STFM-MODULE-5 (1) PDF - Financial Management

Republic of the Philippines GUIMARAS STATE UNIVERSITY Mclain, Buenavista, Guimaras COLLEGE OF BUSINESS AND MANAGEMENT SPECIAL TOPICS IN FINANCIAL MANAGEMENT Module 5 By: ZINNIA B. IBIEZA, MBA  Republic...

Republic of the Philippines GUIMARAS STATE UNIVERSITY Mclain, Buenavista, Guimaras COLLEGE OF BUSINESS AND MANAGEMENT SPECIAL TOPICS IN FINANCIAL MANAGEMENT Module 5 By: ZINNIA B. IBIEZA, MBA  Republic of the Philippines GUIMARAS STATE UNIVERSITY Mclain, Buenavista, Guimaras LESSON 5 LEASE FINANCING AND BUSINESS VALUATION LEARNING OUTCOMES: ✓ Describe the two primary types of leases. ✓ Explain how lease financing affects both financial statements and taxes. ✓ Discuss the factors that create value in lease transactions. ✓ Explain in general terms how businesses are valued. BASICS OF LEASING Businesses generally own fixed assets, but it is the use of land, buildings, and equipment that is important, not their ownership. One way to obtain the use of such assets is to raise debt or equity capital and then use these funds to buy them. An alternative way to obtain the use of assets is by leasing. Before the 1950s, leasing was generally associated with real estate (land and buildings), but today it is possible to lease almost any kind of fixed asset. Although leasing is used extensively in all industries, it is especially prevalent in the health services industry, primarily with medical equipment and information technology hardware and software. Every lease transaction has two parties: The user of the leased asset is called the lessee, while the owner of the property, usually the manufacturer or a leasing company, is called the lessor. Leases are commonly classified into two categories: operating leases and financial leases. Operating Leases - Also referred to as service leases and generally provide for both financing and maintenance. - It is a contract that permits the use of an asset without transferring the ownership rights of said asset. - The accounting for operating leases is governed by the GAAP rules or the Generally Accepted Accounting Principles. - Considered a form of off-balance-sheet financing. This means a leased asset and associated liabilities are not included on a company's balance sheet. Page 2 of 11 FM 8 | SPECIAL TOPICS IN FINANCIAL MANAGEMENT  Republic of the Philippines GUIMARAS STATE UNIVERSITY Mclain, Buenavista, Guimaras - It enabled American firms to keep billions of dollars of assets and liabilities from being recorded on their balance sheets, thereby keeping their debt-to- equity ratios low. - To be classified as an operating lease, the lease must meet certain requirements under (GAAP) that exempt it from being recorded as a capital lease. - Assets that are rented under operating leases include real estate, aircraft, and equipment with long, useful life spans such as vehicles, office equipment and industry-specific machinery. Advantages of Operating Leases Operating leases provide greater flexibility to companies as they can replace/update their equipment more often. No risk of obsolescence, as there is no transfer of ownership. Accounting for an operating lease is simpler. Lease payments are tax-deductible. Financial Leases - Also referred to as capital leases and considered as a purchase of an asset. - It is a contract entitling a lessee to the temporary use of an asset and has the economic characteristics of asset ownership for accounting purposes. - Under this type of lease, the leased asset is treated for accounting purposes as if it were actually owned by the lessee and is recorded on the balance sheet as such. - It requires a lessee to book assets and liabilities associated with the lease if the lease contract meets specific requirements. - It can have an impact on companies' financial statements, influencing interest expense, depreciation expense, assets, and liabilities. - To qualify as a capital lease, a lease contract must satisfy any of the following four criteria: The life of the lease must be 75% or greater for the asset's useful life. The lease must contain a bargain purchase option for a price less than the market value of an asset. The lessee must gain ownership at the end of the lease period. Page 3 of 11 FM 8 | SPECIAL TOPICS IN FINANCIAL MANAGEMENT  Republic of the Philippines GUIMARAS STATE UNIVERSITY Mclain, Buenavista, Guimaras The present value of lease payments must be greater than 90% of the asset's market value. Advantages of Financial Leases Lessee is allowed to claim depreciation on the asset, which reduces taxable income. Interest expense also reduces taxable income. Operating Leases Vs. Financial Leases Basis of Difference Operating Lease Financial Lease Ownership Retained by the lessor Might transfer to the during and after the lease lessee at end of the lease term. term. Bargain Purchase Option Cannot contain a bargain Enables lessee to buy an purchase option. asset at less than fair market