Leasing and Merger

LEASING

BRIEF CONCEPT

Leasing enables the firm to obtain the use of certain fixed assets of which it must make a series contractual, periodic, tax deductible payments.

Lessee : the receiver of the services of the assets under the lease contract

Lessor : is the owner of the assets.

Type of leases :

1.         Operating lease

·         An operating lease is a cancelable contractual arrangement whereby the lessee agrees to make periodic payments to the lessor, often for 5 or fewer years, to obtain an assets services.

·         Generally, the total payments over the term of the lease are less than the lessor’s initial cost of the leased asset.

·         If the operating lease is held to maturity, the lessee returns the leased asset over to the lessor, who may lease it again or sell the asset.

2.         Financial or capital leases

·         A financial lease is a longer-term lease than an operating lease.

·         Financial leases are non-cancelable and obligate the lessee to make payments for the use of an asset over a predefined period of time.

·         The total payments over the term of the lease are greater than the lessor’s initial cost of the leased asset.

·         Financial leases are commonly used for leasing land, buildings, and large pieces of equipment.

Leasing agreements

•         A direct lease is a lease under which a lessor owns or acquires the assets that are leased to a given lessee.

•         A sale-leaseback arrangement is a lease under which the lessee sells an asset for cash to a prospective lessor and then leases back the same asset.

•         A leveraged lease is a lease under which the lessor acts as an equity participant, supplying about 20 percent of the cost of the asset with a lender supplying the balance.

•         Operating leases normally require maintenance clauses requiring the lessor to maintain the assets and to make insurance and tax payments.

•         Renewal options are provisions that grant the lessee the option to re-lease assets at the expiration of the lease.

•         Finally, purchase options are provisions frequently included in both operating and financial leases that allow the lessee to purchase the asset at maturity -- usually at a pre-specified price.

 Lease – versus- purchase decision

•         The lease-versus-buy decision is a common decision faced by firms considering the acquisition of a new asset.

•         This decision involves the application of capital budgeting techniques as does any other asset investment acquisition decision.

•         The preferred method is the calculation of NPV based on the incremental cash flows (lease versys buy) using the following steps:

STEP 1: Find the after-tax cash outflows for each year under the lease alternative.

STEP 2: Find the after-tax cash outflows for each year under the purchase alternative

STEP 3: Calculate the present value of the cash outflows from Step 1 and Step 2 using the after-tax cost of debt as the discount rate.

STEP 4: Choose the alternative with the lower present value of cash outflows.

MERGERS

§  Mergers occurs when two or more firms are combined and the resulting firm maintains the identity of one of the firms. The firm in a merger transcaction that attempts to accuire another firm is commonly called acquiring company. The firm that acquiring company is pursuing is preffered to as the target company.

§    Motives for merging :

ü  Growth or diversification

ü  Synergy

ü  Fund rising

ü  Increased managerial skill or technology

ü  Tax consideration

ü  Increased ownership liquidity

ü  Defense against takeover

§  Types of mergers :

•         The horizontal merger is a merger of two firms in the sale line of business.

•         A vertical merger is a merger in which a firm acquires a supplier or a customer.

•         A congeneric merger is a merger in which one firm acquires another firm that is in the same general industry but neither in the same line of business not a supplier or a customer.

•         Finally, a conglomerate merger is a merger combining firms in unrelated businesses.

 §  Stock swap transaction

v     Ratio of exchange : the ratio of amount paid per share of target company to the market per share of acquiring firm.

Ratio of exchange = amount paid per share of target company

                             market price per share of the acquiring company

v     Effect on earning per share

Acquiring company and target company financial data before merger

items	Acquiring firm	Target firm
Earnings available for common stock	a	f
Number of shares of common stock outstanding	b	g
Earnings per share	c (a/b)	h(f/g)
Market price per share	d	i
Price/earnings (P/E) ratio [4/3]	e (d/c)	j(i/h)

Effects on EPS of merger firms

stockholders	Earnings per share
	Before merge	After merge
Acquiring firm	a/b	a+f b+(ratio of exchange * g)
Target firm	f/g	a+f        x ratio of exchange                   b+(ratio of exchange * g)

v     Effect on market price per share

MPR = MP acquiring * RE

                                     MP target

MPR = market price ratio of exchange

MP acquiring = market price per share of the acquiring company

MP target = market price per share of target company

RE = ratio of exchange