Chapter 25 – Leasing

Chapter 25 continues on the Broad subject of “financing” discussed in Chapters 17-19 and discusses a Financing alternative available for many firms – leasing. In many ways, leasing Is very similar to borrowing money. So, firms can:

1)Buy an asset, Financing the asset with borrowed money, or

2)Lease the asset

Both obligate the firm to make Future payments to the lender (if the money is borrowed) or to the lessor (if The asset is leased).

Different type of leases:

1)Length

Operating Leases – short or long Term with option to cancel

Financing Or “capital” leases - a lease to rent equipment for its full economic life.

2)Who pays for Maintenance, insurance, property taxes

Full service – the Leasing company pays for all costs,(insurance, maintenance, ect) – higher lease Payments

Net – you take Responsibility for all costs for the asset, lease payments will be lower

3)Who owns the asset Before the lease

Direct lease – leasing Company buys the asset and then leases it to the client.

Sale and lease-back – the Client owns the asset, sells it to the leasing company, and then leases it back

So why would a firm want to lease an Asset rather than buy?

1)You only need the Asset for a short period of time (e.G., a one-week car rental)

2)When the Maintenance is provided (for example, with a full service lease) (the lessor Can get a better deal on maintenance vs the lessee because of economies of Scale)

3)Standardization Creates economies of scale (e.G., compare 1000 firms purchasing the asset Individually versus one lessor (company that does the leasing) buying 1000 assets and leasing Using standardized contracts)

4)Tax deductions (tax “shields”) can more effectively be used – more on this later

5)Lessees may have Superior claims in bankruptcy to leased assets

a.Lease is “rejected” by the bankruptcy court – lease is terminated and lessor recovers Leased asset

b.Lease is “affirmed” by the bankruptcy court (since asset is “essential” for the Business) – lessee continues to make full payment on the lease. – best place a lessee can be

c.Lease is “renegotiated” by the bankruptcy court with new terms (probably more favorable To the lessee)

6)Avoid the Alternative minimum tax – since lease expense is not a “tax preference” item -

The alternative minimum Tax is an alternative tax system is which you: an alternative tax system that Is only put in place for a small set of people – must compute the taxes between The two systems and pay the highest

a.Start with taxable Income

b.Add “tax Preference” items – Ex: Accelerated depreciation method

c.Subtract an “exemption” Amount (which applies to corporations with low taxable income)

d.Resulting in “alternative minimum taxable income”

e.Multiply “alternative minimum taxable income” by 20%, resulting in the “tentative Minimum tax”

f.Pay the higher of The tax calculated in the regular way and the “tentative minimum tax”

7)Avoid controls On capital expenditures placed on firms / managers – i.E., you are “leasing” an Asset is not “purchasing” – Leasing is a way of avoiding alternative taxes

So why would a firm want to lease an asset Rather than buy? Continued

8)Allow for “off Balance sheet” financing - Depending on how the lease is designed, accounting Rules can require that the firm include the leased asset as an asset on the Balance sheet. The PV of the lease payments would then be included as a Liability. This will make the firm’s balance sheet appear to be more highly Levered.

Assume the following firm is required to keep their leverage ratio less Than 80%

Current balance sheet

Assets = $100 million

Liabilities = $79 million

Equity = $21 million

Leverage ratio = 79/100 = 79%

What is the firm’s leverage ratio if it leases a $10 million machine With a PV of lease payments equal to $10 million and if the firm is required to Include the leased asset and associated liability on the balance sheet?

Current balance sheet

Assets = 110 million = 10M + 100M

Liabilities = 89 million = 10M + 79M

Equity = 21 million

Leverage ratio = 80.9% (a violation to leverage ratio requirement)

The accounting rules are well defined in this area. Page 643 of the Textbook lists the rules. In short, a lease for most of the asset’s economic Life, or the option to buy the asset at a trivial amount at the end of the Lease will require that the firm put the lease on the balance sheet. Firms try To structure the leases to work one way or the other depending on which is more Advantageous.

9)What effect will Including the lease as an asset/liability on the firm’s balance sheet have on ROA?: ROA = (NI/Assets): If assets go from 100 – 110 million. ROA decreases. This happens because assets Go up and also because net income goes down.

Calculation of the PV of a Lease

Lease payments are typically The same each period and typically are paid in advance (i.E., the first payment Is at time zero). This means that a typical lease can be valued by calculating The present value of an annuity.

