For your initial post, include the following information:
Describe the different types of leases introduced in the textbook.
Explain how they would benefit managers in financial planning.
Note whether your organization has leasing information.
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Years on
Deposit
Quarters on
Deposit
Ending
Amount
1st deposit
$2,500,000
3
1,095
$ 2,900,203
2nd deposit
$5,000,000
2
730
$ 5,520,294
3rd deposit
$7,500,000
1
365
$ 7,880,565
Total 3 years from now
$16,301,063
=FV(rate,nper,,pv)
=FV(4.95%/365,3*365,,$2,500,000) = $2,900,203
=FV(4.95%/365,2*365,,$5,000,000) = $5,520,294
=FV(4.95%/365,1*365,,$7,500,000) = $7,880,565.
The difference between the ending amount and the estimated construction cost in three years for each bank is as follows:
Lower Plains Bank
Mid-West Bank
Ending amount
$16,306,407
$16,301,063
Estimated construction cost
$ 16,153,359
$16,153,359
Difference
$ 153,047
$ 1 47,703
The Decision
Both investments would provide an ending amount sufficient to pay the estimated construction cost in three years. Although the money market account
with Mid-West Bank would result in an ending balance that is less than the CD
with Lower Plains Bank, Achieve management decided to invest its funds in the
money market account. Management considered that it was worth forgoing
($153,047 – $147,703 =) $5,344 in exchange for the flexibility of being able to
withdraw the funds at any time in case of emergencies or changes in construction timing. n
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CHAPTER
FINANCIAL RISK AND REQUIRED RETURN
5
Learning Objectives
After studying this chapter, readers should be able to
•
•
•
•
explain the concept of financial risk in general terms,
define and differentiate between stand-alone risk and portfolio risk,
define market risk,
explain the capital asset pricing model (CAPM) relationship
between market risk and required return, and
• use the CAPM to determine required returns.
Introduction
Two of the most important concepts in healthcare financial management are
financial risk and required return. What is financial risk, how is it measured,
and what effect does it have on required return and hence managerial decisions? Because so much financial decision-making involves risk and return,
one cannot gain a good understanding of healthcare financial management
without having a solid appreciation of risk and return concepts.
If investors—both individuals and businesses—viewed risk as a benign
fact of life, it would have little impact on decision-making. However, decision
makers are, for the most part, averse to risk and believe it should be avoided.
If risks must be taken, there must be a reward for doing so. Thus, investments of higher risk—whether an individual investor’s security investment or
a radiology group’s investment in diagnostic equipment—must offer higher
returns to make the investment financially attractive.
This chapter presents basic risk concepts from the perspectives of individual investors and businesses. Healthcare managers must be familiar with
both contexts because investors supply the capital that businesses need to
function. Unfortunately, merely knowing an investment’s risk is not sufficient
to make good investment decisions. It is also necessary to translate risk into
required rates of return. Thus, the chapter closes with a discussion of the
relationship between risk and required return.
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The Many Faces of Financial Risk
A full discussion of financial risk would take many chapters, perhaps even an
entire book, because financial risk is a complicated subject. First, it depends
on whether the investor is an individual or a business. If the investor is an
individual, it depends on the investment horizon, or the amount of time until
the investment proceeds are needed. To make the situation even more complex, it may be difficult to define, measure, or translate financial risk into
something usable for decision-making. For example, the risk that individual
investors face when saving for retirement is the risk that the amount of funds
accumulated will not be sufficient to fund the lifestyle expected during the
full term of retirement. Needless to say, incorporating such a definition of risk
into investment decisions is not easy. The good news is that our primary
interest concerns the financial risk inherent in making decisions in businesses.
Thus, our discussion focuses on the fundamental factors that influence the
riskiness of real asset investments (e.g., land, buildings, equipment).
Still, two factors complicate our
discussion of financial risk. The first complicating factor is that both businesses
To Mortgage or Not to Mortgage
and investors in businesses are subject to
One of the most perplexing financial issues facing
financial risk. There is some risk inherent
well-to-do individuals is the question of whether
to take out a mortgage on a house purchase.
in the business itself that depends primarAlternatively, how big should the mortgage be?
ily on the type of enterprise. For example,
For example, assume a couple is retiring and movpharmaceutical firms generally face a great
ing to Florida. They are buying a $300,000 house
deal of risk, while healthcare providers
in The Villages (“Florida’s Friendliest Retirement
typically have less risk. Investors—stockHometown,” https://thevillagesflorida.com).
holders and creditors—bear the riskiness
Because they sold their house in Boston, which
they had lived in for 30 years, for $500,000, they
inherent in the business, but the risk is
could easily pay cash for their retirement home.
modified by the contractual nature of
However, the real estate agent in Florida encourthe securities they hold. For example, the
aged them to obtain a 20-percent-down ($60,000)
stock of Manor Care is more risky than its
mortgage and refinance the remaining $240,000.
debt, although the risk of both securities
“After all,” said the agent, “the interest rate on
depends on the inherent risk of a business
the mortgage balance is only 5 percent, and you
can invest the $240,000 saved in stocks and earn
that operates in the long-term care sector.
10 percent. Only a fool would buy a house for
Not-for-profit firms have the same particash.” What do you think of the agent’s advice?
tioning of risk, but the inherent riskiness
On the surface, the agent makes sense, but does
of the business is split between creditors
risk enter into the decision? Assume that the
and the implied stockholders, who generproposed mortgage has a 15-year maturity and
ally are considered to be the community
the interest rate on 15-year Treasury securities
is 4 percent. Is this information relevant to the
at large.
decision?
The second complicating factor
is that the riskiness of an investment
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C h ap ter 5: F inanc ial Risk and Req uired Retur n
depends on the context in which it is held. For example, a stock held alone
is riskier than the same stock held as part of a large portfolio of stocks. Similarly, a magnetic resonance imaging (MRI) system operated independently
is riskier than the same system operated as part of a large, geographically
diversified business that owns and operates numerous types of diagnostic
equipment.
1. What complications arise when dealing with financial risk in a
business setting?
SELF-TEST
QUESTION
Returns on Investments
The concept of return provides investors with a convenient way to express
the financial performance of an investment. To illustrate, suppose you buy
ten shares of a stock for $100. The stock pays no dividends, and at the end
of one year, you sell the stock for $110. What is the return on your $100
investment?
One way to express an investment’s return is in dollar terms:
Dollar return = Amount to be received − Amount invested
= $110 − $100 = $10.
If, at the end of the year, you sell the stock for only $90, your dollar return
will be −$10.
Although expressing returns in dollars is easy, two problems arise.
First, to make a meaningful judgment about the return, you need to know
the scale (size) of the investment; a $100 return on a $100 investment is
a great return (assuming the investment is held for one year), but a $100
return on a $10,000 investment would be a poor return. Second, you also
need to know the timing of the return; a $100 return on a $100 investment
is a great return if it occurs after one year, but the same dollar return after
100 years is not very good. The solution to these scale and timing problems
is to express investment results as rates of return or percentage returns. For
example, when $1,100 is received after one year, the rate of return on the
one-year stock investment, is 10 percent:
Rate of return = Dollar return ÷ Amount invested
= $100 ÷ $1,000 = 0.10 = 10%.
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The rate of return calculation “standardizes” the dollar return by considering
the annual return per unit of investment.
Introduction to Financial Risk
Generically, risk is defined as “a hazard; a peril; exposure to loss or injury.”
Thus, risk refers to the chance that an unfavorable event will occur. If an individual engages in skydiving, she risks injury or death. If an individual gambles
at roulette, he is not risking injury or death but is taking a financial risk.
Even when an individual invests in stocks or bonds, she risks losing money in
hopes of earning a positive rate of return. Similarly, when a healthcare business invests in new assets—such as diagnostic equipment, new hospital beds,
or a new managed care plan—it is taking a financial risk.
For an illustration of basic financial risk, consider two potential
personal investments. The first investment consists of a one-year, $1,000
face-value US Treasury bill (T-bill) bought for $950. Treasury bills are
short-term federal debt securities that are sold at a discount (i.e., less than
face value) and return face, or par, value at maturity. The investor expects to
receive $1,000 at maturity in one year, so the anticipated rate of return on
the T-bill investment is 5.26 percent. To calculate this using a spreadsheet,
see the following image.
A
1
2
3
4
B
1
C
Nper
Number of periods
$(950.00)
Pv
Present value
$1,000
Fv
Future value
5.26%
=RATE(A2,,A3,A4) (entered into cell A8)
D
5
6
7
8
9
10
The $1,000 payment is fixed by contract (the T-bill promises to pay
this amount), and the US government is certain to make the payment unless
a national disaster occurs—an unlikely event. Thus, there is virtually a 100
percent probability that the investment will earn the roughly 5.3 percent rate
of return expected. In such situations, an investment is defined as riskless, or
risk free.1
Now, assume that the $950 is invested in a biotechnology partnership that will be terminated in one year. If the partnership develops a new
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C h ap ter 5: F inanc ial Risk and Req uired Retur n
commercially valuable product, its rights will be sold and $2,000 will be
received from the partnership, for a rate of return of 110.53 percent.
