Weighted Average

Cost of Capital
(WACC) Guide
What is WACC?
Definition: The weighted average cost of capital (WACC) is a financial ratio
that calculates a company’s cost of financing and acquiring assets by
comparing the debt and equity structure of the business. In other words, it
measures the weight of debt and the true cost of borrowing money or raising
funds through equity to finance new capital purchases and expansions based
on the company’s current level of debt and equity structure.

Management typically uses this ratio to decide whether the company should
use debt or equity to finance new purchases.

This ratio is very comprehensive because it averages all sources of capital;

including long-term debt, common stock, preferred stock, and bonds; to
measure an average cost of borrowing funds. It is also extremely complex.
Figuring out the cost of debt is pretty simple. Bonds and long-term debt are
issued with stated interest rates that can be used to compute their overall
cost. Equity, like common and preferred shares, on the other hand, does not
have a readily available stated price on it. Instead, we must compute an
equity price before we apply it to the equation.

That’s why many investors and creditors tend not to focus on this
measurement as the only capital price indicator. Estimating the cost of equity
is based on several different assumptions that can vary between investors.
Let’s take a look at how to calculate WACC.
What is the WACC Formula?
The WACC formula is calculated by dividing the market value of the firm’s
equity by the total market value of the company’s equity and debt multiplied
by the cost of equity multiplied by the market value of the company’s debt by
the total market value of the company’s equity and debt multiplied by the cost
of debt times 1 minus the corporate income tax rate.

Wow, that was a mouthful. Here’s what the equation looks like.

Here’s a list of the elements in the weighted average formula and what each
mean.

 Re = total cost of equity

 Rd = total cost of debt
 E = market value total equity
 D = market value of total debt
 V = total market value of the company’s combined debt and equity or E
+D
 E/V = equity portion of total financing
 D/V = debt portion of total financing
 Tc = income tax rate
WACC Calculation
Now let’s break the WACC equation down into its elements and explain it in
simpler terms.

The WACC calculation is pretty complex because there are so many different
pieces involved, but there are really only two elements that are confusing:
establishing the cost of equity and the cost of debt. After you have these two
numbers figured out calculating WACC is a breeze.

Cost of Equity

The cost of equity, represented by Re in the equation, is hard to measure

precisely because issuing stock is free to company. A company doesn’t pay
interest on outstanding shares. In addition, each share of stock doesn’t have a
specified value or price. It simply issues them to investors for whatever
investors are willing to pay for them at any given time. When the market it
high, stock prices are high. When the market is low, stock prices are low.
There’s no real stable number to use. So how to measure the cost of equity?

We need to look at how investors buy stocks. They purchase stocks with the
expectation of a return on their investment based on the level of risk. This
expectation establishes the required rate of return that the company must pay
its investors or the investors will most likely sell their shares and invest in
another company. If too many investors sell their shares, the stock price could
fall and decrease the value of the company. I told you this was somewhat
confusing. Think of it this way. The cost of equity is the amount of money a
company must spend to meet investors’ required rate of return and keep the
stock price steady.
Cost of Debt

Compared with the cost of equity, the cost of debt, represented by Rd in the
equation, is fairly simple to calculate. We simply use the market interest rate
or the actual interest rate that the company is currently paying on its
obligations. Keep in mind, that interest expenses have additional tax
implications. Interest is typically deductible, so we also take into account the
amount of tax savings the company will be able to take advantage of by
making its interest payments, represented in our equation Rd(1 – Tc)

So what does all this mean?

What is WACC Used For?

To put it simply, the weighted average cost of capital formula helps
management evaluate whether the company should finance the purchase of
new assets with debt or equity by comparing the cost of both options.
Financing new purchases with debt or equity can make a big impact on the
profitability of a company and the overall stock price. Management must use
the equation to balance the stock price, investors’ return expectations, and the
total cost of purchasing the assets. Executives and the board of directors use
weighted average to judge whether a merger is appropriate or not.

