Valuation of asset leasing contracts

This paper describes the relation among a variety of asset leasing contracts, including: (1) cancellable operating leases; (2) leases which grant the lesse an option to extend the life of the lease; (3) leases that grant the lessee an option to purchase the leased asset at a fixed price at the maturity date of the lease; (4) leases that grant the lessee the right to purchase the leased asset at its ‘fair market value’ at the maturity date of the lease; (5) leases that grant an option to the lessee to purchase the leased asset at a prespecified price anytime during the life of the lease; (6) leases that require the lessee to purchase the leased asset at a fixed price at the maturity date of the lease; and (7) leases that contain non-cancellation provisions. The paper uses a compound option pricing framework to develop a general model for valuing (or evaluating) each of the types of leasing contracts. Numerical examples are presented to illustrate the effect of the various elements of a leasing contract — including cancellation risk and residual value risk — on equilibrium rental payments.     

A theory of contractual provisions in leasing

We develop a non-tax rationale for leasing in a double-sided asymmetric information setting, and analyze how various contractual provisions in leasing contracts arise in equilibrium. In our model, a manufacturer of capital goods has private information about their quality; entrepreneurs (users of these capital goods) come to learn this quality only by using them over a period of time. Each unit of the capital goods requires a certain level of maintenance in each period. Entrepreneurs differ in their cost of providing this maintenance; this maintenance cost is information private to each entrepreneur. Leasing emerges as an equilibrium solution to this double-sided asymmetric information problem. Various contractual provisions in leasing contracts (e.g., short-term versus long-term leases with non-cancellation provisions, option to buy at lease termination, and service leases) also emerge as equilibrium solutions under alternative settings. Leases with metering provisions emerge in equilibrium when, in addition to the maintenance cost, entrepreneurs differ in other dimensions, such as their intensity of usage of the capital good. Our model has implications for the lease-versus-sell decision, the situations under which various leasing contract provisions will be used, and for the relative magnitudes of sales prices and leasing costs (for leases with different contractual provisions).     

Do leases expand debt capacity?

Theoretically and empirically, debt and leases have been shown to be both substitutes and complements. To explore the relation, we divide our sample into two subsets: those that exhibit a complementary relation (43% increase debt after increasing leases), and those that exhibit a substitutionary relation (57% decrease debt after increasing leases). For complement firms, we find a significant negative relation between leasing and the firm's size, marginal tax rate, and z-score, consistent with “complementary” theories. For substitute firms, we find a positive and significant relation between leasing, the marginal tax rate and changes in cash. We also find a significant positive stock market reaction to the announcement of the SLB, which is stronger for the complement subset of firms.     

Mutual Fund Tax Clienteles

Mutual funds are held by investors in taxable and tax‐qualified retirement accounts. We investigate whether the characteristics, investment strategies, and performance of mutual funds held by these diverse tax clienteles differ. Examining both mutual fund distributions and mutual fund holdings, we find that funds held primarily by taxable investors choose investment strategies that result in lower tax burdens than funds held primarily in tax‐qualified accounts. Despite these differences, we find no evidence that any investment constraints that may arise from these tax‐efficient investment strategies result in performance differences between funds held by different tax clienteles.     

Taxable income,future profitability,and stock returns

Prior research suggests that investors behave ‘as if’ taxable income contains information about future performance by providing evidence of a positive association between taxable income and stock returns. We draw on the fundamental analysis literature and provide direct evidence on this assertion by examining whether taxable income predicts future pretax performance. We find that taxable income positively predicts future pretax cash flows, pretax book income, and ‘Street’ pretax earnings, suggesting that taxable income provides incremental information to book income regarding performance. Moreover, we find a positive association between taxable income and analysts’ pretax forecasts, consistent with analysts utilizing the information in taxable income when forming earnings expectations. We do not find an association between taxable income and future analyst forecast errors, implying analysts do not overreact or underreact to taxable income's performance signal. Overall, we find that taxable income provides a signal of fundamental value and corroborate the implications of prior research.     

