Residual value risk in the lease-or-buy analysis.ABSTRACT Whether debt and lease are substitutes or complements is one of the major issues in leasing literature. Most of the academic literature on leasing focused on the tax deduction Tax deduction An expense that a taxpayer is allowed to deduct from taxable income. tax deduction See deduction. as one of the main motivations for the leasing alternative. Some of them discussed the issue of residual value Residual value Usually refers to the value of a lessor's property at the time the lease expires. residual value The price at which a fixed asset is expected to be sold at the end of its useful life. in pricing the leasing contracts. However, no one carefully examined the impact of both taxes and residual value on the lease-or-buy decision. This study intends to incorporate both the tax liability and the residual value risk in the analysis of lease-or-buy decisions and the relation between debt and leases. This paper develops a simple model to illustrate the effects of tax liability and residual value risk on the lessee's lease-or-buy decision and whether debt and leases are substitutes. It is shown that when the earning and residual value processes are negatively correlated cor·re·late v. cor·re·lat·ed, cor·re·lat·ing, cor·re·lates v.tr. 1. To put or bring into causal, complementary, parallel, or reciprocal relation. 2. , the debt and leases are indeed substitutes and the firm is better off buying the assets rather than leasing. When the correlation of earnings and residual value is positive, debt and leases can be complements and it is better for the firm to lease in order to eliminate the redundancy of nondebt tax shields Tax Shield The reduction in income taxes that results from taking an allowable deduction from taxable income. Notes: For example, because interest on debt is a tax-deductible expense, taking on debt can act as a tax shield. . The implications obtained in the analysis for the lessee One who rents real property or Personal Property from another. A lessee of land is a tenant. Cross-references Landlord and Tenant. lessee n. the person renting property under a written lease from the owner (lessor). and lessor One who rents real property or Personal Property to another. A lessor of land is a landlord. Cross-references Landlord and Tenant. lessor n. the owner of real property who rents it to a lessee pursuant to a written lease. can be further formulated for·mu·late tr.v. for·mu·lat·ed, for·mu·lat·ing, for·mu·lates 1. a. To state as or reduce to a formula. b. To express in systematic terms or concepts. c. as empirically testable hypotheses. Both the firm characteristics and asset attributes are determinants of the corporate leasing policy. The impact of the interaction between the asset attributes and the firm characteristics on a firm's financing decision can be readily tested. 1. INTRODUCTION Many scholars have devoted their effort to examining the role of leasing as an alternative to corporate financing. Given the enormous growth of the leasing industry, it is not surprising that the topic of asset leasing continues to attract so much attention. In the last decade, leasing volume has significantly increased from $126 billions in 1993 to $216 billions in 2001. Over the past four decades, about one third of business equipment investment was arranged through leasing. Most of the academic literature on leasing focused on the tax deduction as one of the main motivations for the leasing alternative. Some of them discussed the issue of residual value in pricing the leasing contracts. However, no one carefully examined the impact of both taxes and residual value on the lease-or-buy decision and on the pricing of lease payments. For example, the well-cited paper by McConnell McConnell may refer to:
This study intends to incorporate both the tax liability and the residual value risk in the analysis of lease-or-buy decisions and the relation between debt and leases. Residual value plays an important role in leasing arrangements, yet it is hard to estimate. Lease, McConnell, and Schallheim (1990) showed that the average actual residual value is 150% of the estimated residual values. In addition to the factors of accelerated depreciation Accelerated Depreciation Any method of depreciation used for accounting or income tax purposes that allows greater deductions in the earlier years of the life of an asset. Notes: The straight-line depreciation method spreads the cost evenly over the life of an asset. and unexpected inflation, the difficulty in estimating the residual values contributes to conservative pricing of the residual value. A better understanding of the interaction between the residual value risk and the lessee/user firm's financing decision will help to identify potential