A
1
2
B
1
3
4
C
Nper
Number of periods
$(950.00)
Pv
Present value
$2,000
Fv
Future value
110.53%
=RATE(A2,,A3,A4) (entered into cell 8)
D
5
6
7
8
9
10
On the other hand, if nothing worthwhile is developed, the partnership will be worthless, no money will be received, and the rate of return will
be −100 percent.
A
1
2
3
4
B
1
C
Nper
Number of periods
$(950.00)
Pv
Present value
$0.01
Fv
Future value
D
5
6
7
8
9
10
–100.00%
=RATE(A2,,A3,A4) (entered into cell 8)
Note that spreadsheets give no solution when the future value is
entered as zero, but if a very small number—for example, 0.01—is entered
for the future value, the solution for interest rate is −100.00 percent.
Now, assume that there is a 50 percent chance that a valuable product
will be developed. In this admittedly unrealistic situation, the expected rate
of return—a statistical concept that will be discussed shortly—is the same 5.3
percent as on the T-bill investment: (0.50 × 110.53%) + (0.50 × [−100%]) =
5.3%. However, the biotechnology partnership is a far cry from being riskless.
If things go poorly, the entire $950 investment will be lost, and the realized
rate of return will be –100 percent. Because there is a significant chance of
earning a return that is far less than expected, the partnership investment is
described as being very risky.
Thus, financial risk is related to the probability of earning a return that
is less than expected. The greater the chance of low or negative returns, the
greater the amount of financial risk.
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SELF-TEST
QUESTIONS
1. What is the generic definition of risk?
2. Explain the concept of financial risk in general terms.
Risk Aversion
Why are defining and measuring financial risk so important? Because, for the
most part, both individual and business investors dislike risk. Suppose you
were given a choice between a sure $1 million and the flip of a coin for either
$0 or $2 million. You—and just about everyone else—would likely take the
$1 million and run. An individual who takes the sure $1 million is risk averse;
an individual who is indifferent between the two alternatives, or views them
as the same, is risk neutral; and an individual who prefers the gamble to the
sure thing is a risk seeker.
Of course, people and businesses do gamble and take chances, so all
of us typically exhibit some risk-seeking behavior. However, most individual
investors would never put a sizable proportion of their net worth at risk, and
most business executives would never “bet the business”—most people are
risk averse when it really matters.
What are the implications of risk aversion for financial decisionmaking? First, given two investments with similar returns but differing risk,
investors will favor the lower-risk alternative. Second, investors will require
higher returns to invest in higher-risk investments. These typical outcomes
of risk averse behavior have a significant impact on many facets of financial
decision-making; hence, they will appear repeatedly in later chapters.
SELF-TEST
QUESTIONS
1. What is risk aversion?
2. What are the implications of risk aversion for financial
decision-making?
Probability Distributions
The chance that an event will occur is called probability of occurrence, or
just probability. For example, a weather forecast might predict a 40 percent
chance of rain. Or, when rolling a single die, the probability of rolling a two
is one out of six, or 1 ÷ 6 = 0.1667 = 16.67%. If all possible outcomes related
to a particular event are listed, and a probability is assigned to each outcome,
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CHAPTER
LEASE FINANCING
8
Learning Objectives
After studying this chapter, readers should be able to
• describe the different types of leases,
• explain how lease financing affects financial statements and taxes,
• analyze basic lease transactions from the perspectives of both the
lessee and the lessor, and
• discuss the factors that create value in lease transactions.
Introduction
Businesses generally own fixed (capital) assets, but it is the use of the buildings and equipment that is important to the business, not their ownership.
One way to obtain the use of such assets is to raise debt or equity capital and
then use this capital to buy the assets. An alternative way to obtain the use of
fixed assets is to lease them. Prior to the 1950s, leasing was generally associated with real estate—land and buildings. Today, almost any kind of fixed
asset can be leased.
Leasing is used extensively in the health services field. For example, it
is estimated that 35 percent to 40 percent of all medical equipment used in
the United States is leased. In 2018 alone, healthcare providers leased more
than $10 billion worth of equipment. Diagnostic imaging devices account for
about half of all provider leasing, with a typical lease term of about five years.
In addition to diagnostic equipment, there has been increasing use of leasing
to acquire information technology, which is consuming a larger and larger
proportion of healthcare businesses’ capital expenditures.
Lease Parties and Types
There are two parties to any lease transaction. The user of a leased asset is
called the lessee, while the owner of the property—usually the manufacturer
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or a leasing company—is called the lessor. (“Lessee” is pronounced “less-EE”
[not “lease-ee”], and “lessor” is pronounced “LESS-or.”)
Historically, leases have been classified in one of three categories: (1)
operating leases, (2) finance leases, and (3) combination leases. In this section, we discuss these informal classifications. In later sections, we will discuss
more formal classifications used by accountants and by the Internal Revenue
Service (IRS).
Operating Leases
Operating leases generally provide for both financing and maintenance in
addition to use of the asset. IBM was one of the pioneers of operating lease
contracts. Computers and office copiers—together with automobiles, trucks,
and medical diagnostic equipment—are the primary types of assets involved
in operating leases. Ordinarily, operating leases require the lessor to maintain
and service the leased equipment, and the cost of the maintenance is built
into the lease payments.
Another important characteristic of operating leases is partial amortization. The lease contract is usually written for a period considerably shorter
than the expected economic life of the leased asset; thus, the payments
required under the lease contract are not sufficient for the lessor to recover
the full cost of the equipment. However, the lessor can expect to recover all
costs eventually by lease renewal payments, by releasing the equipment to
other lessees, or through sale of the equipment.
Finally, operating leases often contain a cancellation clause, which gives
the lessee the right to cancel the lease and return the equipment before the
expiration of the basic lease agreement. This feature is important to the lessee
because it means that the equipment can be returned if it is rendered obsolete
by technological advances or if it is no longer needed because of a decline in
the lessee’s business.
Finance Leases
Finance leases, which are also called capital leases, are differentiated from
operating leases in that they (1) typically do not provide for maintenance
service, (2) typically are not cancelable, (3) generally are executed for a
period that approximates the useful life of the asset, and hence (4) are fully
amortized—that is, the lessor receives rental payments equal to the full cost
of the leased asset plus a return on the funds employed.
A lease is classified as a finance lease if one or more of the following
conditions exist:
• Under the terms of the lease, ownership of the property is effectively
transferred from the lessor to the lessee.
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C hap ter 8: Lease F inanc ing
• The lessee can purchase the property at less than its true market value
when the lease expires.
• The lease runs for a period equal to or greater than 75 percent of the
asset’s life. Thus, if an asset has a ten-year life and the lease is written
for eight years, the lease must be capitalized.
• The present value of the lease payments is equal to or greater than
90 percent of the initial value of the asset. The discount rate used to
calculate the present value of the lease payments must be the lower of
(1) the rate used by the lessor to establish the lease payments, which
is discussed later in the chapter; and (2) the rate of interest that the
lessee would have to pay for new debt with a maturity equal to that
of the lease. Note that any maintenance payments embedded in the
lease payment must be stripped out prior to checking this condition
(FASB 2016).
In a typical finance lease, the lessee selects the item it requires and
negotiates the price and delivery terms with the manufacturer. The lessee then
arranges to have a leasing firm (lessor) buy the equipment from the manufacturer, and the lessee simultaneously executes a lease agreement with the lessor.
The lessee is generally given an option to renew the lease at a reduced rate
on expiration of the initial lease agreement. However, under a “pure” finance
lease, the initial lease cannot be canceled. Also, the lessee generally pays the
insurance premiums and any property taxes due on the leased property.
The terms of the lease call for full amortization of the lessor’s investment plus a rate of return on the unamortized balance, which is close to
the percentage rate the lessee would have paid on a secured term loan. For
example, if a radiology group practice would have to pay 10 percent for a
term loan to buy an X-ray machine, the lessor would build a rate of about
10 percent into the lease contract. The parallel to borrowing is obvious in a
finance lease. Under a secured loan arrangement, the lender would normally
receive a series of equal payments just sufficient to amortize (pay off) the
loan and to provide a specified rate of return on the outstanding loan balance. Under a finance lease, the lease payments are set up exactly the same
way—the payments are just sufficient to return the full purchase price to the
lessor, plus a stated return on the lessor’s investment.
