It is mentioned that “we will assume that the lessor is the manufacturer of the machine, and that its value in its inventory is $80,000. For the direct financing lease, we will assume that the lessor is a dealer (who bought it from the manufacturer), and that the value of the machine in its inventory is the fair market value of $100,000.”
Can someone please explain why did we choose $80K? Why not choose $2 to start with? I am not sure. Does it have anything to do with the the applicability of conditions required for operating vs. financial lease rules for GAAP? I am just curious.
This is a manufacturer; they built the machine. They had to buy raw materials, add direct labor, use electricity, and so on to get a finished product. All of the direct costs are capitalized (added to the amount in inventory), then expensed (as COGS) when the machine is sold.
Thanks S2000magician. Your responses, as always, are really helpful. Secondly, on your blog, you have mentioned that for finance lease, total expense = Interest expense + depreciation. Why so?
Isn’t lesse paying 23,341 in cash? A portion of this goes to meet interest requirement of the lease and the other to meet principle, just as it happens with loans? I am a bit confused. Can you please explain this? Also, why is depreciation included in interest?
Think of a finance lease as a purchase on credit: you obtain a loan, you buy an asset. As you pay off the loan, you’ll have interest and principle payments. The interest is an expense; the principle is not. But, as you own the asset, you are allowed to depreciate it; the depreciation is an expense. Thus, your total expense is interest + depreciation. Depreciation isn’t “included in interest”; rather, _ both interest and depreciation_ are included in expenses.
Suppose that you have this balance sheet:
Assets = $100
Liabilities = $60
Equity = $40
If you have an operating lease it won’t change any of these numbers, so D/A = $60 / $100 = 0.60. (I’m assuming all liabilities are debt to keep it simple.)
If you have a finance lease with the present value of the minimum lease payments being $20, then your balance sheet changes to:
Assets = $120
Liabilities = $80
Equity = $40
and D/A = $80 / $120 = 0.67. You’re correct that assets increase, but liabilities increase as well, by the same (dollar) amount.
The reason that this happens is that $20 is a bigger percentage of $60 than of $100; if equity is positive, this has to happen, because Assets > Liabilities.
Every year, the principle payment for the finance lease is transferred from long-term liabilities to current liabilities. Thus, current liabilities are higher under a finance lease, while current assets remain unchanged (compared to an operating lease).
The current portion of an finance lease (I hate that term, s/b capital lease) is a current liability, impacting working capital. Operating leases have no balance sheet impact.
^ I thought it was an American thing. I guess the dislike of “finance lease” a term is a global phenomenon. I had honestly never heard of such a reference until the CFA materials.
Thanks geo and S2000magician. This now makes sense.
I have a quick question — why is it that initially, the expenses for the finance lease will be higher than those for the operating lease in the early years, and lower in the later years? I have seen examples on http://financialexamhelp123.com/leases-iii-effect-on-financial-statements-and-ratios/ and curriculum where this is true. However, I don’t know *intuitively* why this would be true. I think one of the key things required for CFA is to develop an understanding of the subject. I don’t want to memorize this, or learn by solving 100 problems. If there is any logical explanation, I would really appreciate it.
The key is that the total depreciation is equal to the total of the principle payments; so the total expense is the same under both lease types. Typically, the depreciation is either straight-line (same amount each year) or accelerated (more in the early years, less in the late years). The principle payments, however, are smaller in the early years, larger in the late years; thus, the interest is higher in the early years, lower in the later years. Because the (finance lease’s) expenses are interest plus depreciation, and the (operating lease’s) rent is (in amount equal to) interest plus principle, the depreciation being higher than the principle in the early years means that the finance lease’s expenses will be higher than the operating lease’s expenses in the earlier years (when depreciation > principle), and lower in the later years (when depreciation < principle).
Can you please explain why pretax cash flow is the same for operating and finance lease, but after-tax cash flow is lower for operating lease?
Secondly, you have mentioned that “Under a finance lease, the interest paid is an operating cash (out)flow, but the principle paid is an investing cash (out)flow.” – Wouldn’t repayment of principle be considered CFF (lessee) and CFI (lessor) (finance lease)? I am a bit confused.
Pretax cashflow is the same because the lease payment is the same.
After-tax cash flow is higher for a finance lease in the early years because the expenses are higher in the early years, so taxable income is lower, so income taxes are lower. Lower cash outflow means higher cash flow.
My mistake: my brain was thinking “financing”, while my fingers were typing “investing”. I’ve corrected it. Thanks for catching that!
{I will use dot notation. For instance, Net Income.O means Net income from Operation Lease}
Now Net Income.O > Net Income.F
Moreover, Depreciation.O = 0 < Depreciation.F
From these two inequalities, how can I determine whether whether the sum of left-hand side is >=< than right-hand side? These inequalities cannot be added. I am definitely missing something. Can you please help?
I believe you are saying this because the payments in both the types of leases are the same. The treatment of depreciation, which is a non-cash flow, and interest + principle is different in both the leases. Am I correct?
The pretax cash flows are the same, but taxable income with a finance lease is less than taxable income with an operating lease (in the early years, because depreciation (finance lease) is higher than principle (operating lease)). The lower taxable income means lower taxes paid, so lower cash outflow from taxes.
It’s similar to the difference between using FIFO and LIFO when prices are rising. LIFO gives loser net income, but higher cash flow (because of lower taxes). In the early years, a finance lease will give lower net income and higher cash flow (because of lower taxes) than an operating lease.
I have a question. I read, re-read your posts, but I couldn’t follow this:
For cash flow analysis, we don’t consider depreciation at all. Right? For instance in the above quoted post you have mentioned that
Hence, if I discount depreciation as an expense, I am left with interest for Finance (Capital) lease and interest plus principle for Operating Lease. Isn’t it? I am still not able to understand why after-tax " cash flow" is different. I understand that after-tax " net income" will be different because of the higher expenses associated with Finance (Capital) lease. However, I am not quite sure about after-tax cash flow.
I would really appreciate if you could explain this to me.