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• For accounting purposes, what constitutes a capital lease?
• How are capital leases reported?

Taxes, the IRS and Leases
The lessee can deduct lease payments for income tax purposes if the lease is deemed to
be a true lease by the Internal Revenue Service. The tax shields associated with lease
payments are critical to the economic viability of a lease, so IRS guidelines are an im-
portant consideration.
Essentially, the IRS requires that a lease be primarily for business purposes and not
merely for purposes of tax avoidance.
In broad terms, a lease that is valid from the IRS™s perspective will meet the follow-
ing standards:
1. The term of the lease must be less than 80 percent of the economic life of the asset.
If the term is greater than this, the transaction will be regarded as a conditional sale.
2. The lease should not include an option to acquire the asset at the end of the lease
term at a price below the asset™s then“fair market value. This type of bargain option
would give the lessee the asset™s residual scrap value, implying an equity interest.
3. The lease should not have a schedule of payments that are very high at the start of
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the lease term and thereafter very low. If the lease requires early “balloon” pay-
ments, this will be considered evidence that the lease is being used to avoid taxes
and not for a legitimate business purpose. The IRS may require an adjustment in the
payments for tax purposes in such cases.
4. The lease payments must provide the lessor with a fair market rate of return. The
profit potential of the lease to the lessor should be apart from the deal™s tax benefits.
5. Renewal options must be reasonable and reflect the fair market value of the asset at
the time of renewal. This requirement can be met by, for example, granting the les-
see the first option to meet a competing outside offer.
The IRS is concerned about lease contracts because leases sometimes appear to be
set up solely to defer taxes. To see how this could happen, suppose that a firm plans to
purchase a $1 million bus that has a five-year life for depreciation purposes. Assume
that straight-line depreciation to a zero salvage value is used. The depreciation expense
would be $200,000 per year. Now suppose the firm can lease the bus for $500,000 per
year for two years and buy the bus for $1 at the end of the two-year term. The present
value of the tax benefits is clearly less if the bus is bought than if the bus is leased. The
speedup of lease payments greatly benefits the firm and basically gives it a form of ac-
celerated depreciation. In this case, the IRS might decide that the primary purpose of
the lease was to defer taxes.

• Why is the IRS concerned about leasing?
• What are some of the standards the IRS uses in evaluating a lease?

The Cash Flows from Leasing
To begin our analysis of the leasing decision, we need to identify the relevant cash
flows. The first part of this section illustrates how this is done. A key point, and one to
watch for, is that taxes are a very important consideration in a lease analysis.

Consider the decision confronting the Tasha Corporation, which manufactures pipe.
Business has been expanding, and Tasha currently has a five-year backlog of pipe or-
ders for the Trans-Missouri Pipeline.
The International Boring Machine Corporation (IBMC) makes a pipe-boring ma-
chine that can be purchased for $10,000. Tasha has determined that it needs a new ma-
chine, and the IBMC model will save Tasha $6,000 per year in reduced electricity bills
for the next five years.
Tasha has a corporate tax rate of 34 percent. For simplicity, we assume that five-year
straight-line depreciation will be used for the pipe-boring machine, and, after five years,
the machine will be worthless. Johnson Leasing Corporation has offered to lease the
same pipe-boring machine to Tasha for lease payments of $2,500 paid at the end of each
of the next five years. With the lease, Tasha would remain responsible for maintenance,
insurance, and operating expenses.3
3 We have assumed that all lease payments are made in arrears, that is, at the end of the year. Actually, many
leases require payments to be made at the beginning of the year.