A sale and leaseback is a special type of finance lease, often used with
real estate, that can be arranged by a user that currently owns some asset.
Here, the user sells the asset to another party and simultaneously executes
an agreement to lease the property back for a stated period under specific
terms. In a sale and leaseback, the lessee receives an immediate cash payment
in exchange for a future series of lease payments that must be made to rent
the asset sold.
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Combination Leases
Although the distinction between operating and finance leases has historical
significance, today many lessors offer leases under a wide variety of terms.
Therefore, in practice, leases often do not fit exactly into the operating lease
or finance lease category but rather combine some features of each. For
example, many of today’s finance leases contain cancellation clauses, which
historically have been associated only with operating leases. However, when
used in finance leases, these clauses generally include prepayment provisions
whereby the lessee must make penalty payments sufficient to enable the lessor
to recover some or all of the remaining lease payments.
SELF-TEST
QUESTIONS
1. What is the difference between an operating lease and a finance
lease?
2. What is a sale and leaseback?
3. Explain the features of a combination lease.
Per Procedure Versus Fixed Payment Leases
Lease (rental) payments on operating leases can be structured in two different
ways. Under fixed payment terms, an agreed-on fixed amount is made to the
lessor periodically—usually monthly. With this type of payment, the cost to
the lessee is known with certainty. Under per procedure (per use) terms, a fixed
amount is paid each time the equipment is used. In essence, a per procedure
lease converts a lessee’s fixed cost for the equipment (which is independent
of volume) into a variable cost (which is directly related to volume). We will
have more to say about per procedure leases later in the chapter.
SELF-TEST
QUESTION
1. How do per procedure and fixed payment operating lease terms
differ?
Tax Effects
For both investor-owned and not-for-profit healthcare businesses, tax effects
can play an important role in the lease-versus-buy decision.
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C hap ter 8: Lease F inanc ing
For investor-owned businesses, the
full amount of lease payments is a tax
deductible expense for the lessee provided that the IRS agrees that a particular contract is a genuine lease and
not simply a loan that is called a lease.
Thus, it is important that a lease contract
be written with terms that are acceptable
to the IRS. A lease that complies with all
of the IRS requirements for taxable businesses is called a guideline, or tax-oriented,
lease. In a guideline lease, ownership tax
benefits (primarily depreciation) accrue to
the lessor and the lessee’s lease payments
are fully tax deductible. A lease that does
not meet the tax guidelines is called a
nonguideline, or non-tax-oriented, lease.
For this type of lease, the lessee can deduct
only the implied interest portion of each
lease payment. However, the lessee is
effectively the owner of the leased equipment; thus, the lessee, rather than the lessor, receives the tax depreciation benefit.
The main provisions of the tax
guidelines are as follows:
• The lease term, including any
extensions or renewals at a fixed
rental rate, must not exceed
80 percent of the estimated
useful life of the equipment at
the commencement of the lease
transaction. Thus, at the projected
end of the lease, the property must
have an estimated remaining life
equal to at least 20 percent of its
original life. Furthermore, the
remaining useful life must not be
less than one year. This requirement
limits the maximum term of a
guideline lease to 80 percent of
285
LASIK and Per Use Leases
LASIK—commonly referred to as laser eye
surgery or laser vision correction—is a type of
refractive surgery for the correction of myopia,
hypermetropia, and astigmatism. The surgery
is performed by an ophthalmologist who uses a
laser to reshape the cornea to improve visual acuity. For most patients, LASIK provides a permanent alternative to eyeglasses or contact lenses.
As of 2018, more than 19 million such procedures
have been performed in the United States.
LASIK surgery was first approved by the Food
and Drug Administration for use in the United
States in the early 1990s, after its successful
application in other countries. At the time, the
equipment itself cost about $100,000. Initially,
there was significant uncertainty regarding the
effectiveness and patient acceptance of the
procedure, and hence the volume of surgeries
was highly speculative. The end result was that
most ophthalmologists were unwilling to risk the
$100,000 purchase price.
To encourage widespread use, the manufacturer, along with other lessors, offered to lease
the equipment to physicians on a per procedure
(per use) basis. The lease required no upfront
payment and the lessor handled equipment
maintenance and any required repairs. In addition, the lessor provided delivery and installation
along with all required technical training for a
per use charge of roughly $800. The end result
was a fixed contribution of about $1,200 for each
procedure performed, which first covers all other
operating costs and then flows to profit. Under
a traditional fixed payment lease, the risk of low
volume is borne by the practice, but under a per
use lease, this risk is assumed by the lessor. At
anticipated volumes, the per use lease cost more
than a fixed payment lease, but the per use lease
provided protection (insurance) for the lessee
against low volumes.
Because of the attractiveness of the per use
lease financing option to ophthalmologists, LASIK
surgery took off like gangbusters and today
remains one of their leading revenue sources.
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•
•
•
•
the asset’s useful life. Note that an asset’s useful life is normally much
longer than its tax depreciation class life.
The equipment’s estimated value (in constant dollars without
adjustment for inflation) at the projected expiration of the lease must
equal at least 20 percent of its value at the start of the lease. Note
that the estimated value of the asset at the end of the lease is called
the residual value. This requirement also has the effect of limiting the
maximum lease term.
Neither the lessee nor any related party can have the right to purchase
the property from the lessor at a price substantially less than its fair
market value.
Neither the lessee nor any related party can pay or guarantee payment
of any part of the price of the leased equipment. Simply put, the lessee
cannot make any investment in the equipment, other than through the
lease payments.
The leased equipment must not be “limited use” property, which is
equipment that can be used only by the lessee or a related party at the
end of the lease.
If the contract is classified as a tax-oriented lease, then the lessor is
entitled to the tax benefits of ownership, including depreciation and any
investment tax credits. The lessor also bears the responsibilities of ownership,
such as maintenance expenses. The reverse is true for a non-tax-oriented
lease: The lessee retains the tax benefits and pays for the maintenance. The
IRS guidelines mean that almost all operating leases are tax-oriented leases
and almost all finance leases are non-tax-oriented leases.
The reason for the IRS’s concern about lease terms is that, without
restrictions, a business can set up a “lease” transaction that calls for rapid lease
payments, which would be deductible from taxable income. The effect would
be to depreciate the equipment over a much shorter period than the IRS
allows in its depreciation guidelines. For example, suppose that New England
Laboratories, Inc., an investor-owned corporation that owns clinical laboratories in New Hampshire, Maine, Massachusetts, and Vermont, planned
to acquire a $2 million computer that has a three-year life for tax purposes.
According to current tax laws (Modified Accelerated Cost Recovery System
[MACRS]), the annual depreciation allowances would be $660,000 in year
1; $900,000 in year 2; $300,000 in year 3; and $140,000 in year 4. If New
England Laboratories were in the 30 percent federal-plus-state tax bracket,
the depreciation would provide a tax savings of 0.30 × $660,000 = $198,000
in year 1; $270,000 in year 2; $90,000 in year 3; and $42,000 in year 4, for
a total savings of $600,000. At a 6 percent discount rate, the present value
of these tax savings would be $568,081.
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C hap ter 8: Lease F inanc ing
Now, suppose the firm could acquire the computer through a oneyear lease arrangement with First Bank of Boston for a payment of $2 million, with a one-dollar purchase option. If the $2 million payment were
treated as a lease payment, it would be fully deductible, so it would provide
tax savings of 0.30 × $2,000,000 = $600,000 versus a present value of only
$568,081 for the depreciation shelters associated with ownership. Thus,
the lease payment and the depreciation would both provide the same total
amount of tax savings—30 percent of $2 million, or $600,000—but the
savings would come in faster, and hence have a higher present value, with
the one-year lease. This acceleration would benefit businesses, but it would
be costly to the government and hence to individual taxpayers. For this
reason, the IRS has established the rules just described for defining a lease
for tax purposes.
Even though leasing can be used only within limits to speed up the
effective depreciation schedule, there are still times when substantial tax
benefits can be derived from a leasing arrangement. For example, if an
investor-owned hospital has a large construction program that has generated
so much depreciation that it has no current tax liabilities, then depreciation shelters are not very useful. In this case, a leasing company set up by a
profitable business, such as General Electric, can buy the equipment, receive
the depreciation shelters, and then share these benefits with the hospital by
charging lower lease payments.1 This issue will be discussed in detail later in
the chapter, but the point to be made now is that if businesses are to obtain
tax benefits from leasing, the lease contract must be written in a manner that
will qualify it as a true lease under IRS guidelines. Any questions about the
tax status of a lease contract must be resolved by the potential lessee prior to
signing the contract.
