Lease Financing and Alternatives

Why This Topic Matters
Lease financing sits inside the AFP CTP domain on Capital Structure and Long-Term Capital because treasury professionals are routinely asked to decide how a company should acquire the use of long-lived assets: buy them with cash, borrow to buy them, or lease them. The choice affects the balance sheet, debt covenants, credit ratings, taxes, cash flow timing, and the weighted average cost of capital. Since the adoption of ASC 842 (US GAAP) and IFRS 16, almost all leases now appear on the balance sheet, which changed leverage ratios, covenant calculations, and the historic appeal of 'off-balance-sheet' financing. The CTP exam tests this topic both conceptually (definitions, accounting criteria, advantages and disadvantages) and quantitatively (lease-versus-buy net present value analysis). Expect roughly two to four questions that touch leasing directly or as part of a broader long-term financing question.

What Lease Financing Is
A lease is a contract in which the owner of an asset (the lessor) grants another party (the lessee) the right to use the asset for a specified period in exchange for periodic payments. Leasing is a form of asset-based financing: instead of borrowing cash to purchase equipment, real estate, vehicles, or technology, the company pays for the use of the asset over time. The lessor retains legal title (in a true lease) and bears the residual value risk unless the contract transfers it to the lessee.

Key vocabulary you must know:
• Lessor – owner and provider of the asset (bank, captive finance company, independent leasing company, manufacturer).
• Lessee – user of the asset who makes lease payments.
• Lease term – the non-cancelable period plus any renewal options reasonably certain to be exercised.
• Residual value – the estimated fair value of the asset at the end of the lease; this drives lease pricing.
• Bargain purchase option – an option to buy the asset at a price well below expected fair value, which signals that the lease is really a financed purchase.
• Implicit rate – the discount rate embedded in the lease; if unknown, the lessee uses its incremental borrowing rate.
• Net lease – lessee pays maintenance, insurance, and taxes; full-service (gross) lease – lessor covers those costs and builds them into the payment.

Types of Leases
1. Operating lease. A shorter-term arrangement in which the lessor keeps substantially all risks and rewards of ownership. Historically treated as a rental expense and kept off the balance sheet under ASC 840; under ASC 842 the lessee now records a right-of-use (ROU) asset and a lease liability, but the income statement shows a single straight-line lease expense. Common for vehicles, office equipment, and real estate.

2. Finance lease (formerly 'capital lease'). Economically a purchase financed by the lessor. The lessee records the ROU asset and liability and reports amortization of the asset plus interest expense on the liability, so expense is front-loaded. Under ASC 842 a lease is a finance lease if it meets any one of five criteria: (a) ownership transfers at the end of the term; (b) there is a purchase option the lessee is reasonably certain to exercise; (c) the term covers a major part of the remaining economic life (the old bright line was 75%); (d) the present value of payments plus any residual guarantee equals substantially all of the fair value (old bright line 90%); or (e) the asset is so specialized it has no alternative use to the lessor.

3. IFRS 16 treatment. IFRS uses a single lessee model: essentially every lease over 12 months (excluding low-value assets) is accounted for like a finance lease, with depreciation plus interest. The operating/finance distinction remains only for lessors. The exam may test that US GAAP keeps a dual model for lessees while IFRS does not.

4. Sale-and-leaseback. A company sells an asset it already owns (often real estate) to a lessor and immediately leases it back. This converts an illiquid fixed asset into cash while retaining use of the asset. Treasury uses it to raise liquidity, deleverage, or monetize appreciated property. Under ASC 842 the transaction qualifies as a sale only if control transfers; otherwise it is treated as a financing (a loan secured by the asset).

5. Direct lease. The lessee acquires use of a new asset directly from a manufacturer or a leasing company that buys it on the lessee's behalf.

6. Leveraged lease. A three-party structure in which the lessor puts up only part of the asset cost (often 20 to 40 percent) and borrows the rest from long-term lenders on a non-recourse basis. The lessor gets the tax benefits (depreciation, interest deductions) on the entire asset while investing only a fraction of its value. Used for large assets such as aircraft, rail cars, and power plants.

7. Synthetic lease. A structure designed to be an operating lease for accounting purposes but a loan for tax purposes, so the lessee gets depreciation deductions while historically keeping the asset off the balance sheet. ASC 842 greatly reduced the accounting appeal of synthetic leases, but the tax-ownership concept remains testable.

