Abstract
We revisit the standard model for valuing lease contracts to explore the necessary conditions it implies for a lease to have a non-negative net tax advantage. While the literature commonly places an emphasis on the depreciation tax-savings benefits as a primary source of the benefits from leasing, we demonstrate that they can never produce sufficient tax savings to explain why that asset was leased instead of purchased. Instead, it is the interest tax savings related to the debt supported by lease payments that are necessary for the lease to have a net tax advantage, not the transferred depreciation write-offs. Additionally, we demonstrate that asset characteristics and contract provisions also have an effect on the net tax advantage of a lease. Because asset characteristics and contract provisions have implications for the agency effects of leasing, our analysis demonstrates that an interaction exists between the tax and agency effects of leasing. Our paper provides a better understanding of what drives tax-motivated leasing and dispels some myths surrounding it.
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Notes
Practitioner oriented books that carry the standard leasing model as the as the centerpiece of valuing lease contracts include Schallheim (1994, ch. 6) and Fabozzi and Nevitt (2008, ch. 6). Examples of textbooks in a similar vein are Brealey and Myers (2017, ch. 25) and Berk and DeMarzo (2014, ch. 25).
Heaton (1986) shows that if tax loss write-offs are incomplete, leasing may produce tax savings even if the lessee and the lessor have the same tax rate.
Smith and Wakeman (1985) discount the role of taxes in explaining variations in either the economic characteristics between leased and purchased assets or the choice of lease contract provisions. Thus, they argue that (p. 907):
.. .taxes are important in determining the identity of lessor and lessee, but are less important in identifying specific assets to be leased. Finally, tax provisions offer little explanation for the choice of specific provisions in lease contracts such as metering, service provisions, or limitation in use.
The only specific tax-related asset characteristics identified by Smith and Wakeman are the depreciation schedule and the investment tax credit. They do not identify any tax-related contract provisions. We provide an analytical framework within which the importance of asset characteristics and lease contract provisions in tax-motivated leasing can be meaningfully assessed.
While it is unclear from the statement of the problem whether the computer is to be depreciated under the straight-line method or under MACRS, the difference between the present value of the depreciation tax shield under the two methods is small. Under MACRS depreciation, the lessor’s unlevered NAL is $22,197—a difference of only $1119.
If the asset is depreciated under MACRS instead of straight-line, PVTS(D) = $5146 and NALLessor, Unlevered = −$16,509. PVTS(D) + NALLessor, Unlevered = −$11,363. Thus, PVTS(L), $10,185, is still not large enough to offset the negative sum of PVTS(D) and NALLessor, Unlevered.
While Brealey and Myers (2017, p. 665) observe that gains from leasing are enhanced when lease payments are deferred, they do not identify the source of the gain.
See Smith and Wakeman (1985) for a discussion of the linkage between these provisions and salvage value.
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Miles, J.A., Ezzell, J.R. & Vora, P.P. Revisiting the standard lease valuation model: new results. J Econ Finan 42, 409–420 (2018). https://doi.org/10.1007/s12197-017-9407-9
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DOI: https://doi.org/10.1007/s12197-017-9407-9