Not-for-profit businesses also benefit from tax laws, but in a different way. Because not-for-profit corporations do not obtain tax benefits from
depreciation, the ownership of assets has no tax-related value. However,
lessors, which are all taxable businesses, do benefit from ownership. This
benefit, in turn, can be shared with the lessee in the form of lower rental
payments. Note, however, that the cost of tax-exempt debt to not-for-profit
firms can be lower than the after-tax cost of debt to taxable firms, so leasing
is not automatically less costly to not-for-profit businesses than borrowing in
the tax-exempt markets and buying.
A special type of financial transaction—called a tax-exempt lease—has
been created for not-for-profit businesses. Legally, this transaction is not really
a lease, but it has all of the general characteristics of one. The major difference between a tax-exempt lease and a conventional lease is that the implied
interest portion of the lease payment is not classified as taxable income to the
lessor. Thus, a portion of the lease payment received by the lessor is exempt
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from federal income taxes. The rationale for this tax treatment is that the
interest paid on most debt financing used by not-for-profit organizations is
tax exempt to the lender, and a lessor is, in actuality, a lender. Tax-exempt
leases provide a greater after-tax return to lessors than do conventional leases,
so some of this “extra” return can be passed back to the lessee in the form of
lower lease payments. Thus, a not-for-profit lessee’s payments on tax-exempt
leases can be lower than the payments on conventional leases.
SELF-TEST
QUESTIONS
1. What is the difference between a guideline and a nonguideline lease?
2. What are some provisions that would make a lease nonguideline?
3. Why should the IRS care about lease provisions?
4. What is a tax-exempt lease?
Reporting Leases on Financial Statements
Previously, neither the leased asset nor the liabilities under an operating lease
contract appeared on the lessee’s balance sheet. This type of financing is often
called off-balance-sheet financing, which makes it difficult for investors to
identify an organization’s true financial obligations. The Financial Accounting Standards Board (FASB) recently
issued new financial reporting standards
for operating leases that effectively elimiFinancial Accounting Standards
nate off-balance-sheet financing for leases.
Board Changes to Lease Accounting
Under the new Accounting Standards
Guidelines
Update (ASU 2016-02), any lease lasting
FASB Statement 13, “Accounting for Leases,”
more than a year must be capitalized by
which has been in effect since 1977, spells out in
reporting it on the balance sheet as a liabildetail the conditions under which a lease must
be capitalized and the procedures for capitalizing
ity and an asset. In short, operating leases
it. FASB is the primary organization promulgatnow appear on the balance sheet under
ing the rules that form the basis of generally
their own accounts. Consistent with the
accepted accounting principles (GAAP), which,
new accounting standards, the leased asset
in turn, guide the preparation of financial statewill appear as both the asset (described as
ments. FASB recently established a significant
a “right-of-use” asset) and a lease liability.
new Accounting Standards Update (ASU 2016-02)
for leasing that goes into effect in 2019 for most
Regardless of current accounting
organizations.
rules, from an economic (financial) perAlthough a complete discussion of the
spective, a lease has the same economic
changes is beyond the scope of this text, the
consequences for a business as a loan in
most important change is that any operating
which the asset is pledged as collateral. If
(continued)
a firm signs a lease contract, its obligation
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C hap ter 8: Lease F inanc ing
to make lease payments is just as binding
as if it had signed a loan agreement; failure
to make lease payments has the potential
to bankrupt a firm, just as failure to make
principal and interest payments on a loan
can result in bankruptcy. Thus, leases are
considered the same as debt for capital
structure purposes, and they have roughly
the same effects as debt on the financial
condition of the firm.
However, there are some legal differences between loans and leases, mostly
involving the rights of lessors versus lenders when a business in financial distress
reorganizes or liquidates. In most financial
distress situations, lessors fare better than
lenders do, so lessors may be more willing
than would lenders to deal with firms in
poor financial condition. At a minimum,
lessors may be willing to accept lower rates
of return than lenders would when dealing
with financially distressed firms because
their risks are lower.
289
(continued from previous page)
lease greater than or equal to 12 months in length
appears on the balance sheet, whereas previously operating leases only appeared on the
income statement as an expense. This change
has the ability to affect a firm’s debt balance;
however, there is room for the language of the
lease to ensure that it is not considered a portion of a firm’s debt. Rather, all fixed payment
leases would be accounted for in the same way
on the balance sheet—all leased property would
be listed by lessees on the asset side as “rightto-use assets” and on the liability side as “lease
liabilities.”
Over the term of the lease, leased assets
would be depreciated by the straight-line method
and lease liabilities would be decreased by the
rental payments made. For all practical purposes,
the leased assets and liabilities will balance one
another, so the primary effect will be to increase
both sides of the balance sheet by a like amount.
The ultimate purpose of the proposed rule is to
eliminate operating leases as a source of off-balance-sheet financing and hence report all leases
directly on the balance sheet.
1. Why were some leases referred to as off-balance-sheet financing
prior to 2019?
2. How are leases accounted for in a lessee’s financial statements?
SELF-TEST
QUESTIONS
Evaluation by the Lessee
Leases are evaluated by both the lessee and the lessor. The lessee must determine whether leasing an asset is less costly than obtaining equivalent alternative financing and buying the asset, and the lessor must decide what the lease
payments must be to produce a rate of return consistent with the riskiness of
the investment. This section focuses on the lessee’s analysis.
A degree of uncertainty exists regarding the theoretically correct way
to evaluate lease-versus-purchase decisions, and complex decision models
have been developed to aid in the analysis. However, the simple analysis given
here, coupled with judgment, is sufficient to prevent a lessee from entering
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into a lease agreement that is clearly not in its best interests. In the typical
case, the events leading to a lease arrangement follow this sequence:
• The business decides to acquire a particular building or piece of
equipment; this decision is based on the standard capital budgeting
procedures discussed in chapters 11 and 12. The decision to acquire
the asset is not an issue in the typical lease analysis; this decision was
made previously as part of the capital budgeting process. In lease
analysis, we are concerned simply with whether to obtain the use of the
property by lease or by purchase (how to finance the acquisition).
• Once the business has decided to acquire the asset, the next question is
how to finance its acquisition. A well-run business does not have excess
cash lying around, and even if it does, there are opportunity costs
associated with its use.
• Funds to purchase the asset can be obtained by borrowing; by
retaining earnings; or, if the business is investor owned, by selling new
equity. If the firm is not-for-profit, perhaps the funds can be raised by
soliciting contributions for the project. Some combination of these
sources can also be used. Alternatively, the asset can be leased.
Because a lease is roughly comparable to a loan in the sense that
both have a similar impact on a business’s financial condition, the appropriate comparison when making lease decisions is the cost of lease financing
versus the cost of debt financing. The comparison of lease financing to debt
financing is valid regardless of how the asset actually would be financed if it
were not leased. The asset may be purchased with available cash if not leased
or financed by a new equity sale or a cash contribution. However, because
leasing is a substitute for debt financing and hence uses up a business’s debt
capacity, the appropriate comparison would still be to debt financing.
Simplified Example
To better understand the basic elements of lease analysis, consider this simplified example. Nashville Radiology Group (the Group) needs to use a $100
piece of diagnostic equipment for two years, and the Group must choose
between leasing and buying the machine. (The actual cost is $100,000, but
let’s keep the numbers simple.) If the Group purchases the machine, the bank
will lend the Group the needed $100 at a rate of 10 percent on a two-year,
simple interest loan. Thus, the Group would have to pay the bank $10 in
interest at the end of each year, plus return the $100 in principal at the end
of year 2. For simplicity, assume that, if the Group purchases the machine, it
can depreciate the entire cost over two years for tax purposes by the straightline method, resulting in tax depreciation of $50 in each year. Furthermore,
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C hap ter 8: Lease F inanc ing
the Group’s tax rate is 30 percent. Thus, the depreciation expense produces
a tax savings, or tax shield, of $50 × 0.30 = $15 each year. Also for simplicity,
assume that the machine’s value at the end of two years (its residual value) is
estimated to be $0.
Alternatively, the Group can lease the asset under a guideline lease for
two years for a payment of $55 at the end of each year. The analysis for the
lease-versus-buy decision consists of (1) estimating the cash flows associated
with borrowing and buying the asset—that is, the flows associated with debt
financing; (2) estimating the cash flows associated with leasing the asset; and
(3) comparing the two financing methods to determine which has the lower
cost. Here are the borrow-and-buy flows:
Cash Flows if the Group Buys
Equipment cost
Loan amount
Interest expense
Tax savings from interest
Principal repayment
Tax savings from depreciation
Net cash flow
Year 0
($100)
100
0
$0
Year 1
Year 2
($10)
3
($ 10)
3
( 100)
15
($ 92)
15
$8
The net cash flow is zero in year 0, positive in year 1, and negative in
year 2. Because the operating cash flows (the revenues and operating costs)
will be the same regardless of whether the machine is leased or purchased,
they can be ignored. Cash flows that are not affected by the decision at hand
are said to be nonincremental to the decision. Here are the cash flows associated with the lease:
Cash Flows if the Group Leases
Lease payment
Tax savings from payment
Net cash flow
Year 0
$0
Year 1
($ 55)
16.5
($38.5)
Year 2
($55)
16.5
($38.5)
Note that the two sets of cash flows reflect the tax savings associated
with interest expense, depreciation, and lease payments, as appropriate. If
the lease had not met IRS guidelines, ownership would have resided with
the lessee, and the Group would have depreciated the asset for tax purposes
whether it had been “leased” or purchased. Furthermore, only the implied
interest portion of the lease payment would be tax deductible. Thus, the
analysis for a nonguideline lease would consist of simply comparing the aftertax financing flows on the loan with the after-tax lease payment stream.