8. Tax lease versus non-tax lease. In a true (tax) lease the lessor is treated as owner for tax purposes and claims depreciation; the lessee deducts the full lease payment. In a non-tax lease (conditional sale) the lessee is treated as owner, deducts depreciation and the interest portion of payments, and the lessor is treated as a lender.

How Lease Financing Works Economically
The lessor prices the lease so that the present value of lease payments plus the expected residual value plus the tax benefits of ownership covers the asset cost and provides the required return. The lessee effectively borrows at the lease's implicit rate. Leasing creates value for the lessee mainly when: the lessor is in a higher tax bracket and can use depreciation deductions the lessee cannot (tax arbitrage); the lessor has better residual value information or remarketing capability; the lessee wants to avoid obsolescence risk; or the lessee faces borrowing constraints and the lease provides 100 percent financing with no down payment.

Advantages of Leasing
• 100 percent financing with little or no up-front cash.
• Transfers obsolescence and residual value risk to the lessor (operating leases).
• Flexibility: shorter commitments, upgrade options, bundled maintenance.
• Potential tax benefits when the lessor can use depreciation more efficiently and passes savings through in lower payments.
• May avoid restrictive loan covenants or preserve existing bank lines.
• Often faster and simpler documentation than a secured loan or bond issue.
• Payments can be matched to the asset's useful life and cash generation.

Disadvantages of Leasing
• Total cost is often higher than purchasing with borrowed funds because the lessor must earn a spread.
• The lessee gives up the residual value and any appreciation.
• Loss of ownership tax benefits (depreciation, interest deduction) in a true lease.
• Under ASC 842 and IFRS 16 the liability is on the balance sheet, so leverage ratios still rise.
• Early termination penalties and restrictions on altering or subleasing the asset.
• Rating agencies have always capitalized operating leases in their analysis, so 'hiding' debt never worked with sophisticated analysts.

Lease-versus-Buy (Lease-versus-Borrow) Analysis
This is the core quantitative skill. The decision compares the after-tax cash flows of leasing with the after-tax cash flows of borrowing to purchase the same asset. Because both alternatives are financing decisions with similar, low-risk, contractual cash flows, the correct discount rate is the after-tax cost of debt: r × (1 – t). Do not use the WACC; the investment decision (whether to acquire the asset at all) is separate and uses the project's risk-adjusted rate.

Steps:
1. Identify the cost of the asset (the amount saved by leasing instead of buying).
2. Compute the after-tax lease payments: payment × (1 – t). Note the timing: lease payments are commonly made in advance (beginning of period), which shifts cash flows one period earlier.
3. Compute the depreciation tax shields lost by not owning: depreciation × t for each year.
4. Include the after-tax residual (salvage) value forgone by the lessee.
5. Include any maintenance or service costs the lessor absorbs under a full-service lease (an after-tax saving to the lessee).
6. Discount all cash flows at the after-tax cost of debt.
7. Compute the Net Advantage to Leasing (NAL) = Cost of asset – PV of after-tax lease payments – PV of lost depreciation tax shields – PV of after-tax residual value (+ PV of after-tax operating cost savings). If NAL is positive, lease; if negative, borrow and buy.

An equivalent presentation compares the PV of the cost of leasing with the PV of the cost of owning and picks the lower cost.

Worked Example
A company can buy equipment for $100,000, depreciate it straight-line over 4 years with no salvage, and borrow at a pre-tax rate of 8 percent. The tax rate is 25 percent. Alternatively it can lease for $27,000 per year, paid at the end of each year for 4 years.
• After-tax cost of debt = 8% × (1 – 0.25) = 6%.
• After-tax lease payment = 27,000 × 0.75 = 20,250 per year.
• Depreciation tax shield lost = 25,000 × 0.25 = 6,250 per year.
• Total annual cash outflow from leasing versus owning = 20,250 + 6,250 = 26,500.
• PV annuity factor at 6% for 4 years = 3.4651.
• PV of outflows = 26,500 × 3.4651 = 91,825.
• NAL = 100,000 – 91,825 = +8,175. Leasing is cheaper, so the company should lease.
If the payments were made in advance, you would treat the first payment as occurring at time zero (undiscounted) and the remaining three as an ordinary annuity, which increases the PV of lease costs and lowers the NAL.