lessees. Because pricing analyses of lease contracts are sensitive to the assumed lessee's firm characteristics, a more precise evaluation of the leasing contracts can be obtained. Regarding the lessees, the following questions should be answered. First, what are the risk characteristics of an asset, in relation to the user's earnings flow, that determine the likelihood that the asset will be leased rather than bought by a specific firm? Second, in what circumstances CIRCUMSTANCES, evidence. The particulars which accompany a fact. 2. The facts proved are either possible or impossible, ordinary and probable, or extraordinary and improbable, recent or ancient; they may have happened near us, or afar off; they are public or (as far as the relation between earnings flow and residual value of assets is concerned) are debt and leases substitutes rather than complements for lessee firms? In section two of this paper, a simple model is presented to illustrate the effects of tax liability and residual value risk on the lessee's lease-or-buy decision and whether debt and leases are substitutes. It is shown that when the earning and residual value processes are negatively correlated, the debt and leases are indeed substitutes and the firm is better off buying the assets rather than leasing. When the correlation of earnings and residual value is positive, debt and leases can be complements and it is better for the firm to lease in order to eliminate the redundancy of nondebt tax shields. The main factor that determines these results is that the residual value risk can be a natural hedging component against the cash flow risk from operation, depending on whether the correlation of these two risk components is positive or negative. This hedging phenomenon can affect a firm's financing decisions Financing decisions Decisions concerning the liabilities and stockholders' equity side of the firm's balance sheet, such as a decision to issue bonds. in two ways. First, when the residual value risk of the used asset works to stabilize stabilize See peg. the firm's cash flow, the firm's debt capacity can be increased. Second, due to the fact that the tax function is convex Convex Curved, as in the shape of the outside of a circle. Usually referring to the price/required yield relationship for option-free bonds. in taxable cash flow and the after-tax af·ter-tax also af·ter·tax adj. Relating to or being that which remains after payment, especially of income taxes: after-tax profits. value of the firm is concave Concave Property that a curve is below a straight line connecting two end points. If the curve falls above the straight line, it is called convex. , any reduction in cash flow volatility can increase the expected after-tax value of the firm. This hedging explanation is more credible for lessee/user firms which have larger proportion of total cash flow related to the use of the leased assets. This study also has implications for leasing companies in pricing the lease payments and the choice of debt level. Following the same argument that the tax function is convex in taxable cash flow, increase in the residual value risk will increase the lessor firm's tax liability. The lessor can reduce the volatility in net cash flow by diversification Diversification A risk management technique that mixes a wide variety of investments within a portfolio. It is designed to minimize the impact of any one security on overall portfolio performance. Notes: Diversification is possibly the greatest way to reduce the risk. (pooling different residual value risks together), since an option on a portfolio of assets is less valuable than a portfolio of options on individual assets. As a result, the lessor's debt capacity and the lease payments it charges will be affected by the asset residual value risk. If the residual value risk is increased (decreased), then the lessor will reduce (raise) the debt level and/or increase (decrease) the lease payments. If a more accurate estimate of residual value can be obtained, the leasing company may be able to charge more competitive lease payments and take over a greater market share. These implications for the lessor firm lead to a possible extension of this study. An option pricing model option pricing model A mathematical formula for determining the price at which an option should trade. The model expresses the value of an option as a function of the value of the underlying asset, length of time until maturity, exercise price, yields on and numeric numeric see numerical. numeric cluster see ten-key pad. analysis can be applied to analyze the impact of residual value risk on the pricing of the lease payments. In addition, the results of this study can be extended beyond the single period case to the multi-period case. In the next section, a simple model to illustrate effects of tax liability and residual value risk on lessee's decision is presented. This paper concludes by discussing other possible extensions of this research. 