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To compare the cost streams of buying and leasing, we must put them
on a present value basis. As we will explain later, the correct discount rate
is the lessee’s after-tax cost of debt, which for the Group is 10% × (1 − T)
= 10% × (1 − 0.3) = 7%. Applying this rate, we find the present value cost
of buying to be $72.88 and the present value cost of leasing to be $69.61.
Because leasing has the lower present value of costs, it is the less costly financing alternative, so the Group should lease the asset.
This simplified example shows the general approach used in lease
analysis, and it also illustrates a concept that can simplify the cash flow estimation process. Look back at the loan-related cash flows if the Group buys the
machine, which consist of the interest expense, tax savings from interest, and
principal repayment. The after-tax loan-related flows are –$7 in year 1 and
–$107 in year 2. When these flows are discounted to year 0 at the 7 percent
after-tax cost of debt, their present value is –$100, which is the negative of
the loan amount shown in year 0. This equality results because we first used
the cost of debt to estimate the future financing flows, and we then used
this same rate to discount the flows back to Year 0, all on an after-tax basis.
In effect, the loan amount positive cash flow and the loan cost negative cash
flows cancel one another out. Here is the cash flow stream associated with
buying the asset after the Year 0 loan amount and the related Year 1 and Year
2 flows have been removed:
Cash Flows if the Group Buys
Cost of asset
Tax savings from depreciation
Net cash flow
Year 0
($100)
($100)
Year 1
Year 2
$15
$15
$15
$15
The present value cost of buying here is $72.88, which is the same
number we found earlier. The two approaches will always produce consistent
estimates regardless of the specific terms of the debt financing—as long as
the discount rate is the after-tax cost of debt, the cash flows associated with
the loan can be ignored.
More Realistic Example
To examine a more realistic example of lease analysis, consider the following
lease-versus-buy decision facing the Nashville Radiology Group:
• The Group plans to acquire a new computer system that will automate
the Group’s clinical records, as well as its accounting, billing, and
collection processes. The computer has an economic life of eight years
and costs $200,000 (delivered and installed). However, the Group
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C hap ter 8: Lease F inanc ing
•
•
•
•
•
293
plans to lease the equipment for only four years because it believes that
computer technology is changing rapidly and wants the opportunity to
reevaluate the situation at that time.
The Group can borrow the required $200,000 from its bank at a
before-tax cost of 10 percent.
The computer’s estimated scrap value is $5,000 after eight years of use,
but its estimated residual value when the lease expires after four years
of use is $20,000. Thus, if the Group buys the equipment, it would
expect to receive $20,000 before taxes when the equipment is sold in
four years.
The Group can lease the equipment for four years at a rental charge of
$57,000, payable at the beginning of each year, but the lessor will own
the equipment on expiration of the lease. (The lease payment schedule
is established by the potential lessor, as described in a later section, and
the Group can accept, reject, or negotiate it.)
The lease contract stipulates that the lessor will maintain the
computer at no additional charge to the Group. However, if the
Group borrows money to buy the computer, it will have to bear the
cost of maintenance, which would be performed by the equipment
manufacturer at a fixed contract rate of $2,500 per year, payable at the
beginning of each year.
The computer falls in the MACRS five-year class life, the group’s
marginal tax rate is 30 percent, and the lease qualifies as a guideline
lease under a special IRS ruling. (Refer to chapter 1 to review tax
depreciation, if necessary.)
Dollar Cost Approach
Exhibit 8.1 shows the steps involved in a complete dollar cost analysis. As
in the simplified example, our approach here is to compare the dollar cost
of owning (borrowing and buying) to the dollar cost of leasing. All else the
same, the lower-cost alternative is preferable. Part I of the exhibit is devoted
to the costs of borrowing and buying. Here, line 1 shows the equipment’s
cost, and line 2 shows the maintenance expense; both are cash costs or outflows. Note that whenever an analyst is setting up cash flows on a time line,
one of the first decisions to be made is what time interval will be used—
that is, months, quarters, years, or some other period. As a starting point,
we generally assume that all cash flows occur at the end of each year. If, at
some point later in the analysis, we conclude that another interval is better,
we will change it. Longer intervals—such as years—simplify the analysis but
introduce some inaccuracies because all cash flows do not occur at the end
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of the year. For example, tax benefits occur quarterly because businesses
pay taxes on a quarterly basis. On the other hand, shorter intervals—such
as months—often are used for lease analyses because lease payments typically occur monthly. For ease of illustration, we are using annual flows in
this example.
Line 3 shows the maintenance tax savings, and because maintenance
expense is tax deductible, the Group saves 0.30 × $2,500 = $750 in taxes
by virtue of paying the maintenance fee. Line 4 shows the depreciation tax
savings, which is the depreciation expense multiplied by the tax rate. For
example, the MACRS allowance for the first year is 20 percent, so the depreciation expense is 0.20 × $200,000 = $40,000, and the depreciation tax savings is 0.30 × $40,000 = $12,000.
Lines 5 and 6 show the residual value cash flows. The residual value is
estimated to be $20,000, but the tax book value after four years of depreciation is $34,000. Thus, the Group is losing $14,000 for tax purposes, which
produces the 0.3 × $14,000 = $4,200 tax savings shown as an inflow in line
EXHIBIT 8.1
Lessee’s Dollar
Cost Analysis
Year 0
Year 1
I. Cost of Owning (Borrowing and Buying)
1. Net purchase price
($200,000)
2. Maintenance cost
(2,500) ($2,500)
3. Maintenance tax savings
750
750
4. Depreciation tax savings
12,000
5. Residual value
6. Residual value tax
0
0
7. Net cash flow
($201,750) $10,250
8. PV cost of owning =
($145,097)
II. Cost of Leasing
9. Lease payment
10. Tax savings
11. Net cash flow
12. PV cost of leasing =
($ 55,000) ($55,000)
16,500 16,500
($ 38,500) ($38,500)
($139,536)
Year 2
($ 2,500)
750
19,200
0
$17,450
Year 3
Year 4
($ 2,500)
750
11,400 $ 7,200
20,000
0
4,200
$ 9,650 $31,400
($55,000) ($55,000)
16,500 16,500
($38,500) ($38,500)
III. Cost Comparison
13. Net advantage to leasing (NAL) = PV cost of leasing – PV cost of owning
= –$139,536 – (–$145,097) = $5,561.
Note: The MACRS depreciation allowances are 0.20, 0.32, 0.19, and 0.12 in years 1 through 4,
respectively. In practice, a lease analysis such as this one would be done on a monthly basis
using a spreadsheet program.
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C hap ter 8: Lease F inanc ing
6. Line 7, which sums the component cash flows, shows the net cash flows
associated with borrowing and buying.
Part II of exhibit 8.1 contains an analysis of the cost of leasing. The
lease payments, shown in line 9, are $55,000 per year; this rate, which
includes maintenance, was established by the prospective lessor and offered
to the Group. If the Group accepts the lease, the full amount will be a
deductible expense, so the tax savings, shown in line 10, is 0.30 × Lease payment = 0.30 × $55,000 = $16,500. The net cash flows associated with leasing
are shown in line 11.
The final step is to compare the net cost of owning with the net cost
of leasing. First, we must put the annual cash flows associated with owning
and leasing on a common basis by converting them to present values, which
brings up the question of the proper rate at which to discount the net cash
flows. We know that the riskier the cash flows, the higher the discount rate
used to find the present value will be. This same principle was observed in
our discussion of security valuation, and it applies to all discounted cash
flow analyses, including lease analysis. Just how risky are the cash flows
under consideration here? Most of them are relatively certain, at least when
compared with the types of cash flow estimates associated with stock investments or with the Group’s operating cash flows. For example, the loan
payment schedule is set by contract, as is the lease payment schedule. The
depreciation expenses are also established by law and not subject to change,
and the annual maintenance fee is fixed by contract as well. The tax savings are somewhat uncertain, but they will be as projected as long as the
Group’s marginal tax rate remains at 30 percent. The residual value is the
least certain of the cash flows, but even here, the Group’s management is
fairly confident because there are a great deal of historical data available to
help make the estimate.