Alternatives to Lease Financing
The exam frames leasing as one option within long-term capital, so know the substitutes:
• Secured term loans / equipment loans – fixed-rate or floating-rate bank debt collateralized by the asset; borrower owns the asset and keeps depreciation and residual value.
• Asset-based lending – revolving borrowing against receivables, inventory, and equipment; useful for firms with weaker cash flow but strong collateral.
• Vendor or captive financing – manufacturers' finance arms offering loans or leases, often with promotional rates.
• Bonds and private placements – long-term unsecured or secured debt for larger companies; lower cost but higher fixed costs and disclosure requirements.
• Equipment trust certificates – secured notes used heavily by airlines and railroads.
• Project finance – non-recourse financing of a specific asset or project repaid from its own cash flows.
• Sale-leaseback – a hybrid that releases cash from owned assets.
• Retained earnings / internal cash – outright purchase funded internally, which avoids financing costs but consumes liquidity.
• Equity issuance – most expensive source, typically not used for individual asset acquisitions but relevant when leverage is already high.
Choosing among these depends on the company's cost of debt, tax position, covenant headroom, desire for flexibility, obsolescence risk, and the asset's resale market.

Exam Tips: Answering Questions on Lease Financing and Alternatives
1. Memorize the finance lease criteria. Transfer of ownership, reasonably certain purchase option, major part of economic life (75%), substantially all of fair value (90%), and specialized asset. If a question describes any one of these, the answer is finance (capital) lease.
2. Know the accounting model difference. US GAAP ASC 842 keeps operating and finance lease classifications for lessees but puts both on the balance sheet; IFRS 16 uses one model for lessees. Short-term leases of 12 months or less may be excluded.
3. Front-loaded versus straight-line expense. Finance leases show higher total expense in early years (amortization plus interest); operating leases show level straight-line lease expense. EBITDA is higher under a finance lease because amortization and interest sit below EBITDA.
4. Use the after-tax cost of debt for lease-versus-buy. If answer choices include WACC or cost of equity as the discount rate, they are distractors. Compute r × (1 – t) first.
5. Multiply lease payments by (1 – t), multiply depreciation by t. Confusing these two is the most common calculation error. The lease payment is a deductible expense (saves taxes); depreciation is a lost shield when you lease.
6. Watch payment timing. 'Payments in advance' or 'at the beginning of the year' means an annuity due; the first payment is not discounted.
7. Interpret NAL correctly. Positive NAL favors leasing; negative favors borrowing to buy. If asked which alternative has the lower present value of cost, choose the lower PV.
8. Sale-leaseback questions usually test motive (raise cash, improve liquidity, monetize real estate) or accounting (must qualify as a sale, otherwise it is a financing).
9. Leveraged lease questions test the three-party structure and that lessor debt is non-recourse while the lessor enjoys tax benefits on the full asset cost.
10. Tax arbitrage logic. When a question says the lessee has net operating losses or a low tax rate and the lessor has a high tax rate, leasing is more likely to be advantageous because the lessor values depreciation more and shares that value through lower payments.
11. Qualitative advantage questions. Favor answers mentioning 100 percent financing, obsolescence risk transfer, flexibility, and conservation of credit lines. Reject answers claiming leasing is 'always cheaper' or 'keeps debt off the balance sheet' under current standards.
12. Rating agency and covenant angle. Agencies capitalize lease obligations when assessing leverage; a question on why leasing does not improve a credit rating points to this.
13. Read for the role. Confirm whether the question is from the lessee's or lessor's perspective; the lessor's analysis mirrors the lessee's with signs reversed and includes residual value as an inflow.
14. Eliminate by economics. If a company wants to own the asset at the end, keep depreciation benefits, and has strong credit, a secured term loan or bond is typically the better alternative; if it wants flexibility and short usage, an operating lease fits.
15. Manage your time. Lease-versus-buy calculations can be lengthy; set up the three cash-flow components (after-tax payments, lost depreciation shields, residual) in a quick table, use annuity factors where payments are level, and double-check the discount rate before computing.

Quick Review Checklist
• Lessor owns, lessee uses; residual value drives pricing.
• Finance lease = economic purchase; operating lease = true rental; both on balance sheet under ASC 842 and IFRS 16.
• Sale-leaseback raises cash; leveraged lease uses non-recourse debt for the lessor; synthetic lease splits accounting and tax ownership.
• Lease-versus-buy: discount after-tax cash flows at the after-tax cost of debt; NAL = asset cost – PV(after-tax lease payments) – PV(lost depreciation shields) – PV(after-tax residual).
• Alternatives: secured term loans, asset-based lending, vendor financing, bonds and private placements, equipment trust certificates, project finance, internal cash.
• Leasing is favored for tax arbitrage, obsolescence risk, flexibility, and 100 percent financing; borrowing to buy is favored for lower total cost, ownership of residual value, and retention of tax benefits.