4.10 Examination of the Equity Account over the Term of the Lease

This table illustrates the annual calculation of the change in the Equity account and its correlative effect on the Equity account balance over the life of the lease. We have, of course, assumed ceteris paribus.

(\$000)

 YearÂ Str. – LineÂ  Deprec.Â  Exp. Acc.Â Deprec. Amort.Â Acc.Â  Amort.Â Î(A-L)= ÎEquity Equity BalanceÂ 0 1,000 1 138 138 96 96 (138)-(96)= (42) 958 2 138 276 101 197 (138)- (101)= (37) 921 3 138 414 106 303 (138)-(106)= (32) 889 4 138 552 111 414 (138)-(111)= (27) 862 5 138 690 117 531 (138)-(117)= (21) 841 6 138 828 123 654 (138)-(123)= (15) 826 7 138 966 129 783 (138)-(129)= (9) 817 8 138 1,104 135 918 (138)-(135)= (3) 814 9 138 1,242 142 1,060 (138)-(142)= 4 818 10 138 1,380 149 1,209 (138)-(149)= 11 829 11 138 1,518 157 1,366 (138)-(157)= 19 848 12 138 1,656 164 1,530 (138)-(164)= 26 874 13 138 1,794 173 1,703 (138)-(173)= 35 909 14 138 1,932 181 1,884 (138)-(181)= 43 952 15 138 2,076 192 2,076 (138)-(192)= 54 1,000

In summary, we note the following:

• Question: Ceteris paribus (assuming all else equal), will the equity in fact continually change as shown here?
• Take note how the Equity decreases annually at first, and then increases after a time.
• What effect will this phenomenon have on the corporationâs Valuation?
• Note that, over fifteen years, the companyâs Equity has not changed â ceteris paribus! At the end, we are exactly back to where we started.
• Beyond the lease and its effects, there are many other things that are going on here, which are not noted.
• In particular, the corporation took on the lease in order to increase sales and profits. Our default assumption has always been that the corporation has a never-ending appetite for growth. It chose to lease the asset rather than purchase it with borrowed money.
• To the extent that the firm generates and retains profits from the leased asset, the Equity account will further change, hopefully in a positive direction.

In practice, we must evaluate whether it may be preferable to lease, or purchase and debt-finance the asset. Rarely, if ever, will the firm pay for the asset in cash due to the cost involved. The financial analyst would focus on whether the present value of a lease is greater or less than the present value of a purchase with debt financing. The alternative with the lower present value would be the cheaper and preferred alternative.

Other Considerations

One must consider that bank borrowing rates and leasing rates may not be equal. Actual residual values may differ depending on whether the firm purchased or leased the asset. An âownerâ may take better care of the asset than a lessee, and project a greater residual value.

This raises some difficult qualitative questions.

• What is the assetâs intended use? Will that subject the asset to an unacceptable level of wear and tear, including degradation?â
• Will the lessee abuse the asset because he does not own it?
• Is there a valuable service contract attached to the lease?
• Leasing companies often provide a complete service contract to ensure the maximum ongoing working condition and value of the asset.
• Will the assetâs productive life likely extend beyond the leaseâs term?
• Is this an asset, which is subject to technological improvement every few years, making ownership less attractive?

Our discussion has focused on an amortized lease. The scenario would look different for a simple, bullet loan or for a cash purchase. A bullet loan is one that requires interest-only payments, and no principal payments, over the life of the loan. At the loanâs term, the entire principal must be paid. This makes annual payments, or cash flow requirements lighter, but leaves a great financial burden on the table later.

The asset may also be paid for in cash, in which case one must assess the opportunity cost of using cash. The opportunity cost represents the investment alternative forgone due to having used cash for the subject asset. New equity may also be issued to purchase the asset, in which case the relevant cost would be the external cost of equity capital.

Financing leases may be a means, especially in conglomerates, of transferring an asset to a higher tax bracket entity. This is usually a subsidiary. High effective tax rate firms tend to capitalize leases. The higher-bracket subsidiary receives a greater benefit from deducting (expensing) the lease payments from its income. At the same time, the lower-bracket subsidiary, which receives the income, is taxed at a lower rate.