Because the cash flows under the lease and under the borrow-andpurchase alternatives are both relatively certain, they should be discounted
at a relatively low rate. What market-determined rate is readily available that
reflects relatively low risk? Most analysts recommend that the firm’s cost of
debt financing be used, and this rate seems reasonable in our example. However, the Group’s cost of debt—10 percent—must be adjusted to reflect the
tax deductibility of interest payments because this benefit of borrowing and
buying is not accounted for in the cash flows. Thus, the Group’s effective
cost of debt becomes Before-tax cost × (1 − Tax rate) = 10% × 0.7 = 7%.
Accordingly, the cash flows in lines 7 and 11 are discounted at a 7 percent
rate. The resulting present values are $145,097 for the cost of owning and
$139,536 for the cost of leasing, as shown in lines 8 and 12. Leasing is the
lower-cost financing alternative, so the Group should lease, rather than buy,
the computer.
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The cost comparison can be formalized by defining the net advantage
to leasing (NAL) as follows:
Key Equation 8.1: Net Advantage to Leasing (NAL)
NAL = PV cost of leasing − PV cost of owning
= −$139,536 − (−$145,097) = $5,561.
The positive NAL indicates that leasing creates more value than buying, so the Group should lease the equipment. Indeed, the value of the
Group is increased by $5,561 if it leases, rather than buys, the computer.
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Percentage Cost Approach
The Group’s lease-versus-buy decision can also be analyzed using percentage cost analysis, which involves comparing the effective cost rate on the
lease to the effective cost rate on the loan. Signing a lease is similar to signing a loan contract—the firm has the use of the equipment but must make
a series of payments under either type of contract. We know the effective
cost rate built into the loan: It is the 7 percent after-tax interest rate. If the
after-tax cost rate in the lease is less than 7 percent, there is an advantage
to leasing.
Exhibit 8.2 sets forth the cash flows needed to determine the percentage cost of the lease. Here is an explanation of the exhibit:
• The first step is to calculate the leasing-versus-owning cash flows. We
do so by subtracting the owning cash flows shown in line 7 from the
leasing cash flows shown in line 11 (see exhibit 8.2). The differences
are the incremental cash flows that relate to the Group if it leases,
rather than buys, the computer.
EXHIBIT 8.2
Lessee’s
Percentage Cost
Year 0
1. Leasing cash flow
Year 2
Year 3
($38,500) ($38,500) ($38,500) ($38,500)
2. Less: Owning cash flow (201,750)
3. Leasing-versus-owning
cash flow
Year 1
$163,250
10,250
17,450
9,650
Year 4
$0
31,400
($48,750) ($55,950) ($48,150) ($31,400)
NAL = $5,561.
IRR = 5.4%.
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• Note that exhibit 8.2 consolidates the analysis shown in exhibit 8.1
into a single set of net cash flows. At this point, we can discount the
net (consolidated) cash flows shown in line 3 of exhibit 8.2 by 6
percent to obtain the NAL, $5,561. In exhibit 8.1, we discounted the
owning and leasing cash flows separately and then subtracted their
present values to obtain the NAL. In exhibit 8.2, we subtracted the
cash flows first to obtain a single set of flows and then found their
present value. The end result is the same.
• The consolidated cash flows provide good insight into the economics
of leasing. If the Group leases the computer, it avoids having to lay
out the cash required to buy the equipment in year 0, but it is then
obligated to make a series of cash outflows for four years. In marketing
materials, leasing companies are quick to point out that leasing does
not require a large, upfront cash outlay ($163,250 in this example).
However, they are not so quick to mention that the “cost” to save
this outlay is an obligation to make payments over the next four years.
Leasing makes sense financially (disregarding other factors) only if the
savings are worth the cost.
• By inputting the leasing-versus-owning cash flows listed in exhibit 8.2
into a spreadsheet and using the internal rate of return (IRR) function,
we can find the cost rate inherent in the cash flow stream: 5.6 percent.
This rate is the equivalent after-tax cost rate implied in the lease
contract. Because this cost rate is lower than the 7 percent after-tax
cost rate on a regular loan, leasing is less expensive than borrowing and
buying. Thus, the percentage cost analysis confirms the NAL analysis.
Some Additional Points
So far, we have discussed the main features of a lessee’s analysis, including
both dollar cost and percentage cost approaches. Before we move on to the
lessor’s analysis, note the following points:
• The dollar cost and percentage cost approaches will always lead to
the same decision. Thus, one method is as good as the other from a
decision standpoint.
• If the net residual value cash flow (residual value and tax effect)
is considered riskier than the other cash flows in the analysis, it is
possible to account for this differential risk by applying a higher
discount rate to this flow, which results in a lower present value.
Because the net residual value flow is an inflow in the cost-of-owning
analysis, a lower present value leads to a higher present value cost of
owning. Thus, increasing residual value risk decreases the attractiveness
of owning an asset. For example, assume that the Group’s managers
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believe that the computer’s residual value is much riskier than the
other flows in exhibit 8.1. Furthermore, they believe that 10 percent,
rather than 7 percent, is the appropriate discount rate to apply to
the residual value flows. When the exhibit 8.1 analysis is modified
to reflect this risk, the present value cost of owning increases to
$149,314, while the NAL increases to $15,070. The riskier the
residual value, all else the same, the more favorable leasing becomes,
because residual value risk is borne by the lessor. However, all else will
generally not be the same. Increasing residual value risk would cause
the lessor to increase the lease payment, thereby making the lease less
attractive to the lessee.
• As we discuss in chapter 11, net present value (NPV) is the dollar
value of a project, assuming that it is financed using debt and equity
financing. In lease analysis, the NAL is the additional dollar value of
a project attributable to leasing, as opposed to conventional (debt)
financing. Thus, to approximate the value of a leased asset to the firm,
we increase the project’s NPV by the amount of the NAL:
Key Equation 8.2: Adjusted NPV
Adjusted NPV = NPV + NAL.
The value added through leasing, in some cases, can turn unprofitable
(negative NPV) projects into profitable (positive adjusted NPV) projects.
Thus, projects (assets) that are marginally unprofitable when evaluated on
the basis of conventional financing should be reevaluated on the basis of
lease financing (if available) to see whether alternative financing will make the
project financially acceptable.
SELF-TEST
QUESTIONS
1. Explain how the cash flows are structured in conducting a dollarbased NAL analysis.
2. What discount rate should be used when lessees perform lease
analyses?
3. What is the economic interpretation of the NAL?
4. What is the economic interpretation of a lease’s IRR?
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C hap ter 8: Lease F inanc ing
299
Evaluation by the Lessor
Thus far, we have considered lease analysis from the lessee’s viewpoint. It is
also useful to analyze the transaction as the lessor sees it: Is the lease a good
investment for the party that writes the lease (i.e., the party that buys the
asset)? The lessor will generally be a specialized leasing firm; a bank or bank
affiliate; or a manufacturer, such as Siemens Healthcare, that uses leasing by
an affiliated entity as a marketing tool.
Any potential lessor needs to know the rate of return on the capital
invested in the lease. This information is also useful to the prospective lessee
because lease terms on large leases are generally negotiated; so, the lessor and
the lessee should know one another’s position. The lessor’s analysis involves
(1) determining the net cash outlay, which is usually the invoice price of the
leased equipment less any lease payments made in advance; (2) determining
the periodic cash inflows, which consist of the lease payments minus income
taxes and any maintenance expenses the lessor must bear; (3) estimating the
after-tax residual value of the property when the lease expires; and (4) determining whether the rate of return on the lease is adequate for the riskiness
of the investment.
To illustrate the lessor’s analysis, we assume the same facts for the
Nashville Radiology Group lease and this situation. The potential lessor is
Medicomp, Inc. (https://medicompinc.com), a commercial leasing company
that specializes in leasing computers to healthcare providers. Medicomp’s
marginal federal-plus-state tax rate is 30 percent. To provide maintenance
to the Group, Medicomp must contract with the computer manufacturer
under the same terms available to the Group—that is, $2,500 at the beginning of each year. Medicomp views computer lease arrangements as relatively
low-risk investments. There is, however, some small chance of default on the
lease, so Medicomp typically assumes that a lease investment is about as risky
as buying AA-rated corporate bonds. Because four-year, AA-rated bonds are
yielding 7.5 percent at the time of the analysis, Medicomp can earn an aftertax yield of 7.0% × (1 − T) = 7.0% × 0.7 = 4.9% on such investments. Thus,
4.9 percent is the after-tax return that Medicomp can obtain on alternative
investments of similar risk (the opportunity cost rate).
