paying lessor. Also, it may be less costly and time-consuming to sign a standardized lease contract than to negotiate a long-term secured loan.
When a firm borrows money, it pays the after-tax rate of interest on its debt. Therefore, the opportunity cost of lease financing is the after-tax rate of interest on the firm’s bonds. To value a financial lease, we need to discount the incremental cash flows from leasing by the after-tax interest rate.
An equivalent loan is one that commits the firm to exactly the same future cash flows as a financial lease. When we calculate the net present value of the lease, we are measuring the difference between the amount of financing provided by the lease and the financing provided by the equivalent loan:
Value |
|
financing provided |
value of |
of lease |
|
by lease |
equivalent loan |
We can also analyze leases from the lessor’s side of the transaction, using the same approaches we developed for the lessee. If lessee and lessor are in the same tax bracket, they will receive exactly the same cash flows but with signs reversed. Thus, the lessee can gain only at the lessor’s expense, and vice versa. However, if the lessee’s tax rate is lower than the lessor’s, then both can gain at the federal government’s expense.
A useful general reference on leasing is:
J.S. Schallheim: Lease or Buy? Principles for Sound Decisionmaking, Harvard Business School Press, Boston, MA, 1994.
The approach to valuing financial leases presented in this chapter is based on:
S.C. Myers, D. A. Dill, and A. J. Bautista: “Valuation of Financial Lease Contracts,” Journal of Finance, 31:799–819 (June 1976).
J.R. Franks and S. D. Hodges: “Valuation of Financial Lease Contracts: A Note,” Journal of Finance, 33:647–669 (May 1978).
Other useful works include Nevitt and Fabozzi’s book and the theoretical discussions of Miller and Upton and of Lewellen, Long, and McConnell:
P. K. Nevitt and F. J. Fabozzi: Equipment Leasing, 4th ed., Frank Fabozzi Associates, 2000.
M. H. Miller and C. W. Upton: “Leasing, Buying and the Cost of Capital Services,” Journal of Finance, 31:761–786 (June 1976).
W. G. Lewellen, M. S. Long, and J. J. McConnell: “Asset Leasing in Competitive Capital Markets,” Journal of Finance, 31:787–798 (June 1976).
Harold Bierman gives a detailed account of leasing and the AMT in:
H. Bierman: “Buy versus Lease with an Alternative Minimum Tax,” Financial Management, 17:87–92 (Winter 1988).
The options embedded in many operating leases are discussed in:
T.E. Copeland and J. E. Weston: “A Note on the Evaluation of Cancelable Operating Leases,” Financial Management, 11:68–72 (Summer 1982).
J.J. McConnell and J. S. Schallheim: “Valuation of Asset Leasing Contracts,” Journal of Financial Economics, 12:237–261 (August 1983).
S.R. Grenadier, “Valuing Lease Contracts: A Real Options Approach,” Journal of Financial Economics, 38:297–331 (July 1995).
35 percent. Lease payments are made in advance, that is, at the start of each year. The inflation rate is zero.
6.Refer again to quiz question 5. Suppose a blue-chip company requests a six-year financial lease for a $3,000 desk. The company has just issued five-year notes at an interest rate of 6 percent per year. What is the break-even rate in this case? Assume administrative costs drop to $200 per year. Explain why your answers to question 5 and this question differ.
7.Suppose that National Waferonics has before it a proposal for a four-year financial lease. The firm constructs a table like Table 26.2. The bottom line of its table shows the lease cash flows:
|
Year 0 |
Year 1 |
Year 2 |
Year 3 |
|
|
|
|
|
Lease cash flow |
62,000 |
26,800 |
22,200 |
17,600 |
|
|
|
|
|
These flows reflect the cost of the machine, depreciation tax shields, and the after-tax lease payments. Ignore salvage value. Assume the firm could borrow at 10 percent and faces a 35 percent marginal tax rate.
a.What is the value of the equivalent loan?
b.What is the value of the lease?
c.Suppose the machine’s NPV under normal financing is $5,000. Should National Waferonics invest? Should it sign the lease?