Examples (use a 12% annual Discount rate):

1)Ten-year lease, Annual payments of $1200, starting at time 1 (i.E., from time 1-10)

a.Starting cash flows at time 1 NPV= 6780.26

2)Ten-year lease, Annual payments of $1200, starting at time 0 (i.E., from time 0-9)

a.Starting cash flows at time 0 NPV = 7593.89

The next two examples use Leases with monthly payments. To value, first calculate a monthly discount rate That is equivalent to a 12% annual discount rate.

Equivalent Monthly discount rate = (1+R^12)= 1.12 = 1+r = 1.12^(1/12) – 1 = .0095

3)Ten-year lease, Monthly payments of $100, starting at time 1 (i.E., from time 1-120)

a.PV = 7145.55

4)Ten-year lease, Monthly payments of $100, starting at time 0 (i.E., from time 0-119)

a.PV = 7145.55X(1.0095) = 7213.36
How much should you charge of a lease?

Asset cost = $1000

Maintenance (and other) costs = $100 per year for years 1-4, $200 per year for years 5-7

Asset life = 7 years

Tax depreciation life = 5 Years (20%, 32%, 19.2%, 11.52%, 11.52%, 5.76%, see page 141 of the textbook)

Discount rate = 8%

The rental rate above is the “equivalent annual cost” associated with the asset cost, maintenance, and tax Depreciation benefit (or tax depreciation “shield”) cash flows. Equivalent Annual cost calculations are explained in Chapter 6.

In The above example, we applied an 8% to all the cash flows, implying that all The cash flows have the same risk. Assuming the firm has sufficient taxable Income to ensure that it is in the top corporate tax bracket in all future Years (i.E., above $18,333,333), it’s likely that the cash flow benefit from The tax depreciation is a safer cash flow than the other cash flows and Therefore should be discounted at a lower rate.

Lease versus buy? Compare your Equivalent annual cost to the yearly rent charged by a leasing firmFinancing Leases

An operating lease is Meant to be a short-term lease (or a long-term lease with the right to cancel). Operating leases make sense if you only need the asset for a short period of Time, or the right is cancel is valuable

A financing lease is a Lease for essentially the entire economic life of the asset and is not Cancellable. A financing lease is used as an alternative to borrowing money to Buy the asset.

The decision of whether to use A financing lease versus borrowing and buying the asset has tax consequences.

Borrow And buy

Purchasing Firm deducts interest expense and tax depreciation

Lease

The Lessee firm deducts lease expense

The Lessor firm deducts interest expense and tax depreciation

The IRS has rules that determine whether a lease is legitimate or not (see page 648 Of the textbook)

If The lease is disallowed by the IRS, then the lessee firm is treated as if it Purchased the asset with borrowed money. In this case, it will deduct the Interest expense and tax depreciation. Knowing the tax laws allows the firm to Decide how to structure the lease.

In General, it is better to lease (i.E., let the lessor deduct the interest Expense and tax depreciation) if:

1)Lessor’s marginal Tax rate is significantly higher than lessee’s marginal tax rate (we want it to Be structured as a true lease – like airlines bc they claim high losses all the Time and don’t really need tax breaks

2)Depreciation tax Shields are received early in the lease period (i.E., you use accelerated tax Depreciation)

3)Lease period is Long and lease payments are concentrated towards the end of the lease

4)The interest rate Is high

Chapter 31

Mergers

A merger is a combination of Two companies. In most mergers, one firm (the “acquirer”) is pursuing the other Firm (the “target”). Typically, the managers of the target lose their jobs as Their firm is merged into the acquirer.

Types of Mergers

Horizontal – a merger of two firms in the same industry (two airlines for example)

Vertical – a supplier acquires distributor or vice versa (cable company & content company) same Supply chain

[Walmart buying Tyson]

Conglomerate – a combination of unrelated firms – Urban Outfitters buying a pizza Company.

The main purpose of a merger Is to combine two separate firms into a more valuable single firm. Example:

Worth more together than apart.

1)The main source of Merger gains (sometimes called “synergies”) is economies of scale. Cost Savings through economies of scale are most often see with horizontal mergers:

Reduction in the number of employees

·Reduction in Duplicate offices (e.G., merger of two banks servicing the same city)

·Savings are highest When there are large fixed costs and low variable costs associated with an Expense. Example: two companies, each selling one million units. Separately, both Have expenses of $2 million/year. How about combined?

