Ch21 Asset Based Fing EFS e3

7/30/2019 Ch21 Asset Based Fing EFS e3

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Leasing and Other

Asset-Based

Financing

Corporate Financial Management 3e

Emery Finnerty StoweModified for course use by Arnold R. Cowan


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Lease Financing

A lease is a rental agreement that extends for one

year or longer.

The owner of the asset (the lessor) grantsexclusive use of the asset to the lessee for a fixed

period of time.

In return, the lessee makes fixed periodic payments to

the lessor.

At termination, the lessee may have the option to

either renew the lease or purchase the asset.


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Types of Leases

Full-service lease

Lessor responsible for maintenance, insurance,

and property taxes.Net lease

Lessee responsible for maintenance, insurance,

and property taxes.


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Types of Leases

Operating lease

short-term

may be cancelable

Financial lease

long-term

similar to a loan agreement


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Types of Lease Financing

Direct leases

Sale-and-lease-back agreements

Leveraged leases


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Direct Lease

LesseeManufacturer

/ LessorLease

Lessee LessorLease Sale of AssetManufacturer

/ Lessor

or


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Sale-and-Lease-Back

Sale of Asset

Lease

Lessee Lessor


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Leveraged Lease

LenderLien

Equity

Investor

LesseeLease

Single

Purpose

Leasing

Company

ManufacturerSaleofA

sset

Equity

Loan


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Synthetic Leases

Firms have used synthetic leases to get theuse of assets but keep debt off their balance

sheets.An unrelated financial institution investssome equity and sets up a special-purpose-entity that buys the assets and leases it to

the firm under an operating lease.Since the Enron bankruptcy, firms havebeen reluctant to use synthetic leases.


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Enrons Murky Deals

Lending

Group

Equity

Investor

Enron

Partnership

or Special

PurposeEntity

Enron used outside

partnerships to move assets

off its balance sheet and

monetize assets. But the

company was deeplyinvolved with funding

those partnerships.

Enron sells assets, gets

debt off the balance

sheet and recognizes a

gain on the sale.

Outside investors inject

at least 3% of the

funding so that Enron

doesnt have to claim it

as a subsidiary.

1

3Enron provided some or

all of the 3%.

Banks provided the

other 97% of thefinancing.

45Enron guarantees the loan.

Sometimes with now-

worthless Enron shares.

2


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Enrons Partnerships

As a result, any debt incurred by thepartnership could be kept off the company's

balance sheet.As an added bonus, Enron often recognizeda gain on the sale of the assets.


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Why did Enron want debt off their

balance sheet?

The simple answer is that Enron feared that

too much debt would damage its credit

rating.


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Why did Enron want debt off their

balance sheet?

A more complex answer lies with agency costs.

Enron executives headed and partly owned

some of the partnerships, which provided a hugesource of outside income for those involved.

Enrons former CFO, Andrew Fastow, made more

than $30 million from two partnerships that he ran.

If you were a shareholder in a SPE buying an

asset from your employer, where would your

loyalties lie?


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How Widespread Was This at Enron?

There were hundreds, and perhaps even

thousands, of these partnerships.

The exact number isn't known.In all, Enron had about 3,500 subsidiaries

and affiliates, many of them limited

partnerships and limited-liabilitycompanies, which are a sort of hybrid

between corporations and partnerships.


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How Did They Get Away With It?

The company and its board of directors

claimed that allowing executives to be

involved with the outside partnerships gaveit the advantage of speed.

Enron claimed that it set up safeguards to

protect itself, but in retrospect they wereclearly inadequate.


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Advantages of Leases

Efficient use of tax deductions and tax credits ofownership

Reduced risk

Reduced cost of borrowing

Bankruptcy considerations

Tapping new sources of funds

Circumventing restrictions debt covenants

off-balance sheet financing


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Disadvantages of Leasing

Lessee forfeits tax deductions associated

with asset ownership.

Lessee usually forgoes residual asset value.


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Valuing Financial Leases

Basic approach is similar to debt refunding.

Lease displaces debt.