2. ANALYSES This section discusses two traditional financing issues facing a lessee/user firm: first, lease-or-buy decision and, second, whether the debt and leases are substitutes under taxation and residual value risk. The key idea of this section is that the residual value risk can be a natural hedge against the cash flow risk from operation, depending on whether the correlation of these two risk components is positive or negative. If the fluctuation Fluctuation A price or interest rate change. of asset residual value can offset the volatility of operation cash flow, it can increase a firm's debt capacity and reduce the corporate tax liability. In the usual situation where the personal income tax rate is less than the corporate income tax rate, buying instead of leasing the asset can increase the value of the firm. On the other hand, if the residual value risk increases the volatility of the net cash flow, it is better to lease rather than own the asset. Two extreme cases are presented to illustrate this idea in a straightforward way: perfectly positive versus perfectly negative correlation Noun 1. negative correlation - a correlation in which large values of one variable are associated with small values of the other; the correlation coefficient is between 0 and -1 indirect correlation between the residual value and the operational cash flow. To further sharpen sharp·en tr. & intr.v. sharp·ened, sharp·en·ing, sharp·ens To make or become sharp or sharper. sharp the focus on the valuation of the lessee firm, it is also assumed that the lease payment to lessor is riskless. This can somewhat be supported by the fact that the lease payments often have higher priority than debt payments in the event of default. In the analysis, a two-date, state-preference model is used. The firm makes the lease-or-buy decision and then chooses the debt level at time zero, and all uncertainty is resolved at the end of the period. Both parties (lessee and lessor) are risk-neutral Risk-neutral Insensitive to risk. , and the risk-free rate Risk-free rate The rate earned on a riskless asset. is assumed to be zero. The final, pretax pre·tax adj. Existing before tax deductions: pretax income. pretax adj [profit] → vor (Abzug der) Steuern output of the lessee/user firm, X([theta Theta A measure of the rate of decline in the value of an option due to the passage of time. Theta can also be referred to as the time decay on the value of an option. If everything is held constant, then the option will lose value as time moves closer to the maturity of the option. ]), is assumed to be a function of the random state of nature [theta]. X([theta])= [theta]; [theta] is uniformly distributed over [2[A.sub.0], 4[A.sub.0]], where [A.sub.0] is the initial cost of the only asset used in the operation. The expected pretax cash flow at the end of the period, E(X) = 3[A.sub.0]. The boundaries are set for easy manipulation and for the assumption that the lease payments are riskless. This specification of cash flows implicitly assumes that the lessee's investment decision and financing decision are independent. The firm can buy or lease the asset which is the only equipment required for its operation. If it buys the asset, it bears the residual value risk and the depreciation of the asset is tax deductible That which may be taken away or subtracted. In taxation, an item that may be subtracted from gross income or adjusted gross income in determining taxable income (e.g., interest expenses, charitable contributions, certain taxes). from its operational cash flow. If it leases the asset, it avoids the residual value risk and the lease payments are tax deductible. In this single period case, the asset used by the firm will be liquidated DAMAGES, LIQUIDATED, contracts. When the parties to a contract stipulate for the payment of a certain sum, as a satisfaction fixed and agreed upon by them, for the not doing of certain things particularly mentioned in the agreement, the sum so fixed upon is called liquidated damages. (q.v. at the end of the period so that the accounting depreciation for tax purpose and the economic depreciation in the asset market are assumed to be equal. This assumption is justified by the accounting principle that the gain or loss from sale of asset is treated as ordinary business income. After making the lease-or-buy decision, the firm chooses the debt level to fully utilize the tax shield offered by the tax deductible debt payment. To simplify the analysis, it is assumed that the firm can issue only riskless debt. Without loss of generality Without loss of generality (abbreviated to WLOG or WOLOG and less commonly stated as without any loss of generality) is a frequently used expression in mathematics. , the restriction to issuing riskless debt greatly simplifies the application of the concept of a firm's debt capacity. In addition, this restriction can be considered as a simplified assumption of the real world in which the tax shield is not freely transferable and the firm may not be able to fully enjoy all the tax shields. When the firm can issue risky debt in this risk neutral world, it can, in the extreme case, reduce its corporate tax liability to zero. Tax-related concerns as the main motivation for leasing activities then disappear. This is a rare case in the real world. The asset depreciation (D) is equal to the initial cost minus the residual value of the asset; that is, D = [A.sub.0] - [A.sub.1], where [A.sub.1] is the residual value of the asset and is unknown at time 0. The positive (negative) correlation between the asset depreciation (D) and the operation cash flow (X) is equivalent to the negative (positive) correlation between the residual value of asset ([A.sub.1]) and the operation cash flow (X). Two extreme cases are analyzed an·a·lyze tr.v. an·a·lyzed, an·a·lyz·ing, an·a·lyz·es 1. To examine methodically by separating into parts and studying their interrelations. 2. Chemistry To make a chemical analysis of. 3. . First, the asset depreciation (D) is assumed to equal X/3. Obviously, the asset depreciation and the operational cash flow are perfectly positively correlated. In the second case, the assumed depreciation is: D = 2[A.sub.0] - X/3; therefore, the correlation between D and X is negative unity. In both cases, the expected depreciation is equal to [A.sub.0]. The variation of the depreciation is also identical in these two cases. The following analysis refers to the correlation between the asset depreciation and the operation cash flow. Valuation equations for the lessee/user firm are first developed; then the debt level and the value of the firm in different situations are analyzed. By comparing the firm value and the debt level under the situations of buying and leasing the asset, we can determine the lease-or-buy decision for the lessee/user firm as well as whether the debt and leases are substitutes or complements. 2.1 When the correlation between X and D is negative (D = 2[A.sub.0] - X/3) In this case, higher earnings are accompanied by higher residual asset value and thus lower asset depreciation. This scenario can be explained by an economy-wide boom condition, where the lessee/user firm has higher earnings and the used asset has higher residual value in the second hand market. 2.1.1 If the firm buys the asset When the firm purchases the asset, the asset financing Asset Financing Using balance sheet assets (such as accounts receivable, short-term investments or inventory) to obtain a loan or borrow money - the borrower provides a security interest in the assets to the lender. must be paid at the end of the period. This payment comes from the sale of the used asset and from part of the operational cash flow. This financing arrangement implies that the economic depreciation of the asset (i.e., the usage of the asset) must be paid before any debt gets paid. As a result, the maximum riskless debt the firm can issue, F, is the minimum of after-depreciation cash flow such that the firm can fully utilize all its tax shields. The after-depreciation cash flow is X - D = X - (2[A.sub.0] - X/3) = 4X/3 - 2[A.sub.0]; the maximum riskless debt is equal to 2[A.sub.0]/3 which is the after-depreciation cash flow evaluated at the lower bound of X = 2[A.sub.0]. When the debt payment is assumed to be fully tax deductible at the corporate level, the cash flow available to stockholders is [S.sub.E]([theta]) = max [0, X([theta])- F - [T.sub.C.sup.*]max (0, X([theta]) - F - D)]= X([theta])- 2[A.sub.0]/3 - [T.sub.C.sup.*] (4X([theta])/3 - 8[A.sub.0]/3) With the risk neutrality and zero risk-free rate, the state price is p([theta]) = 1/(4[A.sub.0] - 2[A.sub.0]) = 1/2[A.sub.0]. Evaluating [S.sub.E]([theta]), under the state price, yields [S.sub.E] = 7[A.sub.0]/3 - 4[A.sub.0][T.sub.C]/3, where [T.sub.C] is the corporate income tax rate. [B.sub.E], the after-tax cash flow to debtholders, is equal to [F.sup.*](1-[T.sub.P]), where [T.sub.P] is the personal income tax rate. The market value of the user firm net of the cost of asset usage (the economic depreciation of asset) is (1) [V.sub.E,buy] = [S.sub.E] + [B.sub.E] - ([A.sub.0] - E([A.sub.1])) = [S.sub.E] + [B.sub.E] - E(D) = 2[A.sub.0] - [(2[T.sub.C] + [T.sub.P]).sup.