The lease analysis from the lessor’s standpoint is developed in exhibit
8.3. Here, we see that the cash flows to the lessor are similar to those for
the lessee shown in exhibit 8.1. Line 1 shows the purchase price of the computer—$ 200,000. Line 2 shows the maintenance costs, while line 3 lists the
tax savings attributable to these costs. Line 4 shows the depreciation tax savings, or tax shields, that accrue to the owner of the computer. In line 5, we
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EXHIBIT 8.3
Lessor’s
Analysis
Year 0
1. Net purchase price
Year 1
Year 2
Year 3
(2,500) ($ 2,500)
($ 2,500)
($ 2,500)
750
750
750
12,000
19,200
11,400
Year 4
($200,000)
2. Maintenance cost
3. Maintenance tax savings
750
4. Depreciation tax savings
5. Lease payment
55,000
55,000
55,000
55,000
6. Tax on lease payment
(16,500)
(16,500)
(16,500)
(16,500)
7. Residual value
$ 7,200
20,000
8. Tax on residual value
0
0
0
9. Net cash flow
($ 163,250) $48,750
$ 55,950
4,200
$ 48,150
$31,400
NPV = $1,712
IRR = 5.4%.
show the annual lease rental payment as an inflow, while the taxes that must
be paid on the rental payments are shown in line 6. Lines 7 and 8 show the
residual value and resulting taxes (tax savings in this case). Finally, the cash
flows are summed in line 9.
The value (NPV) of the lease to Medicomp is found by discounting
the line 9 cash flows at the firm’s after-tax opportunity cost of capital—4.9
percent—and then summing the resultant present values. (When using a
spreadsheet for the analysis, use the NPV function.) For Medicomp, the NPV
of the lease investment is $1,712, which means that the firm is somewhat
better off, on a present value basis, if it writes the lease rather than investing
in comparable-risk AA-rated bonds. If the NPV of the lease were negative,
Medicomp would be better off investing in the bonds. Because we saw earlier
that the lease is also advantageous to the Group, the transaction is beneficial
to both the lessee and the lessor.
We can also calculate Medicomp’s expected percentage rate of return on
the lease by finding the IRR of the net cash flows shown in line 9 of exhibit 8.3.
Simply use a spreadsheet’s IRR function to find the answer: 5.4 percent. Thus,
the lease provides a 5.4 percent after-tax return to Medicomp, which exceeds
the 4.9 percent after-tax return available on alternative investments of similar risk: AA-rated, four-year bonds. So, using either the dollar-rate-of-return
(NPV) method or the percentage-rate-of-return (IRR) method, we obtain the
same result: The lease appears to be a satisfactory investment for Medicomp.
Note, however, that the lease investment is actually slightly more risky
than the alternative bond investment because the residual value cash flow is
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C hap ter 8: Lease F inanc ing
less certain than a principal repayment. Thus, Medicomp would probably
require a rate of return somewhat above the 4.9 percent promised on the
bond investment, and the higher the risk of the residual value, the higher the
required return. Also, note that the lessor’s NPV analysis can be extended by
using a higher discount rate on the residual value cash flows than that used
on the other flows. Doing so lowers the NPV and hence makes the lease
investment look less attractive than the bond investment.
1. What discount rate is used in a lessor’s NPV analysis?
2. What is the economic interpretation of the lessor’s NPV? The
lessor’s IRR?
SELF-TEST
QUESTIONS
Lease Analysis Symmetry
Let’s stop for a moment and compare the cash flows in exhibits 8.2 and 8.3.
Upon examination, we find that the cash flows to the lessee and lessor are
symmetrical. They differ in sign, but their values are the same. This symmetry occurs because there are only two parties to a lease transaction, and
our example assumed that the parties would pay the same amount for the
computer, pay taxes at the same rate, forecast the same residual value, and
so on. Thus, a cash inflow to one party becomes a cash outflow to the other.
Taken one step further, if the cost of debt to the lessee in our example had
equaled the opportunity cost to the lessor, the NPV to the lessor would be
equal, but opposite in sign, to the lessee’s NAL. Therefore, if all of the input
values had been the same to both lessee and lessor, Medicomp’s NPV would
have been a negative $5,561.
From this simple observation, we conclude that when there is symmetry between the lessor and the lessee—same tax rates, costs, and so on—
leasing is a zero-sum game.2 If the lease is attractive to the lessee, the lease is
unattractive to the lessor, and vice versa. However, conditions often are such
that leasing can be of benefit to both parties. This situation arises because
of differences in tax rates, estimated residual values, or the ability to bear
residual value risk. We will explore this issue in detail in a later section.
1. What is lease analysis symmetry?
2. What impact does this symmetry have on the economic viability of
leasing?
SELF-TEST
QUESTIONS
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Setting the Lease Payment
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SELF-TEST
QUESTION
In the preceding sections, we evaluated the lease assuming that the lease
payments had already been specified. However, as a general rule (especially
in large leases), the parties will work out the terms of the lease, including
the size of the lease payments. In situations where the lease terms are not
negotiable (which is often the case for small leases), the lessor must still go
through the same type of analysis, setting terms that provide a target rate of
return and then offering these terms to the potential lessee on a take-it-orleave-it basis.
Competition in the leasing industry will force lessors to build market-related returns into their lease payment schedules. For an illustration,
suppose Medicomp—after examining other alternative investment opportunities—decides that the 5.4 percent return on the Nashville Radiology Group
lease is too low and that the lease should provide an after-tax return of 6.3
percent. What lease payment schedule would provide this return?
To answer this question, note again that exhibit 8.3 contains the lessor’s cash flow analysis. If the basic analysis is done on a spreadsheet, it is
easy to change the lease payment until the lease’s NPV = $0 at a 6.3 percent
discount rate or, equivalently, until its IRR = 6.3 percent. We did this with
our spreadsheet lease evaluation model, and we found that the lessor must set
the lease payment at $56,248 to obtain an expected after-tax rate of return
of 6.3 percent. However, if this lease payment is not consistent with market
rates, the Group may be able to strike a better deal with another lessor.
1. How do lessors set the lease payment amount?
Leveraged Leases
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In the early days of lease transactions, only two parties were involved: (1) the
lessor, who put up the front money, and (2) the lessee, who used the asset.
In recent years, however, a new type of lease—the leveraged lease—has come
into widespread use. (In financial parlance, the term leverage means the use
of debt financing.) Under a leveraged lease, the lessor arranges to borrow
part of the required funds, generally giving the lender a lien on the property
being leased, or a first mortgage if the lease is for real estate. (To meet IRS
guidelines for leveraged leases, the lessor must have a minimum 20 percent
equity interest in the lease, so the maximum amount of leverage that can be
used is 80 percent of the purchase price.)
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C hap ter 8: Lease F inanc ing
303
In a leveraged lease, the lessor still receives the tax benefits associated
with depreciation. However, the lessor now has a riskier position because
of its use of debt financing. Incidentally, whether a lease is leveraged is not
important to the lessee; from the lessee’s standpoint, the method of analyzing a proposed lease is unaffected by whether or not the lessor borrows part
of the required capital.
The analysis in exhibit 8.3 can be easily modified if the lessor borrows
part of the required $200,000, making the transaction a leveraged lease.
First, we would add a set of lines to exhibit 8.3 to show the financing cash
flows. The interest component would represent another tax deduction, while
the loan repayment would constitute an additional cash outlay. The “initial
cost” would be reduced by the amount of the loan. With these changes
made, a new NPV and IRR can be calculated and used to evaluate whether
the lease would be a good investment.
For an illustration of this concept, assume that Medicomp can borrow $100,000 of the $200,000 purchase price at a rate of 7 percent on a
four-year, simple interest loan. Exhibit 8.4 contains the lessor’s leveraged
lease analysis. Line 1 shows the unleveraged lease cash flows from exhibit
8.3, while the leveraging cash flows are shown in lines 2 through 5. The net
cash flows to Medicomp are shown in line 6. The NPV of the leveraged lease
is $1,712, which is also the NPV of the unleveraged lease. In this situation,
leveraging had no impact on the lessor’s per lease NPV. This result occurred
because the cost of the loan to the lessor—4.9 percent after taxes—equals
the discount rate, so the leveraging cash flows are netted out on a present
value basis.
Note, though, that the lessor has a net investment of only $63,250 in
the leveraged lease compared to a net investment of $163,250 in the unleveraged lease. Therefore, the lessor has the opportunity to invest in a total of
Year 0
Year 1
Year 2
Year 3
Year 4
($163,250)
$48,750
$55,950
$48,150
$31,400
3. Interest
(7,000)
(7,000)
(7,000)
(7,000)
4. Interest tax savings
2,100
2,100
2,100
2,100
1. Unleveraged cash flow
2. Loan amount
EXHIBIT 8.4
Leveraged
Lease Analysis
100,000
5. Principal repayment
0
0
0
0
(100,000)
6. Net cash flow
($ 63,250)
$43,850
$51,050
$43,250
($73,500)
NPV = $1,712.
