Introduction to Corporate Finance

14: Long-Term Debt and Leasing

of financial ratio analyses to be performed directly on the statement in a way that captures all of the

company’s fixed obligations and indebtedness. Note also that because $1 of leasing commitment

is very similar to $1 of debt financing, we can think of lease financing as being similar to using

100% debt to finance the acquisition of a given asset. The cost of capital associated with 100%

debt financing is the after-tax cost of debt (to see this, consider the weighted average cost of capital

(WACC) formula found in Equation 11.4 on page 409 in Chapter 11, when only debt is used).

Therefore, because of this similarity between leasing and using 100% debt financing, the after-tax

cost of debt is often used as the discount rate when calculating present values in lease analysis, as

was shown in our analysis of Section 14-4d above.

14 - 4f ADVANTAGES AND DISADVANTAGES OF LEASING

Leasing has a number of commonly cited advantages and disadvantages which should be considered

when making a lease-versus-purchase decision. Although not all these advantages and disadvantages

hold in every case, several of them may apply in any given situation.

Frequently Cited Advantages

1 The use of sale-leaseback arrangements may permit the company to increase its liquidity by converting

an asset into cash, which can then be used as working capital. A company short of working capital

or in a liquidity bind can sell an owned asset to a lessor and then lease the asset back for a specified

number of years.

2 Leasing provides 100% financing. Most loan agreements for the purchase of fixed assets require the

borrower to pay a portion of the purchase price as a down payment. Therefore, the borrower is able

to borrow (at most) only 90% to 95% of the purchase price of most assets, and often less. Of course,

this extra borrowing through leasing may reduce the company’s remaining borrowing capacity.

3 When a company becomes insolvent or is reorganised, the maximum claim of lessors against the

corporation is a small fixed number of years of lease payments – and the lessor, of course, reclaims

the asset. If debt is used to purchase an asset, the creditors have a claim that is equal to the total

outstanding loan balance. The lessor also has higher priority in bankruptcy than do most of the

lessee’s other creditors, and, therefore, the lessor can initially charge a little bit less for bankruptcy

risk than other creditors would have to charge.

4 In a lease arrangement, the company may avoid the cost of obsolescence if the lessor fails to anticipate

accurately the obsolescence of assets and sets the lease payment too low. This is especially true in the

case of operating leases, which generally have relatively short lives. Of course, the lessee may pay for

this expected benefit in the form of a higher lease payment.

5 A lessee avoids many of the negative covenants that are usually included as part of a long-term

loan. Requirements with respect to the sale of accounts receivable, subsequent borrowing, business

combinations and so on are not generally found in lease agreements.

6 In the case of low-cost assets that are infrequently acquired, leasing – especially through operating

leases – may provide the company with needed financing flexibility. That is, the company does not

have to arrange other financing for these assets and can obtain them with relative convenience

through a lease.