1.A lessee does not have to pay to buy the leased asset. Thus it’s said that “leases provide 100 percent financing.” Explain why this is not a true advantage to the lessee.
2.In quiz question 5 we assumed identical lease rates for old and new desks.
a.How does the initial break-even lease rate change if the expected inflation rate is 5 percent per year? Assume that the real cost of capital does not change. Hint: Look at the discussion of equivalent annual costs in Chapter 6.
b.How does your answer to part (a) change if wear and tear force Acme to cut lease rates by 10 percent in real terms for every year of a desk’s age?
3.Look at Table 26.1. How would the initial break-even operating lease rate change if rapid technological change in limo manufacturing reduces the costs of new limos by 5 percent per year? Hint: We discussed technological change and equivalent annual costs in Chapter 6.
4.Why do you think that leasing of trucks, airplanes, and computers is such big business? What efficiencies offset the costs of running these leasing operations?
5.Financial leases make sense when the lessee faces a lower marginal tax rate than the lessor. Does this tax advantage carry over to operating leases?
The following questions all apply to financial leases.
6.Look again at the bus lease described in Table 26.2.
a.What is the value of the lease if Greymare’s marginal tax rate is Tc .20?
b.What would the lease value be if Greymare had to use straight-line depreciation for tax purposes?
7.In Section 26.4 we showed that the lease offered to Greymare Bus Lines had a positive NPV of $820 if Greymare paid no tax and a $700 NPV to a lessor paying 35 percent tax. What is the minimum lease payment the lessor could accept under these assumptions? What is the maximum amount that Greymare could pay?
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8.In Section 26.5 we listed four circumstances in which there are potential gains from leasing. Check them out by conducting a sensitivity analysis on the Greymare Bus Lines lease, assuming that Greymare does not pay tax. Try, in turn, (a) a lessor tax rate of 50 percent (rather than 35 percent), (b) immediate 100 percent depreciation in year 0 (rather than five-year ACRS), (c) a three-year lease with four annual rentals (rather than an eight-year lease), and (d) an interest rate of 20 percent (rather than 10 percent). In each case, find the minimum rental that would satisfy the lessor and calculate the NPV to the lessee.
9.In Section 26.5 we stated that if the interest rate were zero, there would be no advantage in postponing tax and therefore no advantage in leasing. Value the Greymare Bus Lines lease with an interest rate of zero. Assume that Greymare does not pay tax. Can you devise any lease terms that would make both a lessee and a lessor happy? (If you can, we would like to hear from you.)
10.A lease with a varying rental schedule is known as a structured lease. Try structuring the Greymare Bus Lines lease to increase value to the lessee while preserving the value to the lessor. Assume that Greymare does not pay tax. (Note: In practice the tax authorities will allow some structuring of rental payments but might be unhappy with some of the schemes you devise.)
11.Nodhead College needs a new computer. It can either buy it for $250,000 or lease it from Compulease. The lease terms require Nodhead to make six annual payments (prepaid) of $62,000. Nodhead pays no tax. Compulease pays tax at 35 percent. Compulease can depreciate the computer for tax purposes over five years. The computer will have no residual value at the end of year 5. The interest rate is 8 percent.
a.What is the NPV of the lease for Nodhead College?
b.What is the NPV for Compulease?
c.What is the overall gain from leasing?
12.The Safety Razor Company has a large tax-loss carryforward and does not expect to pay taxes for another 10 years. The company is therefore proposing to lease $100,000 of new machinery. The lease terms consist of eight equal lease payments prepaid annually. The lessor can write the machinery off over seven years using the tax depreciation schedules given in Table 6.4. There is no salvage value at the end of the machinery’s economic life. The tax rate is 35 percent, and the rate of interest is 10 percent. Wilbur Occam, the president of Safety Razor, wants to know the maximum lease payment that his company should be willing to make and the minimum payment that the lessor is likely to accept. Can you help him? How would your answer differ if the lessor was obliged to use straight-line depreciation?
13.The overall gain from leasing is the sum of the lease’s value to the lessee and its value to the lessor. Construct simple numerical examples showing how this gain is affected by
a.The rate of interest.
b.The choice of depreciation schedule.
c.The difference between the tax rates of the lessor and lessee.
d.The length of the lease.
