Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance- Leasing © The McGraw−Hill^911
Companies, 2002
For example, because an operating lease does not appear on the balance sheet, total
assets (and total liabilities) will be lower with an operating lease than they would be if
the firm borrowed the money and bought the asset. From Chapter 3, we know that ROA
is computed as net income divided by total assets. With an operating lease, the net in-
come is usually bigger and total assets are smaller, so ROA will be larger. In addition,
debt covenants often do not consider operating leases as debt, which may allow a firm
to obtain debtlike financing without a covenant violation.
As we have discussed, however, the impact that leasing has on a firm’s accounting
statements is not likely to fool anyone. As always, what matters are the cash flow con-
sequences, and whether or not a lease has a positive NPV has little to do with its effect
on a firm’s financial statements. However, managerial compensation is sometimes based
on accounting numbers, and this creates an incentive to lease assets. This may be an
agency problem (see Chapter 1) if leasing is otherwise undesirable.100 Percent Financing It is often claimed that an advantage to leasing is that it pro-
vides 100 percent financing, whereas secured equipment loans require an initial down
payment. Of course, a firm can simply borrow the down payment from another source
that provides unsecured credit. Moreover, leases do usually involve a down payment in
the form of an advance lease payment (or security deposit). Even when they do not,
leases may implicitly be secured by assets of the firm other than those being leased
(leasing may give the appearance of 100 percent financing, but not the substance).
Having said this, we should add that it may be the case that a firm (particularly a
small one) simply cannot obtain debt financing because, for example, additional debt
would violate a loan agreement. Operating leases frequently don’t count as debt, so they
may be the only source of financing available. In such cases, it isn’t lease or buy—it’s
lease or die!Low Cost Unscrupulous lessors can encourage lessees to base leasing decisions on the
“interest rate” implied by the lease payments, which is often called the implicit or ef-
fective rate. As we discussed earlier under potential pitfalls, this rate is not meaningful
in leasing decisions, and it also has no legal meaning.Other Reasons for Leasing
There are, of course, many special reasons for some companies to find advantages in
leasing. In one celebrated case, the U.S. Navy leased a fleet of tankers instead of asking
Congress for appropriations. Thus, leasing may be used to circumvent capital expendi-
ture control systems set up by bureaucratic firms. This is alleged to be a relatively com-
mon occurrence in hospitals, for example. Many school districts lease buses and
modular classrooms and pay for them out of their operating budgets when they are un-
able to gain approval for a bond issue to raise funds.CONCEPT QUESTIONS
26.7a Explain why the existence of differential tax rates may be a good reason for
leasing.
26.7bIf leasing is tax motivated, who will have the higher tax bracket, lessee or
lessor?888 PART EIGHT Topics in Corporate Finance