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Determinants of Corporate Leasing Policy

Clifford Smith and L. Macdonald Wakeman

Journal of Finance July 1985

Executive Summary

This work gives an explanation into the various factors that affect the lease-buy decision as well as the type of lease used if the asset is leased. Overall tax policy and differential tax rates, affects many but not all aspects, of leases.

"When a firm buys an asset, it obtains both the right to the services of that asset…plus the right to sell the asset at any future date. With a lease, the firm acquires only the right to the asset's services for a [specified] period."

Taxes play a major role in deciding who is the lessee and who is the lessor, but "provide only a limited explanation of why specific assets are leased rather than owned, and for the choice of provisions in lease contracts."

Keep in mind that the lessor is the owner, lessee is the user of the asset.

"Three conditions must be met for an asset to be leased:

1. NPV of the leasing operation must be nonnegative for the lessor;
2. NPV of the leasing operation must be nonnegative for the lessee;
3. NPV overall must be at least as great as the NPV of owning the asset.

If both lessor and lessee are in the same tax bracket, there is no tax advantage to leasing. The various ways taxes enter (or have entered) the picture are through Investment Tax Credits (ITC), lease payments, maintenance expense, and interest tax shields.

Manufacturer vs. Third Party leasing.

Assuming equal abilities to maintain the product, the major difference is that a third party lessor can depreciate based on the asset's sale price, whereas the manufacturer can only use the manufacturing cost which seems to favor third party leasing. On the other hand, the manufacturing profit need not be immediately recognized which favors manufacturer leases.

Non-Tax Determinants

The authors point out "there are identifiable tax-related incentives for leasing. Yet most of the incentives only identify potential lessors and lessees. There is little guidance to which assets will be leased….Yet we observe systematically different leasing decisions within the same firm for assets with the same tax treatment."

Financial reasons for leases (might be title agency and transaction cost view)

Smith and Warner (1979) "argue that long-term, noncancellable leases" lessen the asset-substitution problem. Secondly the use of a lease (or secured debt) "[allow] the firm to segregate…the project's cash flows." This lessens the underinvestment problem (which states that firms would pass up certain positive NPV projects since the benefits would "accrue as a windfall [gain] to owners of previously issue fixed claims."

(see discussion on notes page of equity as a call option.)

Leases may also have lower transaction costs in the event of bankruptcy, as they are easy to repossess and can be done prior to bankruptcy if a lease payment is not made.

Compensation-related reasons for leasing: Managers may want to use operating leases (and hence keep the asset off the balance sheet) if the manager is paid as a function of ROA or invested capital.

Specialization in Risk Bearing: By lowering the amount necessary for investment, a lease may allow better diversification and hence "a more efficient allocation of riskbearing." Thus, privately held firms more likely to use leasing than larger public firms.

Sensitivity to use and Maintenance Decisions: "The more sensitive the value of an asset to use and maintenance decisions, the higher the probability that the asset will be purchased." Why? Because "if an asset is owned and used by the same agent, then use and maintenance incentives are internalized….But a lessee does not have the right to an asset's residual value and hence has less incentive to care for the asset (Alchian and Demsetz 1972)"

Firm Specific Assets: The more specialized an asset is, the more likely the asset will be purchased. Hence, "we expect to observe corporations leasing office facilities with greater frequency than production or research facilities."

Expected Period of Asset Use: Transaction costs are typically higher for purchasing an asset, thus if the asset will only be used for a fraction of its useful life, it is more likely that the asset will be leased.

1. Lessor may have more ability to price discriminate on any of the many lease-specific characteristics mentioned above. In an asset sale, there are fewer opportunities due to the legal constraints that we sell the same asset at the same price.
2. If the lessor has a comparative advantage in disposing of the asset (either through knowing the market better, reputation effects, or reusing the components), the asset is more likely to be leased.

1. If misuse (or under maintenance is hard to monitor, the lessor will price protect him(her)self and charge a higher rate or demand a higher [security deposit] or penalty.
2. Restrictions on subleasing-the inclusion of this clause will maintain the ability to price discriminate and is particularly important if the use of the asset has a major impact on the residual value.

Other issues

1. Have largely spoken of Operating Leases. Capital (or financial leases) are accounted for as a sale and must appear on the balance sheet.
2. Metering and Tie-in sales-example tying lease payments to usage rate. (Examples: mileage in car rental, number of copies to copy machine rental, retail space to sales.) Metering can also be used to price discriminate. Metering is more common operating (service) leases than in net (financial, or capital) leases since the cost of abuse will be better internalized in a longer-term lease. Finally, metering can be a way of "bonding" certain performances by the lessor. The authors present the example of snow removal at a mall. If the snow is not removed, sales will drop as will lease payments. Likewise, metering can be a hedge for the lessee.
3. Options to purchase the asset at the end of the lease would be another means of controlling the abuse problem.

In the conclusion the authors point out that debt and the use of debt are complementary: firms which issue more debt tend to engage in more financing….This result should not be surprising. Although leasing and debt are substitutes for a given firm, looking across firms, characteristics of firm's investment opportunity sets which provide high debt capacity tend to provide more profitable leasing opportunities.

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