Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance(^910) 26. Leasing © The McGraw−Hill
Companies, 2002
NPV$10,000 2,313.50 (1 1/1.05^5 )/.05
$16.24
which is also positive.
As a consequence of different tax rates, the lessee (Tasha) gains $6.55 and the lessor
(Johnson) gains $16.24. The IRS loses. What this example shows is that the lessor and
the lessee can gain if their tax rates are different. The lease contract allows the lessor to
take advantage of the depreciation and interest tax shields that cannot be used by the
lessee. The IRS will experience a net loss of tax revenue, and some of the tax gains to
the lessor will be passed on to the lessee in the form of lower lease payments.A Reduction of Uncertainty We have noted that the lessee does not own the prop-
erty when the lease expires. The value of the property at this time is called the residual
value(or salvage value). At the time the lease contract is signed, there may be substan-
tial uncertainty as to what the residual value of the asset will be. A lease contract is a
method of transferring this uncertainty from the lessee to the lessor.
Transferring the uncertainty about the residual value of an asset to the lessor makes
sense when the lessor is better able to bear the risk. For example, if the lessor is the man-
ufacturer, then the lessor may be better able to assess and manage the risk associated
with the residual value. The transfer of uncertainty to the lessor amounts to a form of in-
surance for the lessee. A lease therefore provides something besides long-term financ-
ing. Of course, the lessee pays for this insurance implicitly, but the lessee may view the
insurance as a relative bargain.
Reduction of uncertainty is the motive for leasing most cited by corporations. For ex-
ample, computers have a way of becoming technologically outdated very quickly, and
computers are very commonly leased instead of purchased. In one survey, 82 percent of
the responding firms cited the risk of obsolescence as an important reason for leasing,
whereas only 57 percent cited the potential for cheaper financing.Lower Transactions Costs The costs of changing ownership of an asset many times
over its useful life will frequently be greater than the costs of writing a lease agreement.
Consider the choice that confronts a person who lives in Los Angeles but must do busi-
ness in New York for two days. It seems obvious that it will be cheaper to rent a hotel
room for two nights than it would be to buy a condominium for two days and then sell
it. Thus, lower transactions costs may be the major reason for short-term leases (operat-
ing leases). However, it is probably not the major reason for long-term leases.Fewer Restrictions and Security Requirements As we discussed in Chapter 7,
with a secured loan, the borrower will generally agree to a set of restrictive covenants,
spelled out in the indenture, or loan agreement. Such restrictions are not generally found
in lease agreements. Also, with a secured loan, the borrower may have to pledge other
assets as security. With a lease, only the leased asset is so encumbered.Dubious Reasons for Leasing
Leasing and Accounting Income Leasing can have a significant effect on the ap-
pearance of the firm’s financial statements. If a firm is successful at keeping its leases
off the books, the balance sheet and, potentially, the income statement can be made to
look better. As a consequence, accounting-based performance measures such as return
on assets, or ROA, can appear to be higher.CHAPTER 26 Leasing 887