Good Reasons for Leasing

If leasing is a good choice, it will probably be because one or more of the following are true:

1. Taxes may be reduced by leasing.

2. The lease contract may reduce certain types of uncertainty that might otherwise decrease the value of the firm.

3. Transactions costs may be lower for a lease contract than for buying the asset.

4. Leasing may require fewer (if any) restrictive covenants than secured borrowing.

5. Leasing may encumber fewer assets than secured borrowing.

Tax Advantages As we have hinted in various places, by far the most economically justifiable reason for long-term leasing is tax deferral. If the corporate income tax were repealed, long-term leasing would become much less important. The tax advantages of leasing exist because firms are in different tax positions. A potential tax shield that cannot be used as efficiently by one firm can be transferred to another by leasing.

Any tax benefits from leasing can be split between the two firms by setting the lease payments at the appropriate level, and the shareholders of both firms will benefit from this tax transfer arrangement. The loser will be the IRS. A firm in a high tax bracket will want to act as the lessor. Low-tax bracket firms will be lessees, because they will not be able to use the tax advantages of ownership, such as depreciation and debt financing, as efficiently.

Recall the example of Section 26.6 and the situation of Johnson Leasing. The value of the lease it proposed to Tasha was $87.68. However, the value of the lease to Tasha was exactly the opposite (-$87.68). Because the lessor's gains came at the expense of the lessee, no mutually beneficial deal could be arranged. However, if Tasha paid no taxes and the lease payments were reduced to $2,475 from $2,500, both Johnson and Tasha would find there was positive NPV in leasing.

To see this, we can rework Table 26.2 with a zero tax rate and a $2,475 lease payment. In this case, notice that the cash flows from leasing are simply the lease payments of $2,475 because no depreciation tax shield is lost and the lease payment is not tax deductible. The cash flows from leasing are thus:

Lease versus Buy

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Lease payment Cost of machine







Total cash flow







The value of the lease for Tasha is:

NPV = $10,000 - 2,475 X (1 - 1/1.07575755)/.0757575 = $6.55

which is positive. Notice that the discount rate here is 7.57575 percent because Tasha pays no taxes; in other words, this is both the pretax and the aftertax rate.

Using Table 26.3, the value of the lease to Johnson can be worked out. With a lease payment of $2,475, verify that the cash flows to Johnson will be $2,313.50. The value of the lease to Johnson is therefore:

The biggest lessor by dollar value is

The biggest lessor by dollar value is

© The McGraw-Hill Companies, 2002

Edition, Alternate Edition

CHAPTER 26 Leasing 887

NPV = -$10,000 + 2,313.50 X (1 - 1/1.055)/.05 = $16.24

which is also positive.

As a consequence of different tax rates, the lessee (Tasha) gains $6.55 and the lessor (Johnson) gains $16.24. The IRS loses. What this example shows is that the lessor and the lessee can gain if their tax rates are different. The lease contract allows the lessor to take advantage of the depreciation and interest tax shields that cannot be used by the lessee. The IRS will experience a net loss of tax revenue, and some of the tax gains to the lessor will be passed on to the lessee in the form of lower lease payments.

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 (or salvage value). At the time the lease contract is signed, there may be substantial uncertainty as to what the residual value of the asset will be. A lease contract is a method of transferring this uncertainty from the lessee to the lessor.

Transferring the uncertainty about the residual value of an asset to the lessor makes sense when the lessor is better able to bear the risk. For example, if the lessor is the manufacturer, then the lessor may be better able to assess and manage the risk associated with the residual value. The transfer of uncertainty to the lessor amounts to a form of insurance for the lessee. A lease therefore provides something besides long-term financing. Of course, the lessee pays for this insurance implicitly, but the lessee may view the insurance as a relative bargain.

Reduction of uncertainty is the motive for leasing most cited by corporations. For example, computers have a way of becoming technologically outdated very quickly, and computers are very commonly leased instead of purchased. In one survey, 82 percent of the responding firms cited the risk of obsolescence as an important reason for leasing, whereas only 57 percent cited the potential for cheaper financing.

Lower Transactions Costs The costs of changing ownership of an asset many times over its useful life will frequently be greater than the costs of writing a lease agreement. Consider the choice that confronts a person who lives in Los Angeles but must do business in New York for two days. It seems obvious that it will be cheaper to rent a hotel room for two nights than it would be to buy a condominium for two days and then sell it. Thus, lower transactions costs may be the major reason for short-term leases (operating leases). However, it is probably not the major reason for long-term leases.

Fewer Restrictions and Security Requirements As we discussed in Chapter 7, with a secured loan, the borrower will generally agree to a set of restrictive covenants, spelled out in the indenture, or loan agreement. Such restrictions are not generally found in lease agreements. Also, with a secured loan, the borrower may have to pledge other assets as security. With a lease, only the leased asset is so encumbered.

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