Leasing Master Class

Solution: The key difference is ownership. When borrowing to buy, the firm owns the asset. When leasing, the lessor owns the asset. They are not perfect substitutes. A lease is a bundled product that includes financing, the transfer of residual value risk, and potentially maintenance services. Borrowing is purely a financing arrangement.

Solution: A less profitable corporation in a low tax bracket is more likely to be the lessee. The reason is that this firm cannot take full advantage of the tax benefits of ownership, such as depreciation deductions. A profitable corporation in a high tax bracket is more likely to be the lessor, as it can use these tax benefits. The lease allows the tax benefits to be transferred, and the savings can be shared between the two parties.

Solution: One major problem is that the cash flow stream for a lease analysis (lease vs. buy) is unconventional: a large positive cash flow at the beginning, followed by a series of negative cash flows. With this pattern, a lower IRR is better, which is the opposite of the standard capital budgeting decision rule. This can cause confusion and lead to incorrect decisions.

Solution:
a. Leasing reduces the risk of an asset's residual value, which is a form of insurance. However, this does not necessarily reduce the firm's overall cost of capital.
b. This is a dubious claim. Firms can often achieve 100% financing through other means, and leases often require an upfront payment or security deposit.
c. This is an overstatement. While the tax advantages are the primary driver of long-term financial leases, short-term operating leases would still exist due to lower transaction costs and other conveniences.

Solution: Before 2019, a lease had to be reported on the balance sheet if it was a "capital lease." The criteria were designed to identify leases that were economically equivalent to a purchase. For example: (1) Does the lease transfer ownership at the end? (Rationale: If ownership transfers, it's effectively a sale). (2) Is the lease term for a major part of the asset's economic life? (Rationale: If the lessee uses the asset for most of its life, it has received most of the economic benefits of ownership).

Solution: The IRS is concerned with leases that are set up solely to avoid taxes. The criteria for a "true lease" are designed to ensure the lease has a legitimate business purpose. The main principle is that the lessee must have the "right to control" the use of the asset, including receiving substantially all of the economic benefits from its use. This prevents transactions that are leases in name only but are structured to artificially accelerate deductions.

Solution: Off-balance-sheet financing refers to financing arrangements that are not reported as liabilities on the balance sheet. Before 2019, operating leases provided this. The accounting consequence was that a firm could appear to have less debt than it actually did, potentially making its financial ratios look stronger. Economically, however, the firm still had a binding obligation to make lease payments, which represented a real liability.

Solution: A firm might engage in a sale and leaseback to: (1) Generate immediate cash from an asset it already owns, which can be used for other purposes. (2) Transfer the tax benefits of ownership to a lessor if the firm is in a low tax bracket and cannot efficiently use them.

Solution: The after-tax borrowing rate is the appropriate discount rate because the lease-versus-buy decision is a financing decision. The alternative to leasing is borrowing money to buy the asset. The cash flows in a lease analysis (like the after-tax lease payment and the lost depreciation tax shield) are relatively certain, similar to the cash flows from a loan. Therefore, the appropriate rate is the after-tax interest rate on the firm's debt.

Solution: China Southern might prefer to lease for several reasons. They may not have the large amount of capital required for an outright purchase. They might be in a lower tax bracket than the lessor (ALC), making it advantageous to let ALC take the depreciation tax shields. They might also want to reduce the risk of the planes' residual value; by leasing, they transfer this risk to ALC.

Solution: ALC is willing to do this because it is in the business of leasing and can likely do so profitably. It may have a lower cost of capital, be in a higher tax bracket, or be better able to manage the planes' residual value risk than China Southern. This is different from lending money because ALC retains ownership of the planes and bears the risk of their resale value. In a loan, the airline would own the planes and bear this risk.

Solution: At the end of the lease period, the planes are returned to the lessor, ALC. ALC can then either lease them to another airline, sell them on the used aircraft market, or, in some cases, part them out for spares. ALC's profitability on the deal depends heavily on the market value of the planes at the end of the lease term.