value. Term Less than 75% of the Equals or exceeds 75% of asset’s estimated the asset's estimated economic life. useful life. Present Value PV of lease payments is PV of lease payments less than 90% of the equals or exceeds 90% of asset's fair market value. the asset's original cost. Accounting No ownership risks. Lease is considered an Payments are considered asset (leased asset) and as operating expenses; liability (lease payments). shown in the profit and Payments are shown on loss statement (P&L) on the balance sheet. the balance sheet. Tax Lessee considered to be As the owner, lessee renting; lease payment claims depreciation treated as a rental expense and interest expense. expense. Page 4 of 11 FM 8 | SPECIAL TOPICS IN FINANCIAL MANAGEMENT  Republic of the Philippines GUIMARAS STATE UNIVERSITY Mclain, Buenavista, Guimaras Risks/Benefits Right to use only. Transferred to the lessee. Risks/benefits remain with Lessee pays maintenance, the lessor. Lessee pays insurance, and taxes. maintenance costs. TAX EFFECTS OF LEASING For both investor-owned and not-for-profit businesses, tax effects can play an important role in the lease-versus-buy decision. Investor-Owned (Taxable) Businesses For investor-owned businesses, the full amount of each lease payment is a tax- deductible expense for the lessee provided that the IRS agrees that a particular contract is a genuine lease. This makes it important that lease contracts be written in a form acceptable to the IRS. A lease that complies with all of the IRS requirements for taxable businesses is called a guideline lease or tax-oriented lease. In a guideline lease, ownership (depreciation) tax benefits accrue to the lessor, and the lessee’s lease payments are fully tax deductible. A lease that does not meet the tax guidelines is called a non-tax-oriented lease. For this type of lease, a for-profit lessee can deduct only the implied interest portion of each lease payment. However, in this situation the IRS considers the lessee the owner of the leased equipment, so the lessee, rather than the lessor, obtains the tax depreciation benefits. The reason for the IRS’s concern about lease terms is that, without restrictions, a for-profit business could set up a “lease” transaction that calls for rapid lease payments, which would be deductible from taxable income. The effect would be to depreciate the equipment over a much shorter period than the IRS allows in its depreciation guidelines. If just any type of contract could be called a lease and given tax treatment as a lease, the timing of lease tax shelters could be speed up compared with depreciation tax shelters. This speedup would benefit the lessee, but it would be costly to the government and to individual taxpayers. For this reason, the IRS has established specific rules that define a lease for tax purposes. Page 5 of 11 FM 8 | SPECIAL TOPICS IN FINANCIAL MANAGEMENT  Republic of the Philippines GUIMARAS STATE UNIVERSITY Mclain, Buenavista, Guimaras If investor-owned businesses are to obtain tax benefits from leasing, the lease contract must be written in a manner that will qualify it as a true lease under IRS guidelines. Any questions about the tax status of a lease contract must be resolved by the potential lessee prior to signing the contract. Not-for-Profit (Tax-Exempt) Businesses Not-for-profit businesses do not obtain tax benefits from depreciation; therefore, the ownership of assets has no tax value. However, lessors, who are all taxable businesses, do benefit from ownership. In effect, when assets are owned by not-for-profit businesses, the depreciation tax benefit is lost, but when not-for-profit firms lease assets, a tax benefit is realized by the lessor. This realized benefit, in turn, can be shared with the lessee in the form of lower rental payments. However, the cost of tax-exempt debt to not-for-profit firms can be lower than the after-tax cost of debt to taxable firms, so sometimes it is less costly for a not-for-profit firm to borrow money in the tax-exempt markets and buy the equipment rather than lease it. A special type of financial transaction has been created for not-for-profit businesses called a tax-exempt lease. The major difference between a tax- exempt lease and a conventional lease is that the implied interest portion of the lease payment is not classified as taxable income to the lessor, so it is exempt from federal income taxes. The rationale for this tax treatment is that the interest paid on most debt financing used by not-for-profit organizations is tax exempt to the lender, and a lessor is, in actuality, a lender. Tax-exempt leases provide a greater after-tax return to lessors than do conventional leases, so some of this extra return can be passed back to the lessee in the form of lower lease payments. Thus, the lessee’s payments on a tax-exempt lease could be lower than payments on a conventional lease. Page 6 of 11 FM 8 | SPECIAL TOPICS IN FINANCIAL MANAGEMENT  Republic