Investors and creditors, on the other hand, use WACC to evaluate whether
the company is worth investing in or loaning money to. Since the WACC
represents the average cost of borrowing money across all financing
structures, higher weighted average percentages mean the company’s overall
cost of financing is greater and the company will have less free cash to
distribute to its shareholders or pay off additional debt. As the weighted
average cost of capital increases, the company is less likely to create value
and investors and creditors tend to look for other opportunities.
WACC Analysis

You can think of this as a risk measurement. As the average cost increases,
the company must equally increase its earnings and ability to pay the higher
costs or investors won’t see a return and creditors won’t be repaid. Investors
use a WACC calculator to compute the minimum acceptable rate of return. If
their return falls below the average cost, they are either losing money or
incurring opportunity costs.

Let’s take a look at an example.

WACC Example
Assume the company yields an average return of 15% and has an average
cost of 5% each year. The company essentially makes a 10% return on every
dollar it invests in itself. An investor would view this as the company
generating 10 cents of value for every dollar invested. This 10-cent value can
be distributed to shareholders or used to pay off debt.

Now let’s look at an opposite example. Assume that the company only makes
a 10% return at the end of the year and has an average cost of capital of 15
percent. This means the company is losing 5 cents on every dollar it invests
because its costs are higher than its returns. No investor would be attracted to
a company like this. Its management should work to restructure the financing
and decrease the company’s overall costs.

As you can see, using a weighted average cost of capital calculator is not
easy or precise. There are many different assumptions that need to take place
in order to establish the cost of equity. That’s why many investors and market
analysts tend to come up with different WACC numbers for the same
company. It all depends on what their estimations and assumptions were.
This is why many investors use this ratio for speculation purposes and tend to
value more concrete calculations for serious investing decisions.
What is Net Present
Value (NPV)?
Definition: Net present value (NPV) is the current or present estimated dollar
value of an asset, investment, or project based expected future cash inflows
and outflows adjusted for interest rates and the initial purchase price.

Net present value uses initial purchase price and the time value of money to
calculate how much an asset is worth. In other words, net present value is the
present value of an asset less the initial purchase price.

What Does NPV Mean?

The time value of money concept is simple. Over time money can be invested
and will earn interest. A dollar today is worth more than a dollar tomorrow
because the dollar today can be invested today and earn more interest than
the future dollar.

Example
Net present value takes the time value of money concept and applies it to
business investments and capital purchases. Take a large equipment
purchase as an example. A company is trying to decide whether to purchase
a large CNC machine for its factory or lease one. Managerial accountants
have analyzed the production capacity of the new machine and anticipate that
is will bring in $5,000 of cash inflows every year for the next 8 years.

The new machine costs $15,000 and the current market rate of interest is 12
percent. The cash inflows are compounded by the market rate of interest and
the original purchase price is subtracted from the total. Here is the net present
value calculation.
Download this accounting example in excel.

 As you can see, the net present value of this machine is $5,373.50. This
means that the machine will not only pay for itself, it will also make $5,373.50.
The general rule of thumb is that if the net present value of an investment or
capital purchase is greater or equal to zero, it is a good investment
Internal Rate of
Return (IRR)
Internal rate of return (IRR) is the minimum discount rate that management
uses to identify what capital investments or future projects will yield an
acceptable return and be worth pursuing. The IRR for a specific project is the
rate that equates the net present value of future cash flows from the project to
zero. In other words, if we computed the present value of future cash flows
from a potential project using the internal rate as the discount rate and
subtracted out the original investment, our net present value of the project
would be zero.

Definition – What is the Internal Rate of

Return Ratio?
This sounds a little confusing at first, but it’s pretty simple. Think of it in terms
of capital investing like the company’s management would. They want to
calculate what percentage return is required to break even on an investment
adjusted for the time value of money. You can think of the internal rate of
return as the interest percentage that company has to achieve in order to
break even on its investment in new capital. Since management wants to do
better than break even, they consider this the minimum acceptable return on an
investment.
IRR Formula
The IRR formula is calculated by equating the sum of the present value of
future cash flow less the initial investment to zero. Since we are dealing with
an unknown variable, this is a bit of an algebraic equation. Here’s what it
looks like:

As you can see, the only variable in the internal rate of return equation that
management won’t know is the IRR. They will know how much capital is
required to start the project and they will have a reasonable estimate of the
future income of the investment. This means we will have solve for
the discount rate that will make the NPV equal to zero.

