Substitutability of Leases and Debt in Corporate ... - CiteSeerX

Substitutability of Leases and Debt in Corporate Capital Structures

FELICIA MARSTON” AND ROBERT S. HARRIS**

Finance theory suggests that leases and debt are substitutes. Surprisingly, however, prior empirical research using jinancial statement data has been unable to verify this trade-off between the two forms ofjinancing. This study re-examines the issue of substitutability by comparing changes in lease and debt jinancing over a six-year horizon for a large sample of US. jirms. The empirical results strongly support the theoretical contention that leases and debt are substitutes and is thus consistent with evidence from surveys of lending oficers. There is some evidence, however, thatjirms do not view leases as displacing nonleasing debt on a dollar-for-dollar basis.

A large body of literature in finance suggests that leases and debt should be perfect substitutes. Leasing involves a contractual commitment of corporate funds and thus uses debt capacity.’ As a result, for any increase in leasing there should be a corresponding reduction in debt. Surprisingly, empirical work using financial statement data has not even confirmed substitutability between leases and debt. For example, Ang and Peterson (1984) find that lessee firms use more long-term debt than do nonleasing firms. They suggest that, as an empirical matter, leases appear to be complements, which leaves a “leasing puzzle’’ to be explained. This evidence is in sharp contrast to survey results (Bayliss and Diltz [1986] showing that bank loan officers reduce their willingness to lend when a firm takes on lease obligations.

This study re-examines the issue of substitutability using financial state-

*Boston College. **School of Business, University of North Carolina (UNC) at Chapel Hill. The second author

acknowledges the support of the Business Foundation at UNC, the Pogue Foundation, and The Institute of Accounting and Finance at London Business School where he was a visitor. Our thanks go to our colleagues at UNC and to Julian Franks for helpful comments.

I . Some operating leases are cancelable. Leasing, for purposes of this paper, is defined as engaging in any noncancelable lease. The focus on substitutability of leases and debt is in terms of their effects on capital structure.

147

at PENNSYLVANIA STATE UNIV on September 17, 2016jaf.sagepub.comDownloaded from

http://jaf.sagepub.com/

148 JOURNAL OF ACCOUNTING, AUDITING & FINANCE

ment data for a large sample of U.S. firms. Our work differs from prior research in two important respects. First, we examine changes (rather than levels) of lease and debt financing. Second, more comprehensive measures of leasing (capitalized plus noncapitalized) and debt (short-term and long- term) are used. The next section briefly reviews theoretical considerations and related empirical findings. In Section 11, the empirical approach used in this research is presented. Section I11 discusses the sample and methodology. Finally, results and conclusions are offered.

I. Literature Review

In general., the substitutability among leases, nonleasing debt, and equity is complicated. A firm must find the appropriate level of investment as well as the optimal mix of all sources of finance, one of which may be leasing. One-to-one substitutability between leasing and debt financing implies that a dollar of lease obligations displaces a dollar of otherwise-available debt financing. Such would necessarily be the case if, as assumed in the valuation models of Myers, Dill, and Bautista (MDB, 1976) and Franks and Hodges (1978), shareholders’ risks are the same whether the asset is leased or financed by an “equivalent” loan. Indeed, as Franks and Hodges point out, within their framework “it is hard to visualize how $1 of leasing cash flow can displace any amount other than $1 of borrowing cash flow” (p. 664). This substitutability is an example of value additivity in perfect and complete capital markets.

In practice, however, there can be differences in the nature of actual or perceived cash flows assumed under leasing and debt financing arrange- ments. Smith and Wakeman (1985) note examples of such differences and use them to identify potential lessors and lessees as well as the types of assets most likely to be leased by a given lessee. For example, in some noncancelable leases, the term of the agreement is shorter than the economic life of the asset. As Smith and Wakeman observe, this offers advantages to the lessee if the useful life of the asset is expected to be less than the asset’s economic life and if there are significant costs associated with trans- ferring ownership (pp. 900-901).2

Another potential difference between leasing and debt financing arises from claims in the event of bankruptcy. Since the lessor often maintains

2. Further, if there is uncertainty regarding the useful life of the asset to the lessee or if the risk of obsolescence is great, a short-term lease will impart less risk to lessee shareholders than will buying the asset. In essence, a lease provides a way to transfer risks associated with an asset’s future value from the lessee to the lessor. In this case, a dollar of leasing cash flow would be expected to displace less than a dollar of debt service.