Susan Smart has been asked to compare the direct incremental cash flows from leas-
ing the IBMC machine to the cash flows associated with buying it. The first thing she
realizes is that, because Tasha will get the machine either way, the $6,000 savings will
be realized whether the machine is leased or purchased. Thus, this cost savings, and any
other operating costs or revenues, can be ignored in the analysis.
Upon reflection, Ms. Smart concludes that there are only three important cash flow
differences between leasing and buying:4
1. If the machine is leased, Tasha must make a lease payment of $2,500 each year.
However, lease payments are fully tax deductible, so the aftertax lease payment
would be $2,500 (1 .34) $1,650. This is a cost of leasing instead of buying.
2. If the machine is leased, Tasha does not own it and cannot depreciate it for tax pur-
poses. The depreciation would be $10,000/5 $2,000 per year. A $2,000 deprecia-
tion deduction generates a tax shield of $2,000 .34 $680 per year. Tasha loses
this valuable tax shield if it leases, so this is a cost of leasing.
3. If the machine is leased, Tasha does not have to spend $10,000 today to buy it. This
is a benefit from leasing.
The cash flows from leasing instead of buying are summarized in Table B.2. Notice
that the cost of the machine shows up with a positive sign in Year 0. This is a reflection of
the fact that Tasha saves the initial $10,000 equipment cost by leasing instead of buying.

Susan Smart has assumed that Tasha can use the tax benefits of the depreciation al-
lowances and the lease payments. This may not always be the case. If Tasha were los-
ing money, it would not pay taxes and the tax shelters would be worthless (unless they
could be shifted to someone else). As we mentioned before, this is one circumstance
under which leasing may make a great deal of sense. If this were the case, the relevant
lines in Table B.2 would have to be changed to reflect a zero tax rate.

• What are the cash flow consequences of leasing instead of buying?
• Explain why the $10,000 in Table B.2 has a positive sign.

Incremental cash flows for versus Buy Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Tasha Corp. from leasing
Aftertax $1,650 $1,650 $1,650 $1,650 $1,650
instead of buying
Lost $0,680 $0,680 $0,680 $0,680 $0,680
tax shield
Cost of $10,000
Total cash $10,000 $2,330 $2,330 $2,330 $2,330 $2,330

4 There is a fourth consequence of leasing that we do not discuss here. If the machine has a nontrivial resid-
ual value, then, if we lease, we give up that residual value. This is another cost of leasing instead of buying.
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Lease or Buy?
Based on our discussion thus far, Ms. Smart™s analysis comes down to this: if Tasha
Corp. leases instead of buying, it saves $10,000 today because it avoids having to pay
for the machine, but it must give up $2,330 per year for the next five years in exchange.
We now must decide whether getting $10,000 today and then paying back $2,330 per
year is a good idea.

Suppose Tasha were to borrow $10,000 today and promise to make aftertax payments
of $2,330 per year for the next five years. This is essentially what Tasha will be doing
if it leases instead of buying. What interest rate would Tasha be paying on this “loan”?
Note that we need to find the unknown rate for a five-year annuity with payments of
$2,330 per year and a present value of $10,000. It is easy to verify that the rate is 5.317
Suppose Tasha were to borrow $10,000 today and promise to make aftertax pay-
ments of $2,330 per year for the next five years. This is essentially what Tasha will be
doing if it leases instead of buying. What interest rate would Tasha be paying on this
“loan”? Note that we need to find the unknown rate for a five-year annuity with pay-
ments of $2,330 per year and a present value of $10,000. It is easy to verify that the rate
is 5.317 percent.
The cash flows for our hypothetical loan are identical to the cash flows from leasing
instead of buying, and what we have illustrated is that when Tasha leases the machine,
it effectively arranges financing at an aftertax rate of 5.317 percent. Whether this is a
good deal or not depends on what rate Tasha would pay if it simply borrowed the money.
For example, suppose Tasha can arrange a five-year loan with its bank at a rate of
7.57575 percent. Should Tasha sign the lease or should it go with the bank?
Because Tasha is in a 34 percent tax bracket, the aftertax interest rate would be
7.57575 (1 .34) = 5 percent. This is less than the 5.317 percent implicit aftertax
rate on the lease. In this particular case, Tasha would be better off borrowing the money
because it would get a better rate.
We have seen that Tasha should buy rather than lease. The steps in our analysis can
be summarized as follows:
1. Calculate the incremental aftertax cash flows from leasing instead of buying.
2. Use these cash flows to calculate the implicit aftertax interest rate on the lease.
3. Compare this rate to the company™s aftertax borrowing cost and choose the cheaper
source of financing.
The most important thing to note from our discussion thus far is that in evaluating a
lease, the relevant rate for the comparison is the company™s aftertax borrowing rate. The
fundamental reason is that the alternative to leasing is long-term borrowing, so the af-
tertax interest rate on such borrowing is the relevant benchmark.