Example of Calculating IRR

It might be easier to look at an example than to keep explaining it. Let’s look
at Tom’s Machine Shop. Tom is considering purchasing a new machine, but
he is unsure if it’s the best use of company funds at this point in time. With the
new $100,000 machine, Tom will be able to take on a new order that will pay
$20,000, $30,000, $40,000, and $40,000 in revenue.

Let’s calculate Tom’s minimum rate. Since it’s difficult to isolate the discount
rate unless you use an excel IRR calculator. You can start with an
approximate rate and adjust from there. Let’s start with 8 percent.
As you can see, our ending NPV is not equal to zero. Since it’s a positive
number, we need to increase the estimated internal rate. Let’s increase it to 10
percent and recalculate.

As you can see, Tom’s internal return rate on this project is 10 percent. He
can compare this to other investing opportunities to see if it makes sense to
spend $100,000 on this piece of equipment or investment the money in
another venture.

Internal Rate of Return Analysis

Remember, IRR is the rate at which the net present value of the costs of an
investment equals the net present value of the expected future revenues of
the investment. Management can use this return rate to compare other
investments and decide what capital projects should be funded and what ones
should be scrapped.

Going back to our machine shop example, assume Tom could purchase three
different pieces of machinery. Each would be used for a slightly different job
that brought in slightly different amounts of cash flow. Tom can calculate the
internal rate of return on each machine and compare them all. The one with
the highest IRR would be the best investment.

Since this is an investment calculation, the concept can also be applied to any
other investment. For instance, Tom can compare the return rates of investing
the company’s money in the stock market or new equipment. Now obviously
the expected future cash flows aren’t always equal to the actual cash received
in the future, but this represents a starting point for management to base their
purchase and investment decisions on.
What is Capital
Asset Pricing Model
(CAPM)?
Definition: The capital asset pricing model or CAPM is a method of
determining the fair value of an investment based on the time value of money
and the risk incurred. CAPM is used to estimate the fair value of high-risk
stock and security portfolios by linking the expected rate of return with risk.

What Does CAPM Mean?

This model assumes that there are many investors with the same investment
horizon and equal access to information and securities. All investors share
homogenous beliefs about the investment opportunities offered in the market
and are all price takers. They all borrow at a risk-free rate and pay no taxes or
commissions.

This model helps these investors calculate the risk on their investments and
what type of return they should expect to get based on the level of risk
involved with the investment.

Let’s look at an example.

Example
CAPM calculates the expected rate of return and discounts the expected
future cash flows to their present value. The model assumes that the
expected rate of return is equal to the risk-free rate plus a risk premium.
Therefore, if the actual return on investment is not equal or higher than the
expected return, the investment should not be undertaken.

To calculate the expected rate of return, Rs, we need to know:

 rf = risk-free rate
 rm = the expected return of the market
 b = systematic risk

Therefore, the CAPM formula is: Rs = rf + b x (rm – rf)

Pedro is an investment banking analyst at Lazard, and he wants to calculate

the expected rate of return for a security. Pedro finds that the systematic risk
b of the security is 1.2. He also knows that the risk-free rate is 3%, and the
expected return of the market is 12%.

Pedro uses the CAPM model to calculate the expected rate of return and
determine if the investment should be undertaken. Therefore:

R = rf + b x (rm-rf) = 0.03 + [1.2 x (0.12 – 0.03)] = 0.03 + (1.2 x 0.09) = 0.03 +

0.0918 = 0.1218 = 12.2%

If 12.2% is equal to or greater than the required return on investment, the

investment should be undertaken.
What is the Dividend
Discount Model
(DDM)?
Definition: The dividend discount model, or DDM, is a method of valuing a
stock on the basis of present value of its expected dividends. The model
discounts the expected future dividends to the present value, thereby
estimating if a share is overvalued or undervalued.

What Does Dividend Discount Model

Mean?
This model holds that the value of a stock is equal to the sum of the net present
value or NPV of all the expected future dividends. The DDM comes in several
versions based on different assumptions about expected dividend growth.

But, its simplest form is the Gordon Growth Model (GGM), which values a
stock on a stable dividend growth assumption. To calculate the fair value of a
stock using the Gordon Growth model, we need to know:

 D1 = the expected future value of dividends

 r = expected rate of return
 g = the stable dividend growth rate, in perpetuity

Thus the dividend discount model formula to calculate the fair value of a stock
is:

P = D1 / ( r – g )
Let’s look at an example.