A.Fixed costs $500,000, variable costs = $1.5 per unit:  A(1): 500K + 1.5(1M) = $2M A(2): 500K + 1.5(1M) = $2M

B.Fixed costs $1,500,000, Variable costs = $0.5 per unit:  

Reasons for a Merger

2)Synergies from vertical mergers - allows For better coordination / cooperation between supplier and distributor

A Smelter company choosing whether to locate next to a mine

As Separate companies – the smelter company might be worried about being taken advantage Of by the mining company

Can Fix through contracts, but

Costly To write contract, monitor, and enforce

As a Merged company – incentive is to cooperate

3)Complementary Resources – typically a large firm providing resources that are too costly for A small firm to produce on its own

The “large firm” will need to have with excess capacity or capacity that can easily Be scaled up at low cost

4)Surplus funds - remember The “pecking-order” theory of capital structure from Chapter 18:

a.A firm best source Of funds to fund projects is existing cash or marketable securities

b.A firm’s second Best source of funds is to issue risk-free debt, if possible

c.If more funds are Needed to fund a project, they will issue risky debt, and common stock as a Last resort

d.Firms are sometimes So reluctant to issue risky securities (and especially common stock) to fund Projects that they sometimes pass over good projects

e.In this setting, It might make sense for young firms with a cash shortage to merge with mature Firms which have surplus cash

Young Firms – high-growth phase of their lifecycle (lots of new ideas/projects but no cash)

Mature Firms – low-growth phase of their lifecycle (no new ideas/projects but plenty of cash)

Reasons for a Merger - continued

5)Get rid of the Target’s bad management – it’s often hard to fire bad management without a hostile Takeover

Management Usually has support of the current board of directors (and often have a seat on The board)

Many Small investors don’t bother voting

Many Investors use the recommendation of the current management team in deciding how To vote

6)An efficient way To reduce the number of firms in industries with declining profits

Alternative is a series of bankruptcies

7)Diversification – Combining two firms into one firm reduces risk (a “dubious” reason for a merger)

The Combination of assets into a portfolio reduces the risk of the portfolio in Comparison to the risk of the individual assets (assuming the assets are not Perfectly correlated)

Example: All equity so σ does not include debt risk

Merger of two firms (A And B) with market values of $400 million and $600 million respectively

Risk (i.E., standard deviation of Returns) of A = 30%, B = 50%

Correlation of returns Of the two firms = 0.2

a.Formula: σ_p = [x^2a σ²_a + x^2b σ²_b + 2x_ax_bρ_abσ_aσ_b]^0.5

x_a = 0.4, x_b = 0.6, σ_a = 0.3, σ_b = 0.5, ρ_ab = 0.2, σ_p = 34.47%

x_a = 0.4, x_b = 0.6, σ_a = 0.3, σ_b = 0.5, ρ_ab = 1.0, σ_p = 42%

b.So, merging two Firms together (assuming they are not perfectly), will reduce the risk (as measured By standard deviation of returns) of the combined firms to a level less than a Weighted average of the individual standard deviations. The lower the Correlation, the more the diversification benefits.

With no Diversification, you can take the WA & get the same answer = (.4)(.3) + (.6)(.5) = σ_pà 42%

Reasons for a Merger - continued

7)  Diversification – continued

c.But what about Beta? (beta of a merged Company)

β_a = 0.8, β_b = 1.2, β_p = (0.4)(0.8) = (0.6)(1.2) = 1.04 (just WA)

d.However, the two Firms don’t need to merge in order for an investor to realize the benefits of Diversification. For example, assume you have $50,000 to invest. How can you Achieve the same diversification benefits?

Take the 50K & split It into two different investments (40% 0f 50K into A & 60% of 50K into B) – same results

e.So, in our Example, investors don’t gain anything by the two firm merging

f.In fact, it might make Investors worse off (as it doesn’t allow investors to own just one of the two Firms). See the Chapter 31 appendix in the textbook for a more complete Discussion. (If no gains From a merger then no reason to diversify)

g.Although investors Are no better off, what about managers / employees of the two firms (at least Those keeping their jobs)? (Can’t Have two CEO’s)

8)Acquisition of a Target with a low PE ratio will increase EPS of the acquiring firm (another “dubious” reason)

First an example of increasing EPS that no investor would think is Beneficial: A reverse (1:2) stock split: to increase stock $ to avoid delisting.