There are three potential problems with the implicit rate that we calculated on the lease.
First of all, we can interpret this rate as the internal rate of return, or IRR, on the deci-
sion to lease rather than buy, but doing so can be confusing. To see why, notice that the

IRR from leasing is 5.317 percent, which is greater than Tasha™s aftertax borrowing cost
of 5 percent. Normally, the higher the IRR, the better, but we decided that leasing was
a bad idea here. The reason is that the cash flows are not conventional; the first cash
flow is positive and the rest are negative, which is just the opposite of the conventional
case. With this cash flow pattern, the IRR represents the rate we pay, not the rate we get,
so the lower the IRR, the better.
A second, and related, potential pitfall has to do with the fact that we calculated the
advantage of leasing instead of buying. We could have done just the opposite and come
up with the advantage of buying instead of leasing. If we did this, the cash flows would
be the same, but the signs would be reversed. The IRR would be the same. Now, how-
ever, the cash flows would be conventional, so we could interpret the 5.317 percent IRR
as saying that borrowing and buying is better.
The third potential problem is that our implicit rate is based on the net cash flows of
leasing instead of buying. There is another rate that is sometimes calculated, which is
based solely on the lease payments. If we wanted to, we could note that the lease pro-
vides $10,000 in financing and requires five payments of $2,500 each. It would be
tempting to then determine an implicit rate based on these numbers, but the resulting
rate would not be meaningful for making lease versus buy decisions, and it should not
be confused with the implicit return on leasing instead of borrowing and buying.
Perhaps because of these potential sources of confusion, the IRR approach we have
outlined thus far is not as widely used as the NPV-based approach that we describe next.

Now that we know that the relevant rate for evaluating a lease versus buy decision is the
firm™s aftertax borrowing cost, an NPV analysis is straightforward. We simply discount
the cash flows back to the present at Tasha™s aftertax borrowing rate of 5 percent as fol-

NPV $10,000 2,330 (1

The NPV from leasing instead of buying is 2$87.68, verifying our earlier conclusion
that leasing is a bad idea. Once again, notice the signs of the cash flows; the first is pos-
itive, the rest are negative. The NPV we have computed here is often called the net ad-
vantage to leasing (NAL). Surveys indicate that the NAL approach is the most popu-
lar means of lease analysis in the real world.
NPV that is calculated when
deciding whether to lease an
asset or to buy it.
In our lease versus buy analysis, it looks as though we ignored the fact that if Tasha bor-
rows the $10,000 to buy the machine, it will have to repay the money with interest. In
fact, we reasoned that if Tasha leased the machine, it would be better off by $10,000
today because it wouldn™t have to pay for the machine. It is tempting to argue that if
Tasha borrowed the money, it wouldn™t have to come up with the $10,000. Instead,
Tasha would make a series of principal and interest payments over the next five years.
This observation is true, but not particularly relevant. The reason is that if Tasha bor-
rows $10,000 at an aftertax cost of 5 percent, the present value of the aftertax loan pay-
ments is simply $10,000, no matter what the repayment schedule is (assuming that the
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loan is fully amortized). Thus, we could write down the aftertax loan repayments and
work with these, but it would just be extra work for no gain.

In our Tasha Corp. example, suppose Tasha is able to negotiate a lease payment of
$2,000 per year. What would be the NPV of the lease in this case?
With this new lease payment, the aftertax lease payment would be $2,000 (1
.34) $1,320, which is $1,650 1,320 $330 less than before. Referring back to
Table B.2, note that the aftertax cash flows would be $2,000 instead of $2,330. At
5 percent, the NPV would be:

NPV $10,000 2,000 (1

Thus, the lease is very attractive.

• What is the relevant discount rate for evaluating whether or not to lease an asset?
• Explain how to go about a lease versus buy analysis.


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