Example
Marion analyzes a stock that pays an annualized dividend of $1.20 per share.
By looking at the stock’s historical data, Marion finds out that the company
has raised its dividend consecutively for 15 years at an average dividend
growth rate of approximately 7% annually. However, due to the ongoing
financial crisis, the dividend growth has slowed down over the last five years.
Therefore, Marion estimates an average dividend growth rate of 4% annually.

The second step is to estimate r. With a stock that pays an annualized

dividend of $1.20 per share and has a stable dividend growth of 4% annually,
Marion estimates an expected rate of return of 10%. By discounting the
annualized dividend of $1.20 per share at an expected rate of return 10%, she
gets an expected dividend of $1.32 per share.

The third step is to calculate the fair value of the stock. So, Marion plugs in
the numbers and finds that

P = D1 / (r – g) = $1.32 / (10% – 4%) = $1.32 / 6% = $22

What is a Sunk
Cost?
Definition: A sunk cost, also known as a stranded cost, is an expense that
has already occurred and can’t be changed or avoided. In other words, it’s
a cost that has already been paid and can’t be refunded or reduced. It’s in the
past and has no bearing on any future decision making processes.

What Does Sunk Cost Mean

What is the definition of sunk cost? Just like the name implies, sunk costs
are gone and can’t be recovered. Accountants focus on this fact when making
business decisions because costs that occurred in the past should not affect
the actions in the future.

Example
Take a new market for example. When a business decides to branch out into a
new market or product line, it can spend large amounts of money on market
research, product development, and advertising. After a failed entrance
attempt into the market, many managers tend to focus on the overall past
investment into a project as a reason to keep it going. They don’t want to see
all the money, time, and energy spent trying to infiltrate a market lost by
pulling out, so they continue to “invest” in the project.

This is an ineffective way of looking at the situation. Previously spent

research, development, and advertising dollars are sunk costs and
are unavoidable. They have no bearing on the current decisions that will affect
the future. These costs are in the past and should not be a reason to continue
to pour money into a loosing market, segment, or product. Instead, managers
should ignore these previously spent costs and focus on the current market. If
it has potential, they should continue to invest. If it looks like it will continue to
lose money, they should stop investing and end the operations.

All large corporations have faced this dilemma at some point in their history.

Microsoft faced this situation after a failed attempt to infiltrate the portable
MP3 player market with the Zune. After a large failed product launch,
Microsoft ceased Zune production and cut its losses.

Summary Definition
Define Sunk Cost: Sunk costs are expenses that a company has already
incurred and avoid no matter what course of action it takes.
 Lease vs. Buy: Why
Equipment Leasing
is Right for Your
Business
Did you know that approximately 80% of U.S. companies lease some or all of the
equipment they use to conduct business? When it comes to leasing equipment in
today’s business world, people often think about standard office equipment such as
printers and copiers, but there are multiple types of equipment used to conduct
business that can be leased — from forklifts and phones to software and surveillance
systems and everything in between.

When a company evaluates a "lease vs. buy" decision, there is no one correct answer;
each situation is unique and there are always pros and cons. For example, your credit
score could play a role in your ability to obtain a competitive loan rate, or your
organization’s tax situation could be a factor in whether you should lease your office
equipment rather than take out a loan or purchase it outright. It’s important to note,
however, that lease payments can often be deducted as a business expense.

Leasing business and office equipment comes with a variety of benefits – not the least
of which is that it allows flexibility and customization to do what's right for your
organization's specific needs. Below are four reasons equipment leasing is a good idea
and should be a viable option for your business:

1. Minimal Upfront Capital Outlay

Companies big and small are looking for ways to streamline the budgeting process
and forecast expenses. When a major piece of equipment shows up as a line item, it
can disrupt an entire organization’s business strategy and limit growth potential
depending on the equipment financing solution they choose. This is a major reason
companies choose to lease business equipment. Unlike a long-term loan or outright
purchase, a lease agreement typically requires little to no down payment to get started.