Real Estate Ownership, Leasing Intensity, and Value: Do Stock Returns Reflect a Firm’s Real Estate Holdings?

Little is known about the effects of real estate ownership and leasing on the stock return characteristics of public firms. In this study, we first examine the sensitivity of retail firm returns to a real estate factor over the period 1998?C2008. The retail industry is chosen because of the significant use of real estate in a typical retail firm??s production function. Consistent with our expectations, retail stocks exhibit positive real estate risk exposure, even after controlling for sensitivity to general market risk as well as other standard risk factors. The second part of our analysis examines whether the intensity of real estate ownership and the use of off-balance operating leases to finance real property holdings are reflected in the market and real estate betas of retail stocks. We find that greater use of off-balance sheet operating leases is associated with higher market betas. In fact, the use of operating leases appears to have a larger impact on sensitivity to market risk than does the use of on-balance sheet debt. Our findings also confirm our hypothesis that real estate intensive firms display significantly greater exposure to a real estate factor. Moreover, our results strongly suggest that investors are fully aware of the risk associated with off-balance sheet operating leases.     

Modeling exposure to losses on automobile leases

We present an integrated statistical model for assessing risk and projecting financial losses on automobile leases. The model employs nonstationary Markovian state transitions for active leases and hierarchical logistic and regression equations for different outcomes on termination. The model reveals that lower residual risks may partially offset higher credit risk for customers whose credit scores predict higher risk of default. It also reveals a risk profile that differs through time from other secured credits such as mortgages. A three-year follow-up of forecasts versus outcomes for 39,500 leasing contracts shows that the model predicted rates of repossession better than standard roll-rate models with stationary transition probabilities. It displayed similar accuracy in predicting unscheduled terminations and insurance settlements.      

Do firms use dividend changes to signal future profitability? A simultaneous equation analysis

This paper retests the signaling hypothesis of dividends by examining whether managers change dividends to signal their expectation of earnings prospects using a simultaneous-equation approach. This approach allows us to more clearly test the earnings prospects signaling hypothesis and facilitates the control of several alternative motives that managers may have for changing dividends. We also examine the information content of dividend changes with respect to future earnings changes in the same model system. Our results show that managers change dividends to signal equity-scaled rather than asset-scaled earnings prospects. In addition, we find evidence that managers also change dividends for signaling previous earnings changes and for catering to dividend clienteles. As for the information content of dividend changes, we find that dividend changes have significant and negative impact on ROA changes. The findings suggest that if investors consistently cannot recognize the signaling purpose and find that dividend increases (decreases) are not useful in predicting favorable (unfavorable) future earnings, managers may someday give up using dividend changes to signal the earnings prospects of their firms because they cannot obtain the expected market benefits anymore.     

Leases with Purchase Options and Double Moral Hazard

Abstract:  The purpose of this paper is to explain why leases have a purchase option and how the exercise price of this option is determined. We follow Demski and Sappington's (1991) approach by using a double moral hazard setting. One limitation of their model is that the agent has unlimited liability. The agent has to have enough wealth and the obligation to buy the firm when the principal decides to exercise the put option. In our paper, this problem is resolved by using a call option, which is a feature of many lease contracts. We show that leases with a purchase option can completely resolve the double moral hazard problem even if all the variables in the model are unverifiable. It is the threat of being the residual claimant that induces the lessor to provide an efficient level of effort. On the other hand, it is the opportunity of being the residual claimant that induces the lessee to maintain the asset efficiently. Finally, the model predicts that certain leased assets are not properly accounted for under the current accounting standards for leasing.     