*] 2[A.sub.0]/3 2.1.2 If the firm leases the asset Under these circumstances, the lessee firm transfers the residual value risk to the lessor firm and the lease payment is tax deductible. The lease payment is determined in the competitive leasing market and is assumed to equal the expected economic depreciation of the asset; i.e., L = [A.sub.0]. By this assumption, we imply that the lessor is more likely to fully utilize its asset depreciation. The reason may be due to the diversification by the lessor and/or its the expertise in managing the residual value risk. After the decision to lease the asset is made, the maximum riskless debt this firm can issue is F = minimum of X - L. Evaluated at the lower bound of X = 2[A.sub.0], F = [A.sub.0]. The cash flow available to the stockholders is [S.sub.E]([theta]) = max [0, X([theta]) - L - F - [T.sub.C.sup.*]max (0, X([theta]) - L - F)] = [(1 - [T.sub.C]).sup.*](X([theta]) - 2[A.sub.0]) Evaluating [S.sub.E]([theta]), under the state price, yields [S.sub.E] = [A.sub.0.sup.*](1 - [T.sub.C]). [B.sub.E], the after-tax cash flow to debtholders, equals [A.sub.0.sup.*](1 - [T.sub.P]). The market value of the lessee firm is (2) [V.sub.E, lease] = [S.sub.E] + [B.sub.E] = 2[A.sub.0] - [([T.sub.C] + [T.sub.P]).sup.*][A.sub.0] 2.1.3 Comparison of the firm value and the debt level When the correlation between the residual value and the operation cash flow is positive, the firm value under leasing arrangement is higher than that of buying the asset. This is shown by subtracting equation (1) from equation (2), [V.sub.E, lease] - [V.sub.E, buy] = (2) - (1) = [([T.sub.C] - [T.sub.P]).sup.*] [A.sub.0]/3 > 0 if [T.sub.C] > [T.sub.P]. That is, with negative correlation between D and X, and given [T.sub.C] > [T.sub.P], leasing arrangement is a better alternative for the user firm. In addition, when the firm leases the asset, its debt level is higher than the debt level when the firm buys the asset; i.e., [F.sub.lease] = [A.sub.0] is greater than [F.sub.buy] = 2[A.sub.0]/3. It demonstrates that debt and leases are complements when the correlation between X and D is negative. The reason for these results is that the negative (positive) correlation between the operational cash flow and the asset depreciation (the asset residual value) reduces the firm's debt capacity and increases the volatility of its taxable income Under the federal tax law, gross income reduced by adjustments and allowable deductions. It is the income against which tax rates are applied to compute an individual or entity's tax liability. The essence of taxable income is the accrual of some gain, profit, or benefit to a taxpayer. . Since the tax liability function is convex, the increase in variance The discrepancy between what a party to a lawsuit alleges will be proved in pleadings and what the party actually proves at trial. In Zoning law, an official permit to use property in a manner that departs from the way in which other property in the same locality of the taxable income will increase the tax liability. The reduction in debt capacity will result in less debt tax shield. Both will work to decrease the firm's value. Through leasing arrangement, the adverse effect of the residual value risk on the taxable income and debt capacity is reduced. Consequently, leasing the asset is a better alternative for the user firm, and debt and leases are complements. 2.2 When the correlation between X and D is positive (D = X/3) When earnings are higher, asset depreciation is also higher. This positive correlation Noun 1. positive correlation - a correlation in which large values of one variable are associated with large values of the other and small with small; the correlation coefficient is between 0 and +1 direct correlation can occur in the following two situations. First, as stated by Miller and Upton (1976), if boom conditions in the economy stimulate technological innovation, a positive correlation might be found. Second, if the firm performs relatively well, while the economy is on the downturn Downturn The transition point between a rising, expanding economy to a falling, contracting one. downturn A decline in security prices or economic activity following a period of rising or stable prices or activity. , then due to good performance relative to the market, the firm might operate its equipment at a higher rate of usage which will cause a higher rate of wear and tear. At a time when the economy is not strong enough to support the asset market, the asset's residual value will drop, resulting in high asset depreciation. 2.2.1 If the firm buys the asset The after-depreciation cash flow is X - D = X - X/3 = 2X/3. The maximum riskless debt the firm can issue is the minimum of 2X/3, which is 4[A.sub.0]/3. The cash flow available to the stockholders is [S.sub.E]([theta]) = max [0, X([theta]) - F - [T.sub.C.sup.*]max (0, X([theta]) - F - D)] = X([theta])- 4[A.sub.0]/3 - [T.sub.C.sup.