Missed lease payments can result in the lessor claiming the asset.

filing lawsuits.

forcing firm into bankruptcy.

Risk of a firms lease payments are similar to

those of its interest and principal payments.


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Equivalent Ways to Analyze

Net Advantage to Leasing (NAL) approach:

Lease if

NAL > 0.The Internal Rate of Return (IRR) approach:

Lease if

IRR of leasing < after-tax cost of debtfinancing.


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Leases Analysis Example

The Emerson Co. needs the use of a special

purpose stamping machine for the next 10

years.The machine costs $6 million, has a life of

10 years, and a salvage value of $300,000.

Emerson can lease this machine from theGeneral Supply Co. for 10 years, with annual

year-end lease payments of $1.05 million.

Emersons tax rate is 40%.


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Leases Analysis Example

If Emerson were to buy the machine, it

would finance 80% of the purchase price with

a 11.5% secured installment loan, with theremainder being borrowed as unsecured

installment debt at 14% interest.

The after-tax required return on the asset is15%.

Evaluate this leasing opportunity.


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Leasing Displaces Borrowing

Suppose initially that the Emerson Co. has net

assets worth $50 million, and a debt ratio of

50%. Compute the debt ratio if Emerson uses:

Conventional financing for the stamping

machine.

Leases the stamping machine. How

would the target debt ratio be restored?


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InitialCapitalization

Conventional Debt

Financial LeaseObligation

Total Debt

EquityTotal

$ 25 M

$ 0 M$25 M

$25 M$50 M

Debt Ratio 50%


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ConventionalFinancing

Conventional Debt


Total Debt

EquityTotal

$ 28 M

$ 0 M$25 M

$28 M$56 M

Debt Ratio 50%


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LeaseFinancing

Conventional Debt


Total Debt

EquityTotal

$ 2 5 M

$ 6 M$ 31 M

$25 M$56 M

Debt Ratio 5 5.36%


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Debt RatioRestored

Conventional Debt


Total Debt

EquityTotal

$ 22 M

$ 6 M$28 M

$28 M$56 M

Debt Ratio 50%


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Analyzing Leases

TheNet Advantage to Leasing(NAL)

equals the purchase price (P) minus the

present value of the incremental after-taxcash flows (CFAT) associated with the

lease.

NAL =PPV(CFATs)


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Analyzing Leases - the Discount

Rate

The discount rate should be the lessees after-taxcost of similarly secured debt.

Since the lease obligation is not overcollateralized,

the secured debt rate should reflect this.

Fully secured means the asset is worth more than25% of the loan.

$80M loan on $100M asset: $20/$80 = 25%

Use weighted average of secured and unsecureddebt rates if necessary.


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Analyzing Leases - the Cash Flows

Cost of asset (saving)

Lease payments (cost)

Incremental differences in operating andother expenses (cost or savings)

Depreciation tax shelter (foregone benefit)

Expected net residual value (foregone

benefit)

Investment tax credits (foregone benefit)


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Net Advantage to LeasingD

t = yeartdepreciation deduction

DEt= yeartcash expense savings from leasing

ITC = investment tax credit, if available

CFt= lease payment in yeart

N = life of lease (in years)P = purchase price of asset

r = assets after-tax required return

r = cost of debt (secured & unsecured)Salvage = net salvage valueT = lessees marginal income tax rate

'1

(1 )( )

(1 (1 ) ) (1 )

Nt t t

t Nt

T CF E TD SalvageNAL P ITC

T r r

D


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Net Advantage to Leasing

We save paying the purchase priceP.We lose the ITC and salvage value.

We pay the lease payment CF; this may be partlyoffset by savings on operating and other cash

expenses (E) and by tax deductibility.We lose the depreciation tax shield TD.

Discount main cash flows at the after-tax cost ofdebt.