The Debt Equivalence Of Leases In The UK: An Empirical Investigation

In finance theory, leasing is viewed as a form of borrowing. Prior studies have indicated that secured debt and lease are regarded as equivalent by the capital market.The following questions are addressed: i) do debt and lease have the same effects on the volatility of equity return? ii) Have changes in the accounting regulations altered the effect of lease obligation on the volatility of equity return? The results indicate that, on average, finance leases have a positive effect on the volatility of the return on equity as debt does. It is also found that the market considers leases more favourably (less risky) than debt.Two explanations are possible for the favourable treatment: i) the finance lease obligations are less like debts due to the imposed capitalisation requirements; ii) firms pay high costs of leasing because of the benefits from leasing relative to debt and the market reacts to those benefits favourably.     

Evaluating the information content of earnings forecasts

This study develops a framework to compare the ability of alternative earnings forecast approaches to capture the market expectation of future earnings. Given prior evidence of analysts’ systematic optimistic bias, we decompose earnings surprises into analysts’ earnings surprises and adjustments based on alternative forecasting models. An equal market response to these two components indicates that the associated earnings forecast is a sufficient estimate of the market expectation of future earnings. To apply our framework, we examine four recent regression-based earnings forecasting models, alongside a simple earnings-based random walk model and analysts’ forecasts. Using the earnings forecasts of the model that satisfies our sufficiency condition, we identify a set of stocks for which the market is unduly pessimistic about future earnings. The investment strategy of buying and holding these stocks generates statistically signi?cant abnormal returns. We offer an explanation as to why this and similar strategies might be successful.     

Credit Risk and the Term Structure of Lease Rates: A Reduced Form Approach

Previous research either assumes default free leases or leases subject to default risk using a structural approach. However, structural credit risk models suffer from a common criticism that the firm’s asset value process is unobservable. We develop a reduced form credit risk model for leases that avoids making assumptions regarding unobservable asset valuation processes. Furthermore, we assume a correlated market and credit risk that provides us with a simple analytic formula for valuing defaultable lease contracts. Numerical analysis reveals that tenant credit risk can have a substantial impact on the term structure of leases. Finally, we use the model to demonstrate the implied lease term structure for a set of retail and financial firms in the Fall of 2000.

The determinants of yields on financial leasing contracts

This study tests hypotheses about the valuation of leasing contracts. We examine the determinants of the yields of a relatively large, reasonably heterogeneous, and nationally representative sample of financial leases. We find lease yields to be significantly related to treasury bond yields and our proxies for the systematic risk of the leased asset's residual value and the transaction and information costs associated with the lease. There is also some evidence of a relationship between lease yields and the default-risk of the lessee.     

Changes to Income Trust Taxation in Canada: Investor Reaction and Dividend Clientele Theory

Abstract:  This paper explores the relationship between tax-induced dividend clientele theory and the recent changes to the taxation of income trusts in Canada. On October 31, 2006, the Canadian government announced the Tax Fairness Plan ( TFP ) calling for the elimination of the considerable tax advantage enjoyed by income trusts. Generally, distributions from income trusts are now taxed at rates comparable to those imposed on corporate dividends. We examine market reaction to the  TFP  to address three issues: first, whether the valuation effect of a dividend tax increase is consistent with the traditional or the new view of dividend taxation; secondly, whether the market reaction to tax increases has a differential impact on firm value that is related to the tax preferences of taxable, tax-exempt, and foreign investor tax clienteles; and thirdly, whether firms change their dividend policies in response to the preference of institutional investors (tax-based dividend policy effect) or whether institutional investors are sorting themselves across firms based on their dividend policies (investor sorting effect). Our results provide strong evidence as follows. First, the valuation effect in reaction to the  TFP  announcement is consistent with the traditional view of dividend taxation – i.e. that taxes on dividends reduce the net return to investors, increase the firm's cost of capital and lower the firm's ability to access capital markets, thereby discouraging investment and savings. Secondly, we saw that trusts with a larger percentage of their units held by tax-exempt, low-tax, and foreign investors had a higher decline in value when compared with trusts held mostly by ordinary taxable investors. These results support dividend tax clientele theory. Finally, we observed changes in institutional investor clienteles consistent with the investor sorting effect.     