Stockholders Are unlikely to be fooled into thinking the increase in EPS reflects positively On the firm

The company is not Doing better – revenues have not increased.

Reasons for a Merger - continued

8)  Increasing EPS – continued

Example: assume Firm A acquires Firm B for $4 million, paying with 1 Million of its shares (assume no merger gains)

$20M Of stock – you will have to give 1M shares.

*if You acquire a company and make EPS go up, the PE ratio must be less than the Acquired company.

No real benefit unless Investors are fooled into thinking EPS growth reflects a real increase in Earning power

9)Lower financing Costs – still another “dubious” reason for a merger. Assume two firms need to Borrow $50 million (each) and are each charged an interest rate of 10% due to Default risk of the separate loans.

For Example: going from σ = 34.47% vs σ = 42%By Combining the two firms together into one firm, it is likely the merged firm Will be able to negotiate a lower interest rate due to a lower risk level for The combined $100 million loan. However, the lower risk comes at a cost.

For example, before the Merger, Firm A can go bankrupt without hurting Firm B’s stockholders. After the merger, Firm B’s Stockholders end up paying for the Firm A’s loss. So, the lower interest rate Comes from having Firm B’s stockholders, in essence, “guaranteeing” Firm A’s Loan. (Both companies & all stockholders are hurt)

Related example – a Student getting parents to guarantee a loan

         Nothing better for the two Parties – they just shift Risk to the other party.

Estimating Merger Gains

If the gain from the merger is Positive, then there is good economic reason for the merger. However, does the overall Gain from the merger mean that each of the two parties gain? Stockholders of target company Benefit more.

Firm A (acquirer) is buying Firm B (target) for $29 million cash. What is the NPV of The acquisition for Firm A?

NPV = ΔPV_AB – (Cost – PV_B) = $10 million – ($29 million - $20 million) = $1 Million (10% GAIN)

What Portion of the merger gain is earned by the:

Acquirer (Firm A) = $1 million / $10 Million or 10%

Target (Firm B) = $9 million / $10 Million or 90%  (want to be a part of the Company being acquired)

The following should be the Market values of Firm A and B before and after the merger announcement

MV Of a firm (assuming the firm is “all equity”) = Stock price * shares Outstanding

Thus, You can estimate merger gains and how they are split by examining stock price Changes around the announcement.

Estimating Merger Gains - continued

From the previous example, the Gain from merger is easy to calculate if:

1)The acquirer and Target’s stocks are publicly traded

2)The market is “semi-strong” Efficient

3)Investors don’t Anticipate the merger

Merger Gain = $130 million - $100 million - $20 million = $10 million

Target Gain = $29 million - $20 million = $9 million (or 90%)

Acquirer Gain = [$10 million - ($29 million - $20 million)] = $1 million (or 10%) (pg 6 – bottom)

What happens if investors Anticipate the merger? For example, what if the merger was fully anticipated By investors (perhaps because of rumors reported by the press)?

Merger Gain = $130 - $101 - $29 = $0

Target Gain = $29 - $29 = $0

Acquirer Gain = $0 – ($29 -$29) = $0

In This case, there are still gains from the merger, but it’s just not obvious From looking at market prices.

To Estimate merger gains in this case, you want the “intrinsic” value of the Acquirer and target as stand-alone companies (i.E., what would the market value Be if no merger was anticipated). To estimate the intrinsic value:

Calculate The PVs of the two firms by discounting expected future unlevered cash flows at The after-tax WACC

Examine Stock prices from before the rumors

Estimating Merger Gains - continued

TEST QUESTION

In the previous example, Firm A was paying cash for the merger. What if the acquirer pays with stock? Return To the example where the merger was unanticipated by investors.

Assume Firm A and B all both “all equity” firms. Before the merger, Firm A has 5 Million shares outstanding and Firm B has 4 million shares outstanding.

How Many shares will Firm A need to give Firm B stockholders in exchange for their 4 Million shares of stock?