'1

(1 )( )(1 (1 ) ) (1 )

N t t t

t Nt

T CF E TD SalvageNAL P ITCT r r

D


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For the Emerson Co.,

P= $6 million

CFt= $1.05 million per year for 10 yearsD

t= ($6,000,000 - $300,000) / 10 = $570,000

per year for 10 years

DEt= 0,ITC= 0 r= 15%

r = 80%(11.5%) + 20%(14%) = 12.0%


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'1

(1 )( )

(1 (1 ) ) (1 )

Nt t t

t Nt

T CF E TD SalvageNAL P ITC

T r r

D

10

10

1 )15.1(

000,300$

)12.0)40.01(1(

000,570$4.0)05.1)($40.1(6$

tt

mmNAL

068,45$NAL


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The IRR Approach

For Emersons leasing opportunity, the IRR

is 7.58%.

The after-tax cost of debt financing is12%(10.40) = 7.20%.

Since the IRR (the cost of lease financing)

is greater than the after-tax cost of debtfinancing, Emerson should not lease the

machine.


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Break-Even Lease Payments

The break-even lease payments can be

computed by setting the NAL to zero.

In the case of Emersons lease, the annualbreak-even payments are $1,039,206.

Since the lease contract calls for payments of

$1,050,000; the leasing alternative is notpreferred.


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NPV of Lease to the Lessor

In a perfect market with no tax, leasing is a

zero-sum game.

The NPV of the lease to the lessor will be- (NAL to the lessee).

If lessee and lessor have the same marginal

income tax rates, leasing is still a zero sumgame in an otherwise perfect market.


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where T= lessors marginal income tax rate.

' '

Lessor ' '

1

(1 )( )

(1 (1 ) ) (1 )

Nt t t

t N

t

T CF E T D SalvageNAL P ITC

T r r

D


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10

10

1

Lessor)15.1(

000,300$

)12.0)40.01(1(

000,570$4.0)05.1)($40.1(6$

tt

mmNAL

068,45$Lessor NAL

' '

Lessor ' '1

(1 )( )

(1 (1 ) ) (1 )

Nt t t

t Nt

T CF E T D SalvageNAL P ITC

T r r

D


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Effect of Tax Asymmetries

Suppose lessees (Emersons) tax rate is

zero. Also assume that the before-tax

required return on the asset for the lessee is17.50%.

The NAL to Emerson is then $7,460.

The NPV to the lessor is still $45,068.Thus, both parties gain from the leasing

arrangement.


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Tax Treatment of Financial Leases

IRS has guidelines for distinguishing

between true leases and

installment sales agreements. secured loans.

If lessor meets these guidelines:

lessor can claim tax deductions and credits ofasset ownership.

lessee can deduct full amount of lease payment

for tax purposes.

id li f i i l


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IRS Guidelines for Financial

Leases

Term of lease < 80% of assets useful life.

Lessor must maintain an equity investment ofat least 10% of assets original cost.

Exercise price of the purchase option mustequal the assets fair market value at the timethe option is exercised.

Lessee does not pay any portion of the assetspurchase price.

Lessor must hold title to the property.


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Accounting Treatment of Financial

Leases

SFAS 13 requires lessees to capitalize all leases

that meet any one of the following:

Lease transfers ownership of asset to lessee beforethe lease expires.

Lessee has option to purchase asset at a bargain

price.

Term of lease is greater than or equal to 75% of

assets useful economic life.

PV of lease payments is 90% of asset value.


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Project Financing

Desirable when

Project can stand alone as an economic unit.

Project will generate enough revenue (net ofoperating costs) to service project debt.

Examples:

Mines & mineral processing facilities Pipelines

Oil refineries

Paper mills


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Project Financing Arrangements

Completion undertaking

Purchase, throughput, or tolling agreements

Cash deficiency agreements

Ad d Di d f


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Advantages and Disadvantages of

Project Financing

Advantages

Risk sharing

Expanded debt capacity Lower cost of debt

Disadvantages

Significant transaction costs and legal fees

Complex contractual agreements

Lenders require a higher yield premium


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Limited Partnership Financing

Another form of tax-oriented financing.

Allows the firm to sell the tax deductions

and credits associated with asset ownershipto the limited partners.

Income (or loss) for tax purposes flowsthrough to the partners.

Limited partners are passive investors.

General partner operates the limitedpartnership and has unlimited liability.

Documents

Ch21 Asset Based Fing EFS e3