*] (2X([theta])/3 - 4[A.sub.0]/3) Evaluating [S.sub.E]([theta]), under the state price, yields [S.sub.E] = 5[A.sub.0]/3 - 2[A.sub.0][T.sub.C]/3. [B.sub.E], the after-tax cash flow to debtholders, is equal to [F.sup.*](1-[T.sub.P]). The market value of the user firm net of the cost of asset usage (the economic depreciation of asset) is (3) [V.sub.E, buy] = [S.sub.E] + [B.sub.E] - ([A.sub.0] - E([A.sub.1])) = [S.sub.E] + [B.sub.E] - E(D) = 2[A.sub.0] - [([T.sub.C] + 2[T.sub.P]).sup.*]2[A.sub.0]/3 2.2.2 If the firm leases the asset Through leasing, the lessee firm transfers the residual value to the lessor firm. In the case of either positive or negative correlation between X and D, the expected asset depreciation is identical, so in both cases the lease payments are the same. Consequently, the valuation is the same as that obtained when the correlation between X and D is negative. This valuation is repeatedly equation (2). 2.2.3 Comparison of the firm value and the debt level When the correlation between the asset depreciation (residual value) and the operation cash flow is positive (negative), the firm value under leasing arrangement is lower than that of buying the asset. This is shown by subtracting equation (2) from equation (3), [V.sub.E, buy] - [V.sub.E, lease] = (3) - (2) = [([T.sub.C] = [T.sub.P]).sup.*] [A.sub.0]/3 > 0 if [T.sub.C] > [T.sub.P]. That is, with positive correlation between D and X, and given [T.sub.C] > [T.sub.P], buying the asset is a better alternative for the user firm. In addition, when the firm buys the asset, its debt level is higher than the debt level when the firm leases the asset; i.e., [F.sub.buy] = 4[A.sub.0]/3 is greater than [F.sub.lease] = [A.sub.0]. This demonstrates that debt and leases are substitutes when the correlation between X and D is positive. The reason for these results is that the positive (negative) correlation between the operation cash flow and the asset depreciation (the asset's residual value) increases the firm's debt capacity and reduces the volatility of its taxable income. The decrease in tax liability and the increase in debt tax shield yield an increase in the firm value. By buying the asset, the firm takes the residual value risk as a natural hedge against the volatility of its operational cash flow. As a result, buying the asset is a better alternative for the user firm, and debt and leases are substitutes. 3. CONCLUSION Whether debt and lease are substitutes or complements is one of the major issues in leasing literature. This study applies a simple model to illustrate the effects of tax liability and residual value risk on the lessee's lease-or-buy decision and whether debt and leases are substitutes. The analysis shows that debt and lease can be either substitutes or complements, depending on the relationship between the firm's earning flow and the residual value of asset in use. When the earning and residual value processes are negatively correlated, the debt and leases are substitutes and the firm can increase its value by buying the assets rather than leasing. When the correlation of earnings and residual value is positive, debt and leases can be complements and it is better for the firm to lease in order to eliminate the redundancy of nondebt tax shields. The implications obtained in the analysis for the lessee and lessor can be further formulated as empirically testable hypotheses. Both the firm characteristics and asset attributes are determinants of the corporate leasing policy. The impact of the interaction between the asset attributes and the firm characteristics on a firm's financing decision can be readily tested. A better understanding of this impact will help to identify potential lessees, and, consequently, better designed and more correctly priced leasing contracts can be obtained. The simple model used in the paper intends to provide an intuitive understanding Intuitive understanding is comprehension without any necessary contemplation or explanation. When designing products it is useful to think as the "naïve user", someone who will use the product but has no knowledge of how to use it. of the impact of the interaction of taxation and residual value risk on the corporate financing decision. For more detailed analysis and more precise estimate of this impact, it is preferable to apply the option pricing approach with two stochastic processes stochastic process In probability theory, a family of random variables indexed to some other set and having the property that for each finite subset of the index set, the collection of random variables indexed to it has a joint probability distribution. . Although closed-form solutions cannot be obtained from this approach and comparative-static analysis on the obtained equations can not be applied, the numerical analysis numerical analysis Branch of applied mathematics