Acquisition price = $29 million

Shares Issued to Firm B stockholders = $29 Million / $20.20 = 1,436,643.56

Exchange Ratio = 1, 436, 643.56 / 4 Million = 0.358911 (Firm A to Firm B share)

Firm AB shares outstanding after merger = 5 million + 1,436,643.56 = 6,436,643.56

Fraction Of shares in Firm AB owned by Firm B stockholders = 1,436,643.56 / 6,436,643.56 = .22307

Market Value of Firm AB stock after merger = 6,436,643.56* $20.20 = $130 million

Gain From merger = $130M - $100M - $20M (same as before)

Cost = xPV_AB – PV_B = .2230769 * $130 million – $20 million = $9 million GAIN of acquisition To Target

NPV = ΔPV_AB – (Cost – PV_B) = ($130M - $120M) - $9M = $1M GAIN to Acquirer

Of Acquiring company.

Note – paying for the target With stock rather than cash may signal that the acquirer’s stock is overvalued (a “lemon”)

How to Merge

In very general terms, buying Another firm is like buying any other asset, but is much more complicated

1)When you buy a Firm, you are buying all the firm’s assets, making it much harder to Value

2)Federal antitrust Laws may prevent the merger

Clayton Act of 1914 – Will the merger substantially reduce competition or form a monopoly?

Primarily enforced by The Justice Department and the FTC. Competitors can also bring antitrust suits.

Sometimes firms can Sell off certain assets of the merged firm to get around antitrust issues

Acquisitions of firms In other countries can be blocked by equivalent governmental agencies in the Affected countries

3)Depending on how The merger is structured, you may be assuming the target’s liabilities

In a Formal “merger” of two companies, the acquiring firm purchases all the target’s Assets and assumes all the liabilities. Need approval of at least 50% of the Stockholders of both firms.

Buy enough of the stock of the Target to gain control

Buy the Particular assets of the target that you want

4)Accounting issues – we won’t discuss

5)Tax consequences

Payment in cash – Taxable to the selling stockholders as capital gains

Payment in stock – a Non-taxable exchange

Proxy Fights, Takeovers, and the Market For Corporate Control

How do you get rid of a bad Management team? You will either need to wage a “proxy fight” or execute a “hostile takeover”

Proxy fight (or proxy contest)

Stockholders Have control of the firm through their election of the board of directors who Hire management

To Elect a new management team, you will probably need to elect a new board of Directors (since the current board of directors probably supports the current Management team)

Stockholders Can either place their votes in person at the annual stockholder meeting or Vote by “proxy” (i.E., give someone else the right to vote for you at the Meeting

Proxy Fight – a dissident stockholder tries to collect enough proxies to be able to Elect their own people to the board

Someone who does Not have enough shares to vote – borrows votes

Hostile takeover

A Dissident stockholder (or even someone unaffiliated with the firm) makes a Tender offer to buy shares from existing stockholders

If Enough shares are purchased (e.G., over 50%), then this person can elect a Majority of the board and thereby hire new management

Management Is likely to recommend to stockholders to turn down the tender offer, by Arguing that the firm is really worth more than the amount of the tender offer. They could be making this recommendation in their own self-interests, or in the Interests of stockholders.

Remember, Classified (or “staggered”) boards will delay when a majority of the board can Be put in place

Page 826 of the textbook lists other takeover defenses

How are Merger Gains Split?

As summarized in the textbook, Andrade, Mitchell, and Stafford (2001) show that

The Combined firm is worth on average 2% more than the acquirer and target Separately. They are probs Paying more for the company than what its worth.

Surprisingly, Acquirer’s stockholders on average lose when buying a publicly-traded target. (Other Studies show that acquirer’s gain when buying a private target.)

(If the acquirer Is not making/getting a sizeable gain. You want to own Target co. Stock.)Target stockholder gain on average 16%

Competition Seems to be a likely reason why most of the gains of the merger goes to the Target

Because Of the large profits available, some investment firms specialize in trying to Identify likely targets

The Means that the set of likely targets will have a market value greater than Their intrinsic value (making merger gains harder to measure as discussed on Page 7 of the notes

It’s Hard to measure acquirer gains since acquirers are often much bigger than Targets

$1,000 acquirer

$100 Target

$20 Merger gain ($16 to target, $4 to acquirer)

Percent Return to target = $16/$100 = 16%

Percent Return to acquirer= $4/$1000 = 0.4%