14.Many companies calculate the internal rate of return of the incremental after-tax cash flows from financial leases. What problems do you think this may give rise to? To what rate should the IRR be compared?
15.Discuss the following two opposite statements. Which do you think makes more sense?
a.“Leasing is tax avoidance and should be legislated against.”
b.“Leasing ensures that the government’s investment incentives work. It does so by allowing companies in nontaxpaying positions to take advantage of depreciation allowances.”
1.Magna Charter has been asked to operate a Beaver bush plane for a mining company exploring north and west of Fort Liard. Magna will have a firm one-year contract with the mining company and expects that the contract will be renewed for the five-year duration of the exploration program. If the mining company renews at year 1, it will commit to use the plane for four more years.
Magna Charter has the following choices.
•Buy the plane for $500,000.
•Take a one-year operating lease for the plane. The lease rate is $118,000, paid in advance.
•Arrange a five-year, noncancelable financial lease at a rate of $75,000 per year, paid in advance.
These are net leases: all operating costs are absorbed by Magna Charter.
How would you advise Agnes Magna, the charter company’s CEO? For simplicity assume five-year, straight-line depreciation for tax purposes. The company’s tax rate is 35 percent. The weighted-average cost of capital for the bush-plane business is 14 percent, but Magna can borrow at 9 percent. The expected inflation rate is 4 percent.
Ms. Magna thinks the plane will be worth $300,000 after five years. But if the contract with the mining company is not renewed (there is a 20 percent probability of this outcome at year 1), the plane will have to be sold on short notice for $400,000.
If Magna Charter takes the five-year financial lease and the mining company cancels at year 1, Magna can sublet the plane, that is, rent it out to another user.
Make additional assumptions as necessary.
2.Here is a variation on challenge question 1. Suppose Magna Charter is offered a fiveyear cancelable lease at an annual rate of $125,000, paid in advance. How would you go about analyzing this lease? You do not have enough information to do a full option pricing analysis, but you can calculate costs and present values for different scenarios.
3.Recalculate the value of the lease to Greymare Bus Lines if the company pays no taxes until year 3. Calculate the lease cash flows by modifying Table 26.2. Remember that the after-tax borrowing rate for periods 1 and 2 differs from the rate for periods 3 through 7.
MINI-CASE
Halverton Corporation
Helen James, a newly recruited financial analyst at Halverton Corporation, had just been asked to analyze a proposal to acquire a new dredger.
She reviewed the capital appropriation request. The dredger would cost $3.5 million and was expected to generate cash flows of $470,000 a year for nine years. After that point, the dredger would almost surely be obsolete and have no significant salvage value. The company’s weighted-average cost of capital was 16 percent.
Helen proposed a standard DCF analysis, but this suggestion was brushed off by Halverton’s top management. They seemed to be convinced of the merits of the investment but were unsure of the best way to finance it. Halverton could raise the money by issuing a secured eight-year note at an interest rate of 12 percent. However, Halverton had large tax-loss carryforwards from a disastrous foray into foreign exchange options. As a result, the company was unlikely to be in a tax-paying position for many years. Halverton’s CEO thought it might be better to lease the dredger than to buy it.
Helen’s first step was to invite two leasing companies, Mount Zircon Finance and First Cookham Bank, to submit proposals. Both companies were in a tax-paying position and could write off their investment in the dredger using five-year MACRS tax depreciation.
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Helen received the following letters, the first from Mount Zircon Finance:
February 29, 2006
Dear Helen,
We appreciated the opportunity to meet you the other day and to discuss the possibility of providing lease finance for your proposed new JLT4 dredger. As you know, Mount Zircon has extensive experience in this field and, because of our large volumes and low borrowing costs, we are able to offer very attractive terms.
We would envisage offering a 9-year lease with 10 annual payments of $544,300, with the initial lease payment due on entering into the lease contract. This is equivalent to a borrowing cost of 11.5 percent per annum (i.e., 10 payments of $544,300 paid at the beginning of each year discounted at 11.5 percent amounts to $3,500,000).