that studies methods for solving complicated equations using arithmetic operations, often so complex that they require a computer, to approximate the processes of analysis (i.e., calculus). can be used to get some simulation results. For example, it should be possible to find a range of correlation between X and D such that a firm will prefer to lease rather than buy, and debt and leases will be seen as substitutes. It should also be possible to determine the impacts of the magnitude of the residual value variance and the correlation between two processes on the competitive lease payments and the optimal debt levels of the lessee and the lessor firm. In general, this numerical analysis may enhance understanding of the estimation estimation In mathematics, use of a function or formula to derive a solution or make a prediction. Unlike approximation, it has precise connotations. In statistics, for example, it connotes the careful selection and testing of a function called an estimator. of residual value and hence the pricing of the lease contracts. Endnotes (1) According to according to prep. 1. As stated or indicated by; on the authority of: according to historians. 2. In keeping with: according to instructions. 3. the estimate by the Economic Leasing Association, the dollar amount involved in equipment leasing Equipment Leasing is a financing option to lease equipment for a certain amount of time. Leasing Benefits
(1) In the paragraph discussing the metering and risk, Smith and Wakeman (1985, p.905) presented the argument that "metering and tie-in sales reduce the volatility of the lessee's net cash flow by charging more when asset use is high and less when it is low. This hedging explanation is more forceful force·ful adj. Characterized by or full of force; effective: was persuaded by the forceful speaker to register to vote; enacted forceful measures to reduce drug abuse. when the lessee is an individual, a partnership or a small, closely held corporation Noun 1. closely held corporation - stock is publicly traded but most is held by a few shareholders who have no plans to sell corp, corporation - a business firm whose articles of incorporation have been approved in some state ." (1) For example, Johnson, Dowen, and Norton (1993) found that due to competitive pressure to reduce lease payment, lessors booked higher residual values. With higher residual value bookings, lessors had to realize higher equipment values in equipment remarketing. As a result, lessors increasingly depended on equipment management expertise as a source of profit and competitive advantage. (1) To illustrate this idea, let S equal the book value of the asset after accumulated depreciation accumulated depreciation The total amount of depreciation that has been recorded for an asset since its date of acquisition. For example, a computer with a 5-year estimated life that was purchased for $2,000 would have accumulated depreciation of $800 [( (D). [A.sub.0] and [A.sub.1] are the asset value at the beginning and the end of the period. S = [A.sub.0] - D. When the asset is sold at the end, the gain from sale equals [A.sub.1] - S, which is treated as ordinary business income. When the firm buys the asset, it gets the tax shield on D, but has to pay tax on gain from sale of asset. The tax liability involved is [T.sub.C.sup.*] ([A.sub.0] - S) - [T.sub.C.sup.*] ([A.sub.1] - S) = [T.sub.C.sup.*] ([A.sub.0] - [A.sub.1]) = [T.sub.C.sup.*] (economic depreciation). (1) If this assumption is relaxed without putting any penalty on default, then, as in the modified M-M M-M Multiplex-Multicast proposition, the obtained optimal debt level will be a corner solution in this risk neutral world; i.e., the firm will issue as much debt as possible to make the taxable income zero. When the firm is allowed to issue risky debt, it can be assumed that the cost of financial distress Financial distress Events preceding and including bankruptcy, such as violation of loan contracts. is convex in the amount of default (increasing at an increasing rate) so that the bankruptcy bankruptcy, in law, settlement of the liabilities of a person or organization wholly or partially unable to meet financial obligations. The purposes are to distribute, through a court-appointed receiver, the bankrupt's assets equitably among creditors and, in most cost will gradually outweigh out·weigh tr.v. out·weighed, out·weigh·ing, out·weighs 1. To weigh more than. 2. To be more significant than; exceed in value or importance: The benefits outweigh the risks. the tax benefits of risky debt. Consequently, a firm with higher volatility in net cash flow (after asset depreciation and/or lease payment) will issue less debt. With some qualification on the parameter (1) Any value passed to a program by the user or by another program in order to customize the program for a particular purpose. A parameter may be anything; for example, a file name, a coordinate, a range of values, a money amount or a code of some kind. values, the same results as those in the case of only riskless debt allowed can be obtained, only at the expense of messiness. (1) In his paper about the generalized gen·er·al·ized adj. 1. Involving an entire organ, as when an epileptic seizure involves all parts of the brain. 