of the Philippines GUIMARAS STATE UNIVERSITY Mclain, Buenavista, Guimaras FINANCIAL STATEMENT EFFECTS OF LEASING Regardless of the type of lease, the lessee reports lease payments as an expense item on the income statement in the year they are made. Furthermore, if the lease is a capital lease and is listed on the balance sheet, the leased asset is depreciated each year, and the annual depreciation expense is reported on the income statement. However, under certain conditions, neither the leased asset nor the contract liabilities (present value of lease payments) appear on the lessee’s balance sheet. For this reason, leasing is often called off-balance-sheet financing. Certain types of leases are not reported as debt on the balance sheet. The items leased under these circumstances also do not appear as assets on the balance sheet. No interest expense or depreciation expense is therefore included in the income statement. Financial reporting standards sometimes differ from reporting under tax regulations. As a result, a company may own an asset for tax purposes while not reflecting it in its financial statements. Accounting rules require businesses that enter into certain leases to restate their balance sheets to report the leased asset as a fixed asset and the present value of the future lease payments as a liability. This process is called capitalizing the lease, and hence such a lease is called a capital lease. LEASE EVALUATION Leases are evaluated by both the lessee and the lessor. The lessee must determine whether leasing an asset is less costly than obtaining equivalent alternative financing and buying the asset, and the lessor must decide what the lease payments must be to produce a rate of return consistent with the risk of the investment. The events that lead to a lease arrangement are as follows: The business decides to acquire a particular building or piece of equipment; this decision is based on the capital budgeting procedures. The decision to acquire the asset is not an issue in a typical lease analysis; this decision was made previously as part of the capital budgeting process. In lease analysis, it is concerned simply with whether to obtain the use of the property by lease or by purchase. Page 7 of 11 FM 8 | SPECIAL TOPICS IN FINANCIAL MANAGEMENT  Republic of the Philippines GUIMARAS STATE UNIVERSITY Mclain, Buenavista, Guimaras Once the business has decided to acquire the asset, the next question is how to finance the acquisition. A well-run business does not have excess cash lying around, and even if it did, opportunity costs would be associated with its use. Funds to purchase the asset could be obtained from excess cash, by borrowing, or (if the business is investor owned) by selling new equity. Alternatively, the asset could be leased. MOTIVATIONS FOR LEASING The following are the motivations to engage in Leasing: Ability to Bear Obsolescence (Residual Value) Risk : Leasing is an attractive financing alternative for many high-tech items that are subject to rapid and unpredictable technological obsolescence. For example, assume that a small, rural hospital plans to acquire a magnetic resonance imaging (MRI) device. If it buys the MRI equipment, it is exposed to the risk of technological obsolescence. In a relatively short time, some new technology might be developed that makes the current system nearly worthless, which could create a financial burden on the hospital. Because it does not use much equipment of this nature, the hospital would bear a great deal of risk if it bought the MRI device. Ability to Bear Utilization Risk: Many lessors offer per procedure leases. In this type of lease, instead of a fixed annual or monthly payment, the lessor charges the lessee a fixed amount for each procedure performed. For example, the lessor may charge the hospital $300 for every scan performed using a leased MRI device, or it may charge $400 per scan for the first 50 scans in each month and $200 for each scan above 100. Because the hospital’s reimbursement for MRI scans typically depends primarily on the amount of use and because the per procedure lease changes the hospital’s costs for the MRI from fixed to variable, the hospital’s risk is reduced. Ability to Bear Project Life Risk: Leasing can also be attractive when a business is uncertain about how long an asset will be needed. Hospitals sometimes offer services that are dependent on a single staff member. For example, a physician who performs liver transplants. To support the physician’s practice, the hospital might have to invest millions of dollars in equipment that can be used only for Page 8 of 11 FM 8 | SPECIAL TOPICS IN FINANCIAL MANAGEMENT  Republic of the Philippines GUIMARAS STATE UNIVERSITY Mclain, Buenavista, Guimaras this particular procedure. The hospital will charge for the use of the equipment, and if things go as expected, the investment will be profitable. However, if the physician dies or leaves the hospital