We hope that you agree with us that this is an attractive rate. It is well below your company’s overall cost of capital. Our leasing proposal will cover the entire $3.5 million cost of the dredger, thereby preserving Halverton’s capital for other uses. Leasing will also allow a very attractive return on equity from your company’s acquisition of this new equipment.
This proposal is subject to a routine credit check and review of Halverton’s financial statements. We expect no difficulties on that score, but you will understand the need for due diligence.
Thank you for contacting Mount Zircon Finance. We look forward to hearing your response. Sincerely yours,
Henry Attinger
For and on behalf of Mount Zircon Finance
The next letter was from First Cookham.
February 29, 2006
Dear Helen,
It was an honor to meet you the other day and to discuss how First Cookham Bank can help your company to finance its new dredger. First Cookham has a small specialized leasing operation. This enables us to tailor our proposals to our clients’ needs.
We recommend that Halverton consider leasing the dredger on a 7-year term. Subject to documentation and routine review of Halverton’s financial statements, we could offer a 7-year lease on the basis of 8 payments of $619,400 due at the beginning of each year. This is equivalent to a loan at an interest rate of 11.41 percent.
We expect that this lease payment will be higher than quoted by the larger, mass-market leasing companies, but our financial analysts have determined that, by offering a shorter lease, we can quote a lower interest rate.
We are confident that this is a highly competitive offer, and we look forward to your response. Yours sincerely,
George Bucknall, First Cookham Bank
Both proposals appeared to be attractive. However, Helen realized the need to undertake careful calculations before deciding whether leasing made sense and which firm was offering the better deal. She also wondered whether the terms offered were really as attractive as the two lessors claimed. Perhaps she could persuade them to cut their prices.
Questions
1.Calculate the NPV to Halverton of the two lease proposals.
2.Does the dredger have a positive NPV with (a) ordinary financing, (b) lease financing?
3.Calculate the NPVs of the leases from the lessors’ viewpoints. Is there a chance that they could offer more attractive terms?
4.Evaluate the arguments presented by each of the lessors.
C H A P T E R T W E N T Y - S E V E N
MOST OF THE time we take risk as God-given. An asset or business has its beta, and that’s that. Its cash flow is exposed to unpredictable changes in raw material costs, tax rates, technology, and a long list of other variables. There’s nothing the manager can do about it.
That’s not wholly true. To some extent managers can choose the risks that the business takes. We have already come across one way that they can do so. In our discussion of real options in Chapter 22 we described how companies reduce risk by building flexibility into their operations. A company that uses standardized machine tools rather than specialized equipment lowers the cost of bailing out if things go wrong. A petrochemical plant that is designed to use either oil or natural gas as a feedstock reduces the impact of an unfavorable shift in relative fuel prices. And so on.
In this chapter we shall explain how companies also enter into financial contracts that insure against or hedge (i.e., offset) a variety of business hazards. But first we should give some reasons why they do so.
Insurance and hedging are seldom free: At best they are zero-NPV transactions.1 Most businesses insure or hedge to reduce risk, not to make money. Why, then, bother to reduce risk in this way? For one thing, it makes financial planning easier and reduces the odds of an embarrassing cash shortfall. A shortfall might mean only an unexpected trip to the bank, but if financing is hard to obtain on short notice, the company might need to cut back its capital expenditure program. In extreme cases an unhedged setback could trigger financial distress or even bankruptcy. Banks and bondholders are aware of this possibility, and, before lending to your firm, they will often insist that it is properly insured.
In some cases hedging also makes it easier to decide whether an operating manager deserves a stern lecture or a pat on the back. Suppose your confectionery division shows a 60 percent profit increase in a period when cocoa prices decline by 12 percent. How much of the increase is due to the change in cocoa prices and how much to good management? If cocoa prices were hedged, it’s probably good management. If they were not, things have to be sorted out with hindsight by asking, What would profits have been if cocoa prices had been hedged? 2
Finally, hedging extraneous events can help focus the operating manager’s attention. It’s naive to expect the manager of the confectionery division not to worry about cocoa prices if her bottom line and bonus depend on them. That worrying time would be better spent if the prices were hedged.3
Of course, managers are not paid to avoid all risks, but if they can reduce their exposure to risks for which there are no compensating rewards, they can afford to place larger bets when the odds are in their favor.
