, and 100. The 100 is used to convert the APR, expressed as a percentage, to a
decimal number. The 12 converts this rate to a monthly rate. Finally, the monthly rate is
applied to the sum of the net capitalization cost plus the residual. If we divide this sum
by 2, the result is the average anticipated book value. Thus, the end result of the calcula-
tion using the money factor is to multiply a monthly rate by the average book value to
get a monthly payment. The lease factor the dealer quotes you is .00211.
The monthly lease payment consists of three parts: depreciation fee, finance fee, and
sales tax. The depreciation fee is the net capitalized cost minus the residual value divided
by the term of the lease. The finance fee is the net capitalization cost plus the residual
times the money factor, and the monthly sales tax is the monthly lease payment times the
tax rate. What APR is the dealer quoting you? What is your monthly lease payment for
a 36-month lease if the sales tax is 6 percent?
CHALLENGE 17. Lease vs. Borrow Return to the case of the diagnostic scanner discussed in Problems 1
(Questions 17–18) through 6. Suppose the entire $5.2 million purchase price of the scanner is borrowed.
The rate on the loan is 8 percent and the loan will be repaid in equal installments. Cre-
ate a lease-versus-buy analysis that explicitly incorporates the loan payments. Show that
the NPV of leasing instead of buying is not changed from what it was in Problem 1. Why
is this so?
18. Lease or Buy High electricity costs have made Farmer Corporation’s chicken-plucking
machine economically worthless. Only two machines are available to replace it. The Inter-
national Plucking Machine (IPM) model is available only on a lease basis. The lease

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 Chapter 21 Leasing  ■■■  737

payments will be $80,000 for five years, due at the beginning of each year. This machine
will save Farmer $29,000 per year through reductions in electricity costs. As an alterna-
tive, Farmer can purchase a more energy-efficient machine from Basic Machine Corpora-
tion (BMC) for $365,000. This machine will save $32,000 per year in electricity costs. A
local bank has offered to finance the machine with a loan. The interest rate on the loan
will be 10 percent on the remaining balance and will require five annual principal pay-
ments of $73,000. Farmer has a target debt-asset ratio of 67 percent and a tax rate of
21 percent. After five years, both machines will be worthless. The machines will be
depreciated on a straight-line basis.
a. Should Farmer lease the IPM machine or purchase the more efficient BMC machine?
b. Does your answer depend on the form of financing for direct purchase?
c. How much debt is displaced by this lease?
19. Cost of Lease In Section 21.9, we detailed a lease deal done by Tata Steel with IL&FS
Limited for the replacement of mining equipment in West Bokaro mines. With the details
provided, estimate the cost of lease for Tata Steel Limited. How would you approach the
problem when given the task to compare the deal with its option of equipment credit with
a manufacturer?

Mini Case The Decision to Lease or Buy at Warf Computers

Warf Computers has decided to proceed with the manufacture and distribution of the virtual
keyboard (VK) the company has developed. To undertake this venture, the company needs to
obtain equipment for the production of the microphone for the keyboard. Because of the
required sensitivity of the microphone and its small size, the company needs specialized equip-
ment for production.
Nick Warf, the company president, has found a vendor for the equipment. Clapton Acous-
tical Equipment has offered to sell Warf Computers the necessary equipment at a price of
$6.1 million. Because of the rapid development of new technology, the equipment falls in the
three-year MACRS depreciation class. At the end of four years, the market value of the equip-
ment is expected to be $780,000.
Alternatively, the company can lease the equipment from Hendrix Leasing. The lease
contract calls for four annual payments of $1.48 million, due at the beginning of the year.
Additionally, Warf Computers must make a security deposit of $400,000 that will be returned
when the lease expires. Warf Computers can issue bonds with a yield of 9 percent and the
company has a marginal tax rate of 21 percent.
1. Should Warf buy or lease the equipment?
2. Nick mentions to James Hendrix, the president of Hendrix Leasing, that although the
company will need the equipment for four years, he would like a lease contract for
two years instead. At the end of the two years, the lease could be renewed. Nick also
would like to eliminate the security deposit, but he would be willing to increase the lease
payments to $1.875 million for each of the two years. When the lease is renewed in
two years, Hendrix would consider the increased lease payments in the first two years
when calculating the terms of the renewal. The equipment is expected to have a market
value of $3.2 million in two years. What is the NAL of the lease contract under these
terms? Why might Nick prefer this lease? What are the potential ethical issues concerning
the new lease terms?
3. In the leasing discussion, James informs Nick that the contract could include a purchase option
for the equipment at the end of the lease. Hendrix Leasing offers three purchase options:

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 738  ■■■  Part V Long-Term Financing

a. An option to purchase the equipment at the fair market value.

b. An option to purchase the equipment at a fixed price. The price will be negotiated
before the lease is signed.
c. An option to purchase the equipment at a price of $200,000.
How would the inclusion of a purchase option affect the value of the lease?
4. James also informs Nick that the lease contract can include a cancellation option. The
cancellation option would allow Warf Computers to cancel the lease on any anniversary
date of the contract. In order to cancel the lease, Warf Computers would be required to
give 30 days’ notice prior to the anniversary date. How would the inclusion of a cancel-
lation option affect the value of the lease?

Appendix 21A
APV Approach to Leasing
To access the appendix for this chapter, please visit www.mheducation.co.in.

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