Leasing allows your business to utilize its cash or credit line to meet other business
needs and reserve cash flow to address unexpected liabilities or major initiatives that
have the highest potential for ROI. Whereas purchasing equipment can require a
major outlay of capital up front, leasing allows for payments to be stretched out over a
longer period of time.

2. Protection against Outdated

Equipment
That new smartphone in your pocket with all its added features or the influx of digital
assistants to the market should indicate just how quickly things can change...and how
quickly other technologies can become obsolete. Consider the technology innovations
that have come and gone in the last few years alone. Likewise, business equipment
obsolescence is a real concern for organizations that want to avoid unanticipated
replacement costs and stay one step ahead of their competitors.

The pace of innovation in your business environment is rapid and constant. Leasing
rather than owning equipment, which can become obsolete prior to the end of its
expected life, allows your business to use it during the lease term and then return it if
so desired. That’s because leases can typically be modified during the lease term so
you can upgrade your equipment to take advantage of newer technology or, if you still
like your equipment, you can make arrangements to extend the lease. Some
companies prefer to arrange a lease-to-own agreement which gives them the option of
purchasing equipment outright at the end of the lease term.

As quickly as business environments and markets can shift, it’s good to have the
flexibility of a leasing option to mitigate the risks of obsolescence and rapidly
evolving technology.

3. Flexibility
Leases can be structured to meet the specific needs of your business. The length or
term of your lease can be adjusted to help you reach a more desirable monthly
payment amount that fits into your budget. Or, if you prefer quarterly payments rather
than monthly installments that can likely be arranged, too. Other terms of the lease
can also be modified, including the commencement date and first payment date, as
well as which day of the month you’d like payments to be due.

You’ll also want to consider your end-of-term stipulations and which options will be
best suited for your business model and financial situation. Leasing provides a broad
range of flexible options that are often lacking in standard loan agreements, especially
when you choose to work with a localized leasing agent that is experienced in your
industry, familiar with your local market and willing and able to structure lease
agreements to meet your needs.

4. Fixed Payments
Perhaps nothing is more disruptive to business than fluctuating or unexpected
expenses from one month to the next. Leasing offers the advantage of being able to
more accurately forecast expenses and manage budgets and cash flow because the
periodic lease payment is a fixed amount over the lease term. This constant payment
amount provides your business with consistency for planning purposes.

The fixed payment amount also provides protection against interest rate increases.
While inflation and interest rates have remained relatively low in recent years, there’s
no guarantee that will remain the case in the future, and leasing can hedge against
such potential increases in inflation.

For most businesses — whether a large manufacturer or service firm that needs major
equipment, or a small office that just needs a good printer — leasing is often the most
economical and sensible choice versus buying equipment. The next time your
organization considers an investment in equipment, contact the Gordon Flesch
Company’s team of experts to see whether leasing is the option that’s right for you
6 Intelligent
Reasons
behind
Leasing
Leasing is an alternative to purchasing. Because the lessee is obligated to
make a series of payments, a lease arrangement resembles a debt contract.
Thus, the advantages cited for leasing are often based on a comparison
between leasing and purchasing using borrowed funds.

This post reveals 7 intelligent reasons behind the decision to leasing.

These reasons do not necessarily mean that leasing is always better
than purchasing. Leasing could be not a right option for certain
conditions. But the reasoning revealed here may enlighten to a better
decision whether to lease or to purchase. Enjoy!

Reason 1: Cost

Many lessees find true leasing attractive because of its apparent low
cost. This is particularly evident where a lessee cannot currently use tax
benefit associated with equipment ownership due to such factors as
lack of currently taxable income or net operating loss carry forwards.

If it were not for the different tax treatment for owning and leasing equipment,
the costs would be identical in an efficient capital market. However, due to the
different tax treatment as well as the diverse abilities of taxable entities to
currently utilize the tax benefit associated with ownership, no set rule can be
offered as to whether borrowing to buy or a true lease is the cheaper form of
financing.
The  cost  of  a  true  lease  depends  on  the  size  of  the  transaction  and
whether the  lease  is tax-oriented or nontax-oriented. the equipment  leasing
market  can  be  classified  into  the  following  three market  sectors:  (1) a 
small-ticket  retail market with  transactions  in  the  $5,000  to  $100,000
range,  (2)  a middle market with  large-ticket  items  covering  transactions
between $100,000 and $5 million, and (3) a special-products market involving
equipment cost in excess of $5 million.