Demand for the truth in principal–agent relationships

Consider the following puzzle: If earnings management is harmful to shareholders, why don’t they design contracts that induce managers to reveal the truth? To answer this question, we model the shareholders–manager relationship as a principal–agent game in which the agent (the manager) alone observes the economic outcome. We show that the limited liability (LL) of the agent, defined as the agent’s feasible minimum payment, might explain the demand for earnings management by the principal. Specifically, when the LL level is high (low), a contract that induces earnings management may be less (more) costly than a truth-revealing contract. This finding offers a new explanation of the demand for earnings management.     

Use of benchmarks in predicting earnings management?

This study conducts multiple approaches to identify whether earnings benchmarks are an indicator for earnings management within the Australian market. We investigate firms reporting small positive earnings and small positive earnings changes, referred to as benchmark beaters. Accrual quality models, earnings distributions and earnings persistence measures are applied to identify whether benchmark beating firms are manipulating earnings. Our findings suggest that the small positive earnings benchmark attracts earnings managers. However, we do not identify any evidence to indicate that the positive earnings change benchmark is a signal for earnings management.     

The Leasing Decision: A Comparison of Theory and Practice

The UK leasing industry has grown dramatically in the 1980s. The academic literature suggests that there are two major reasons for leasing—taxation benefits and off-balance sheet financing. Recently taxation and financial reporting changes have substantially reduced the taxation and off-balance sheet financing benefits from leasing. Against this background a postal questionnaire survey of the opinions of UK financial managers on various issues relating to finance leases was undertaken. This paper reports on the findings of the questionnaire survey. A distinguishing feature of the survey is that the replies were analysed by various financial characteristics of the responding companies.     

The investment opportunity set,director ownership,and corporate policies: evidence from an emerging market

This paper provides evidence of the association between a firm's investment opportunity set (IOS), director ownership, and corporate policy choices. Using a sample of growth and non-growth firms in an emerging Asian market, we find that the IOS theory has significant explanatory power in the financing, dividend, executive compensation, and leasing aspects of corporate policies. Growth firms have lower debt-to-equity ratios and dividend yields, pay higher cash compensation and bonus amounts to their top executives, and finance a higher proportion of their asset acquisitions through operating leases. We also find that director ownership moderates and counteracts the association between IOS and corporate policies. Our results are consistent with contracting theory predictions that high director ownership mitigates the need for incentive or bonus compensation plans in growth firms.     

Asset liquidity and financial contracts: Evidence from aircraft leases

Financial contracting theories agree that more-liquid assets decrease the expected cost of external financing, thus making leasing more attractive and reducing lessors’ equilibrium return. However, the literature has ambiguous predictions about the effect of liquidity on the maturity of leases. These predictions are further complicated by the existence of two types of lease contracts—operating and capital—that differ in whether asset ownership transfers to the lessee at the end of the contract. Using data from commercial aircraft, I find that more-liquid assets (1) make leasing, operating leasing in particular, more likely; (2) have shorter operating leases; (3) have longer capital leases; and (4) command lower markups of operating lease rates.     

Dividend tax signaling and the pricing of future earnings: a case of taxable stock dividends

The purpose of our study is to explore what types of information content are conveyed by dividends on future earnings. We examine this issue by investigating the effect of dividends on the association between current year stock returns and future earnings (i.e. the future earnings response coefficient, FERC). Based on exploring the Taiwan market, our results reveal that taxable stock dividends enhance the FERC while nontaxable stock dividends do not, consistent with the tax-based signaling argument. We also find a positive relation between cash dividends and the FERC in firms with severe free cash flow problems, and this suggests that higher cash payouts mitigate manager over-investment so future earnings are more highly valued, consistent with the agency argument. Our main contributions are to specify what factors make dividends informative with regard to future earnings and the provision of evidence to support the tax-based signaling model.