staff and no other qualified physician can be recruited to fill the void, the project must be abandoned and the equipment becomes useless to the hospital. In this situation, the annual usage may be predictable, but the need for the asset could suddenly cease. Maintenance Services: Some businesses find leasing attractive because the lessor is able to provide better or less expensive (or both) maintenance services. For example, MEDTRANS Inc., a for-profit ambulance and medical transfer service that operates in Pennsylvania, recently leased 25 ambulances and transfer vans. The lease agreement with a lessor that specializes in purchasing, maintaining, and then reselling automobiles and trucks permitted the replacement of an aging fleet that MEDTRANS had built up over seven years. Lower Information Costs: Leasing may be financially attractive to smaller businesses that have limited access to debt markets. For example, a small, recently formed family group practice may need to finance one or more diagnostic devices such as an ECG (electrocardiogram) machine. The group has no credit history, so it would be difficult and costly for a bank to assess the group’s credit risk. Some banks might think the loan is not even worth the effort. Others might be willing to make the loan but only after building the high cost of credit assessment into the cost of the loan. Lower Risk in Bankruptcy: Leasing may be less expensive than buying for firms that are poor credit risks. In the event of financial distress leading to reorganization or liquidation, lessors tend to have more secure claims than do lenders. Thus, lessors may be willing to write leases to firms with poor financial characteristics that are less costly than loans offered by lenders, if such loans are even available. Page 9 of 11 FM 8 | SPECIAL TOPICS IN FINANCIAL MANAGEMENT  Republic of the Philippines GUIMARAS STATE UNIVERSITY Mclain, Buenavista, Guimaras BUSINESS VALUATION A business valuation is a general process of determining the economic value of a whole business or company unit. Business valuation can be used to determine the fair value of a business for a variety of reasons, including sale value, establishing partner ownership and taxation. The following are numerous ways in which a company can be valued: Market Capitalization: It is the simplest method of business valuation. It is calculated by multiplying the company’s share price by its total number of shares outstanding. For example, as of January 3, 2018, Microsoft Inc. traded at $86.35. With a total number of shares outstanding of 7.715 billion, the company could then be valued at $86.35 x 7.715 billion = $666.19 billion. Times Revenue Method: Under the times revenue business valuation method, a stream of revenues generated over a certain period of time is applied to a multiplier which depends on the industry and economic environment. For example, a technology company may be valued at 3x revenue, while a service firm may be valued at 0.5x revenue. Earnings Multiplier: Instead of the times revenue method, the earnings multiplier may be used to get a more accurate picture of the real value of a company, since a company’s profits are a more reliable indicator of its financial success than sales revenue is. The earnings multiplier adjusts future profits against cash flow that could be invested at the current interest rate over the same period of time. Discounted Cash Flow (DCF) Method: The DCF method of business valuation is similar to the earnings multiplier. This method is based on projections of future cash flows, which are adjusted to get the current market value of the company. The main difference between the discounted cash flow method and the profit multiplier method is that it takes inflation into consideration to calculate the present value. Book Value: This is the value of shareholders’ equity of a business as shown on the balance sheet statement. The book value is derived by subtracting the total liabilities of a company from its total assets. Liquidation Value: Liquidation value is the net cash that a business will receive if its assets were liquidated and liabilities were paid off today. Page 10 of 11 FM 8 | SPECIAL TOPICS IN FINANCIAL MANAGEMENT  Republic of the Philippines GUIMARAS STATE UNIVERSITY Mclain, Buenavista, Guimaras References Brigham, E. & Houston, J. (2016). Fundamentals of Financial Management Fourteenth Edition https://www.ache.org/-/media/ache/learning-center/publications/book-detail documents/chapters1819.pdf https://www.investopedia.com/terms/o/operatinglease.asp https://www.investopedia.com/terms/c/capitallease.asp https://corporatefinanceinstitute.com/resources/knowledge/accounting/capital -lease-vs-operating-lease/ https://analystprep.com/cfa-level-1-exam/financial-reporting-and- analysis/effects-asset-leases-financial-statements-ratios/ https://www.investopedia.com/terms/b/business-valuation.asp Page 11 of 11 FM 8 | SPECIAL TOPICS IN FINANCIAL MANAGEMENT