Tax-oriented leases generally fall into the second and third markets. Most of
the leveraged lease transactions are found in the third market and the upper
range of the second market. The effective interest cost implied by these lease
arrangements is considerably below prevailing interest rates that the same
lessee would pay on borrowed funds. Even so, the potential lessee must
weigh the lost economic benefit from owning the equipment against the
economic benefit to be obtained from leasing.

Nontax-oriented leases fall primarily into the small-ticket retail market and the
lower range of the second market. There is no real cost savings associated
with these leases compared to traditional borrowing arrangements.

In most cases, however, cost is not the dominant

motive of the firm that employs this method of
financing.

From a tax perspective, leasing has advantages that lead to a reduction in

cost for a company that is in a tax-loss-carry forward position and is
consequently unable to claim tax benefit associated with equipment
ownership currently or for several years in the future.

Reason 2: Conservation of Working Capital

The most frequent advantage of leasing cited by leasing company

representatives and lessees is that it conserves working capital. The
reasoning is as follows:

When a firm borrows money to purchase equipment, the lending institution

rarely provides an amount equal to the entire price of the equipment to be
financed. Instead, the lender requires the borrowing firm to take an equity
position in the equipment by making a down payment. The amount of the
down payment will depend on such factors as the type of equipment, the
creditworthiness of the borrower, and prevailing economic conditions.
Leasing, in contrast, typically provides 100% financing since it does not
require the firm to make a down payment. Moreover, costs incurred to acquire
the equipment, such as delivery and installation charges, are not usually
covered by a loan agreement. They may, however, be structured into a lease
agreement.

The validity of this argument for financially sound firms during normal
economic conditions is questionable. Such firms can simply obtain a  loan
for 100% of  the  equipment or borrow  the down payment  from  another
source  that  provides  unsecured  credit. However, there is doubt that the
funds needed by a small firm for a down payment can be borrowed,
particularly during tight money periods. Also, some leases do, in fact, require
a down payment in the form of advance lease payments or security deposits
at the beginning of the lease term.

Reason 3: Preservation of Credit Capacity by Avoiding Capitalization

Current financial reporting standards for leases require a leasing

obligation classified as a capital lease (discussed later) be capitalized as
a liability and the equipment recorded as an asset on the balance sheet.

According to Financial accounting standards board

(FASB) Statement No. 13, the principle for classifying
a lease as a capital lease for financial reporting
purposes is as follows:

A lease that transfers substantially all of the benefit

and risks incident to ownership of property should
be accounted for as the acquisition of an asset and
the incurrence of an obligation by the lessee.

FASB statement No. 13 specifies four criteria for classifying a lease as a

capital lease. Leases not classified as capital leases are considered
operating leases. Unlike a capital lease, an operating lease is not capitalized.
Instead, certain information regarding such leases must be disclosed in a
footnote to the financial statement.

Many CFOs are of the opinion that avoiding

capitalization of leases will enhance the financial
image of their corporations. By allowing a company
to avoid capitalization, an operating lease
preserves credit capacity.

An operating lease—and particularly a leveraged lease enables a lessee

to utilize institutional (lessor) equity as a source of funding somewhat
like subordinated debt. Because there is generally ample room for designing
lease arrangements so as to avoid having a lease classified as a capital
lease, CFOs generally prefer that lease agreements be structured as
operating leases.

As  a  practical matter, most  long-term  true  leases  (payout-type 

leases for  the  lessors)  are  structured  to  qualify  as  operating 
leases  for  financial accounting purposes for the lessees at the request
of the lessees. Further, the reality is that credit rating services evaluate a
company’s balance sheet by including the assets and liabilities of operating
leases. Hence, structuring a lease as an operating lease does not, in
practicality, remove it from consideration as a liability.

Reason 4: Risk of Obsolescence and Disposal of Equipment

When a firm owns equipment, it faces the possibility that at some future
time the equipment may not be as efficient as more recently
manufactured equipment. The owner may then elect to sell the original
equipment and purchase the newer, more technologically efficient version.
The sale of the equipment, however, may produce only a small fraction of its
book value. By  leasing,  it  is  argued,  the firm may  avoid  the  risk of
obsolescence  and the problems of disposal of  the equipment. The validity of
this argument depends on the type of lease and the provisions therein.