IRR = 14.6%.
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$163,250 ÷ $63,250 = 2.6 identical leveraged leases for the same $163,250
investment required to finance a single unleveraged lease, producing a total
net present value of 2.6 × $1,712 = $4,451. The effect of leverage on the
lessor’s return is also reflected in the leveraged lease’s IRR. The IRR of the
leveraged lease is 14.6 percent, which is substantially higher than the 5.4
percent after-tax return on the unleveraged lease.
Leveraged leases can provide lessors with higher expected rates of
return (IRRs) and higher NPVs per dollar of invested capital than unleveraged leases. However, such leases are also riskier for the same reason that any
leveraged investment is riskier. Sophisticated lessors use simulations similar
to those described in chapter 12 to assess the riskiness associated with leveraged leases. Then, given the apparent riskiness of the lease investment, the
lessor can decide whether the returns built into the contract are sufficient to
compensate for the risks involved.
SELF-TEST
QUESTIONS
1. What is a leveraged lease?
2. How does leveraging affect the lessee’s analysis?
3. What is the usual impact of lease leveraging on the lessor’s
expected rate of return and risk?
Motivations for Leasing
We noted earlier that leasing is a zero-sum game unless there are lease analysis differentials between the lessee and the lessor. In this section, we discuss
some of the differentials that motivate lease agreements.
Tax Differentials
Many leases are driven by tax differentials. Historically, the typical tax asymmetry arose between highly taxed lessors and lessees with low tax rates.
These low tax rates may be the result of low profitability or tax shields
(primarily depreciation) that are sufficient to reduce taxable income to
a small amount, even to zero. In such situations, the lessor can take the
leased asset’s depreciation tax benefits and then share this value with the
lessee. Many other possible tax motivations exist, including tax differentials
between not-for-profit providers and investor-owned lessors, as well as the
alternative minimum tax.
The alternative minimum tax (AMT), which roughly amounts to 20
percent of profits as reported to shareholders, is designed to force profitable firms to pay at least some taxes. The AMT was instituted because the
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C hap ter 8: Lease F inanc ing
use of accelerated depreciation for tax purposes, along with other tax shelters,
allowed many businesses that report significant income to stockholders to pay
little or no federal income taxes.
Firms exposed to heavy tax liabilities under the AMT naturally seek
ways to reduce reported income. Leasing can be beneficial because firms can
use a relatively short period for the lease and consequently have a high annual
payment, resulting in lower reported profits and a lower AMT liability. Note
that the lease payments do not have to qualify as a deductible expense for
regular tax purposes; all they need to do is reduce reported income shown
on a firm’s income statement.
Lessors have designed spreadsheet models to deal with AMT considerations, and they are generating a substantial amount of leasing business as a
direct result of the AMT. Thus, one of the important motivations for leasing
is tax differential.
Ability to Bear Obsolescence (Residual Value) Risk
Leasing is an attractive financing alternative for many high-tech items that are
subject to rapid and unpredictable technological obsolescence. For example,
assume that a small, rural hospital wants to acquire an MRI (magnetic resonance imaging) device. If it buys the MRI equipment, it is exposed to the risk
of technological obsolescence. In a relatively short time, some new technology might be developed that makes the current system almost worthless, and
this large economic depreciation can create a severe financial burden on the
hospital. Because it does not use much equipment of this nature, the hospital
would bear a great deal of risk if it buys the MRI device.
Conversely, a lessor that specializes in state-of-the-art medical equipment might be exposed to significantly less risk. By purchasing and then
leasing many different high-tech items, the lessor benefits from portfolio
diversification; over time, some items will lose more value than the lessor
expected, but these losses will be offset by other items that retain more value
than expected. Also, lessors are especially familiar with the markets for used
medical equipment, so they can both estimate residual values better and
negotiate better prices when the asset is resold than can a hospital. Because
the lessor is better able to bear residual value risk than the hospital, the lessor can charge a premium for bearing this risk that is less than the premium
inherent in ownership.
Some lessors also offer programs that guarantee that the leased asset
will be modified as necessary to keep it abreast of technological advancements. For an increased rental fee, lessors will provide upgrades to keep the
leased equipment current regardless of the cost. To the extent that lessors
are better able to forecast such upgrades; negotiate better terms from manufacturers; and, by greater diversification, control the risks involved with such
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G a p en s k i’s U n d e r s ta n d i n g H e a l th c a re F inanc ial Managem ent
upgrades, it may be cheaper for businesses to obtain state-of-the-art equipment by leasing than by buying.
Ability to Bear Utilization Risk
As we discussed earlier in the chapter, per procedure (per use) leases are gaining popularity among healthcare providers. In this type of lease, instead of a
fixed annual or monthly payment, the lessor charges the lessee a fixed amount
for each procedure performed (each use of the asset). For example, the lessor
may charge the hospital $300 for every scan performed using a leased MRI
device, or it may charge $400 per scan for the first 50 scans in each month
and $200 for each scan above 50. Because the hospital’s MRI revenues
depend on the amount of utilization, and because the per procedure lease
changes the hospital’s costs for the MRI from a fixed payment to a variable
payment, the hospital’s risk is reduced.
However, the conversion of the payment to the lessor from a fixed
amount to an uncertain stream increases the lessor’s risk. In essence, the lessor is now bearing the utilization (operating) risk of the MRI. Although the
passing of risk often produces no net benefit, a per procedure lease can be
beneficial to both parties if the lessor is better able than the lessee to bear
the utilization risk. As we discussed earlier, if the lessor has written a large
number of per procedure leases, some of the leases will be more profitable
than expected and some will be less profitable than expected, but if the lessor’s expectations are unbiased, the aggregate return on all the leases will be
close to that expected.
Ability to Bear Project Life Risk
Leasing can also be attractive when a business is uncertain about how long an
asset will be needed. Consider the following example. Hospitals sometimes
offer services that are dependent on a single staff member—for example, a
physician who does liver transplants. To support the physician’s practice,
the hospital might have to invest millions of dollars in equipment that can
be used only for this procedure. The hospital will charge for the use of the
equipment, and if things go as expected, the investment will be profitable.
However, if the physician dies or leaves the hospital staff, and if no other
qualified physician can be recruited to fill the void, the project must be
terminated and the equipment becomes useless to the hospital. A lease with
a cancellation clause would permit the hospital to simply return the equipment to the lessor. The lessor would charge a premium for the cancellation
clause because such clauses increase the riskiness of the lease to the lessor.
The increased lease cost would lower the expected profitability of the project,
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C hap ter 8: Lease F inanc ing
but it would provide the hospital with an option to abandon the equipment,
and such an option can have a value that exceeds the incremental cost of
the cancellation clause. The leasing company would be willing to write this
option because it is in a better position to remarket the equipment—either
by writing another lease or by selling it outright.
Maintenance Services
Some businesses find leasing attractive because the lessor is able to provide better or less expensive maintenance services (or both). For example,
MEDTRANSPORT, Inc., a for-profit ambulance and medical transfer service, leased 25 ambulances and transfer vans. The lease agreement, with
a lessor that specializes in purchasing, maintaining, and then reselling
automobiles and trucks, permitted the replacement of an aging fleet that
MEDTRANSPORT had built up over several years. “We are pretty good at
providing emergency services and moving sick people from one facility to
another, but we aren’t very good at maintaining an automotive fleet,” said
MEDTRANSPORT’s CEO.
Lower Information Costs
Leasing may be financially attractive for smaller businesses that have limited
access to debt markets. For example, a small, recently formed physician
group practice may need to finance one or more diagnostic devices, such as
an electrocardiogram (EKG) machine. The group has no credit history, so it
would be relatively difficult, and hence costly, for a bank to assess the group’s
credit risk. Some banks might think the loan is not even worth the effort.
Others might be willing to make the loan, but only after building the high
cost of credit assessment into the cost of the loan. On the other hand, some
lessors specialize in leasing to group practices, so their analysts have assessed
the financial worthiness of hundreds, or even thousands, of group practices.
Thus, it would be relatively easy for them to make the credit judgment, and
hence they might be more willing than conventional lenders to provide the
financing and charge lower rates.
Lower Risk in Bankruptcy
Finally, for firms that are poor credit risks, leasing may be less expensive
than buying. As discussed earlier, in the event of financial distress leading to
reorganization or liquidation, lessors generally have more secure claims than
do lenders. Thus, lessors may be willing to write leases to firms with poor
financial characteristics that are less costly than loans offered by lenders, if
such loans are even available.
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