2. Not specifically adapted to a particular environment or function; not specialized. 3. lease-or-buy problem, Mark Wolfson Geoffrey Mark Wolfson, known as Mark Wolfson, (born 7 April, 1934) was the British Conservative MP for Sevenoaks from 1979 until he retired in 1997. References
(1) In discussing the beta of a depreciable depreciable Of, relating to, or being a long-term tangible asset that is subject to depreciation. asset, Miller and Upton (1976) provide an argument for the negative correlation between the asset depreciation and the economy condition: "If necessity is indeed the mother of invention and the pace of technological improvement steps up as the economy falls off, then beta < 0." While they study the correlation between the asset depreciation and the market condition, this study focuses on the correlation between the asset depreciation and the firm-specific risk Firm-specific risk See: Diversifiable risk or unsystematic risk in operation cash flow. (1) This assumption is for the sake of convenience and easy illustration. More precisely speaking, the competitive lease payments should reflect the increase in lessor's corporate tax liability caused by the variation of the asset residual value. In general, more precisely formulated lease payments will not change the main results of the analyses. REFERENCE Johnson, J., R. Dowen, and C. Norton. An Assessment of Lessor Accounting for Residual Values. Accounting Horizons 7 (September 1993), 55-65. Lease, R., J. McConnell, and J. Schallheim. Realized Returns Realized return The return that is actually earned over a given time period. and the Default and Prepayment Prepayment 1. The payment of a debt obligation prior to its due date. 2. The excess payment over a scheduled debt repayment amount. Notes: 1. Examples include deferred expenses such as rent and early loan repayments. 2. Experience of Financial Leasing Contracts. Financial Management 19 (1990), 11-20. Lewellen, J., M. Long, and J. McConnell. Asset Pricing in Competitive Capital Markets. Journal of Finance 31 (June 1976), 737-98. Lewis, C., and J. Schallheim. Are Debt and Leases Substitutes? Journal of Financial and Quantitative Analysis Quantitative Analysis A security analysis that uses financial information derived from company annual reports and income statements to evaluate an investment decision. Notes: 27 (December 1992), 497-511. McConnell, J., and J. Schallheim. Valuation of Asset Leasing Contracts. Journal of Financial Economics 12 (June 1983), 327-61. Miller, M., and C. Upton. Leasing, Buying, and the Cost of Capital Services. Journal of Finance 31 (June 1976), 761-86. Schallheim, J., R. Johnson, R. Lease, and J. McConnell. The Determinants of Yields on Asset Pricing Contracts. Journal of Financial Economics 19 (September 1987), 45-67. Smith, C., and L. Wakeman. Determinants of Corporate Leasing Policy. Journal of Finance 40 (July 1985), 895-908. Wolfson, M. Tax, Incentive, and Risk-Sharing Issues in the Allocation The apportionment or designation of an item for a specific purpose or to a particular place. In the law of trusts, the allocation of cash dividends earned by a stock that makes up the principal of a trust for a beneficiary usually means that the dividends will be treated as of Property Rights: the Generalized Lease-or-Buy Problem. Journal of Business 58 (1985), 159-71. Dr. Wenyuh Tsay earned his Ph.D. at University of Utah The University of Utah (also The U or the U of U or the UU), located in Salt Lake City, is the flagship public research university in the state of Utah, and one of 10 institutions that make up the Utah System of Higher Education. in 1998. Prior to his graduate study, he had more than four years of professional experience as programmer (1) A hardware device used to customize a programmable logic chip such as a PAL, GAL, EPROM, etc. See PROM programmer. (2) A person who designs the logic for and writes the lines of codes of a computer program. and financial analyst. He is currently an assistant professor of finance at California State University, San Marcos California State University San Marcos (also CSUSM or Cal State San Marcos) is a campus of the California State University (CSU) system located in San Marcos, California, a suburban town in north San Diego County. . |
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