With a cancelable operating lease, the lessee can avoid the risk of
obsolescence by terminating the contract. However, the avoidance of
risk is not without  a  cost  since  the  lease  payments  under  such 
lease  arrangements reflect  the  risk of obsolescence perceived by  the
lessor. At the end of the lease term, the disposal of the obsolete equipment
becomes the problem of the lessor. The risk of loss in residual value that the
lessee passes on to the lessor is embodied in the cost of the lease.

The risk of disposal faced by some lessors, however, may not be as

great as the risk that would be encountered by the lessee. Some lessors,
for example,  specialize  in  short-term  operating  leases  of  particular  types 
of  equipment,  such  as  computers or  construction  equipment,  and have 
the  expertise to release or sell equipment coming off lease with substantial
remaining useful  life.

A manufacturer-lessor has less investment exposure since its

manufacturing costs will be significantly less than the retail price. Also,
it is often equipped to handle reconditioning and redesigning due to
technological improvements. Moreover, the manufacturer-lessor will be
more active in the resale market for the equipment and thus be in a better
position to find users for equipment that may be obsolete to one firm but still
satisfactory to another. IBM is the best example of a manufacturer-lessor that
has combined its financing, manufacturing, and marketing talents to reduce
the risk of disposal. This reduced risk of disposal, compared with that faced by
the lessee, is presumably passed along to the lessee in the form of a reduced
lease cost.

Nonetheless, financial institutions and other lessors are financing ever

larger, more complex, and longer-lived assets, and uncertainty over the
residual value of those assets is one of the biggest risks for lessors. A
steel plant, for example, could have an estimated useful life of 30 years, but
its actual useful life could be as short as 25 years or as long as 40 years. If
the useful life of the plant turns out to be less than the lessor has projected,
the lessor could suffer a loss on a lease that appeared profitable in the
original analysis.

For some types of assets there is abundant data to support estimates of

residual value and for other types of assets there is very little data—
particularly for new, unique, complex, or infrequently traded assets. The
primary factors that affect residual value are the three components of
depreciation: useful life (deterioration), economic obsolescence, and
technological obsolescence.

Rode, Fishbeck, and Dean suggest that lessors use the best information
available to simulate the behavior of these three factors as well as the
correlation among the three factors, based on probabilistic ranges of
outcomes, to produce distributions of useful life curves, estimated values, and
confidence intervals. Because conditions inevitably change over time, lessors
should update their modeling frequently during the life of the equipment.

Reason 5: Restrictions on Management

When a lender provides funds to a firm for an extended period of time,

provisions to protect the lender are included in the loan agreement. The
purpose of protective provisions, or protective covenants, is to ensure that the
borrower remains creditworthy during the period over which the funds are
borrowed.

Protective provisions impose restrictions on the borrower. Failure to

satisfy such a protective covenant usually creates an event of default that, if
not cured upon notice, gives the lenders certain additional rights and
remedies under the loan agreement, including the right to perfect a security
agreement or to demand the immediate repayment of the principal. In
practice, the remedy and ability to cure vary with the seriousness of the event
of default.

An advantage of leasing is that a lease agreement typically does not

impose financial covenants and restrictions on management as does a
loan agreement used to finance the purchase of equipment. The historical
reason for this in true leases is that the internal revenue service discouraged
true leases from having attributes of loan agreements. Leases, however, may
contain restrictions as to location of the property and additional investments
by the lessee in the leased equipment in order to ensure compliance with tax
laws.

Reason 6: Impact on Cash Flow and Book Earnings

In a properly structured true lease arrangement, the lower lease

payment from leasing rather than borrowing can provide a lessee with a
superior cash flow. Whether the cash low on an after-tax basis after taking
the residual value of the equipment into account is superior on a present
value basis must be ascertained.

Leasing versus buying has a different effect on book earnings. Lease

payments under a true lease will usually have less impact on book
earnings during the early years of the lease than will depreciation and
interest payments associated with the purchase of the same equipment

Unit 5 p .45-48