2 7 . 1 I N S U R A N C E
Most businesses buy insurance against a variety of hazards—the risk that their plant will be damaged by fire; that their ships, planes, or vehicles will be involved in accidents; that the firm will be held liable for environmental damage; and so on.
1Hedging transactions are zero-NPV when trading is costless and markets are completely efficient. In practice the firm has to pay small trading costs at least.
2 Many large firms insure or hedge away operating divisions’ risk exposures by setting up internal, makebelieve markets between each division and the treasurer’s office. Trades in the internal markets are at real (external) market prices. The object is to relieve the operating managers of risks outside their control. The treasurer makes a separate decision on whether to offset the firm’s exposure.
3A Texas oilman who lost hundreds of millions in ill-fated deals protested, “Why should I worry? Worry is for strong minds and weak characters.” If there are any financial managers with weak minds and strong characters, we especially advise them to hedge whenever they can.
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PART VIII Risk Management |
When a firm takes out insurance, it is simply transferring the risk to the insurance company. Insurance companies have some advantages in bearing risk. First, they may have considerable experience in insuring similar risks, so they are well placed to estimate the probability of loss and price the risk accurately. Second, they may be skilled at providing advice on measures that the firm can take to reduce the risk, and they may offer lower premiums to firms that take this advice. Third, an insurance company can pool risks by holding a large, diversified portfolio of policies. The claims on any individual policy can be highly uncertain, yet the claims on a portfolio of policies may be very stable. Of course, insurance companies cannot diversify away macroeconomic risks; firms use insurance policies to reduce their specific risk, and they find other ways to avoid macro risks.
Insurance companies also suffer some disadvantages in bearing risk, and these are reflected in the prices they charge. Suppose your firm owns a $1 billion offshore oil platform. A meteorologist has advised you that there is a 1-in-10,000 chance that in any year the platform will be destroyed as a result of a storm. Thus the expected loss from storm damage is $1 billion/10,000 $100,000.
The risk of storm damage is almost certainly not a macroeconomic risk and can potentially be diversified away. So you might expect that an insurance company would be prepared to insure the platform against such destruction as long as the premium was sufficient to cover the expected loss. In other words, a fair premium for insuring the platform should be $100,000 a year.4 Such a premium would make insurance a zero-NPV deal for your company. Unfortunately, no insurance company would offer a policy for only $100,000. Why not?
•Reason 1: Administrative costs. An insurance company, like any other business, incurs a variety of costs in arranging the insurance and handling any claims. For example, disputes about the liability for environmental damage can eat up millions of dollars in legal fees. Insurance companies need to recognize these costs when they set their premiums.
•Reason 2: Adverse selection. Suppose that an insurer offers life insurance policies with “no medical needed, no questions asked.” There are no prizes for guessing who will be most tempted to buy this insurance. Our example is an extreme case of the problem of adverse selection. Unless the insurance company can distinguish between good and bad risks, the latter will always be most eager to take out insurance. Insurers increase premiums to compensate.
•Reason 3: Moral hazard. Two farmers met on the road to town. “George,” said one, “I was sorry to hear about your barn burning down.” “Shh,” replied the other, “that’s tomorrow night.” The story is an example of another problem for insurers, known as moral hazard. Once a risk has been insured, the owner may be less careful to take proper precautions against damage. Insurance companies are aware of this and factor it into their pricing.
When these extra costs are small, insurance may be close to a zero-NPV transaction. When they are large, insurance may be a costly way to protect against risk.
Many insurance risks are jump risks; one day there is not a cloud on the horizon and the next day the hurricane hits. The risks can also be huge. For example, Hurricane Andrew, which devastated Florida, cost insurance companies $17 bil-
4This is imprecise. If the premium is paid at the beginning of the year and the claim is not settled until the end, then the zero-NPV premium equals the discounted value of the expected claim or $100,000/ 11 r 2.