SUBSTITUTABILITY OF LEASES AND DEBT 149

legal ownership of assets, the lessee is deprived of the right to sell these assets to help settle other claims. Thus, the lessee gives away a valuable claim on assets in bankruptcy, exposing shareholders to more risks than would be true under an otherwise “equivalent” loan. In this situation, a dollar of leasing cash flow would be expected to displace greater than a dollar of debt ~erv ice .~ However, this effect would likely be counterbal- anced, at least in part, by the fact that secured lenders have a claim on unsecured assets equal to the remaining obligation, whereas lessors generally can recoup at most one year’s lease payments from unsecured assets.

The trade-off between leasing and debt may also be affected by market inefficiencies. Leasing is sometimes claimed to substitute less than one to one for debt because shareholders and/or creditors do not fully appreciate the risks associated with the financial leverage inherent in lease contracts. If such were the case, a future dollar of leasing cash flow could raise more money (in present-value terms) than could that same dollar offered to a creditor because of the perception of lower risks when leasing is used. This would be true even if there were no fundamental differences between the leasing and debt contracts. This line of reasoning frequently is cited as an incentive for off-balance-sheet financing via leases. However, accounting regulations that require disclosure of leases and the substantial energy that often goes into credit valuation would tend to eliminate this proposed market inefficiency.

The determination of the actual degree of substitution between leasing and debt remains an empirical issue. Of particular relevance for the present research are two general approaches to the problem. One examines financial statement data to determine how firms have behaved, assuming that on average corporate behavior leads to an optimal capital structure (e.g., Ang and Peterson [ 19841). An intriguing alternative is to survey the suppliers of financing to assess their willingness to lend to firms with different leasing obligations (Bayliss and Diltz [ 19861).

Each approach has its practical drawbacks. Use of survey techniques based on hypothetical choices may not capture important dimensions of actual decision making and may result in limited samples. For example, Bayliss and Diltz focus on only one class of lenders and, despite considerable follow-up, achieve only an 8.9 percent response rate, which appears in line

3. Our thanks to Julian Franks for suggesting this issue and for many useful comments on the issue of substitutability. The differences between leases and debt in the event of bankruptcy are also discussed by Smith and Wakeman (1985). Some authors (Klein, Crawford, and Alchian [1978]) have argued that leases displace debt more than dollar for dollar because of the more specialized nature of leased assets. The hypothesis forwarded is that such specialized assets have less-well-developed sec- ondary markets and hence expose the firm to more liquidity risk.




with similar survey studies. On the other hand, use of financial statement data to infer lease-debt substitutability requires a satisfactory control for changes in debt capacity. Additionally, as discussed by Bayliss and Diltz, the measure of debt displacement in lease valuation models is not reflected directly in debt-equity or lease-equity ratios, but also depends on various tax shields associated with whether the asset is owned or not (e.g., depreciation). Nonetheless, we would expect the two empirical approaches to provide confirming evidence. This, however, is not the case.

Ang and Peterson compare debt-equity ratios of firms that are lessees to those of firms not using lease financing. The authors hypothesize that the ratio of debt (excluding leases) to equity for leasing firms will be less than that for nonleasing firms. Instead, they find the opposite, suggesting that leases and debt are complements rather than substitutes.

Using results of a survey of bank loan officers, Bayliss and Diltz estimate a very close substitutability between leasing and debt. Employing specific attributes of a hypothetical lease decision, they determine “a coefficient of [debt] displacement for lease obligations of approximately $0.85” (p. I), which they estimate to be stable with respect to key parameters such as asset lives, depreciation methods and discount rates.

11. Empirical Model In light of these conflicting results, this paper re-examines the use of

financial statement data to estimate substitutability between leasing and nonleasing debt. Although financial theory suggests that any leasing un- dertaken will displace debt, it does not predict a priori that debt-equity ratios of leasing firms will be less than those of nonleasing companies since debt capacity considerations for the two groups may differ. Smith and Wakeman (1 985) discuss such differences between leasing and nonleasing firms and conclude that “[al]though leasing and debt are substitutes for a given firm, looking across firms, characteristics of firms’ investment opportunity sets which provide high debt capacity also tend to provide more profitable leasing opportunities” (p. 907). To address this issue, Ang and Peterson (1984) compare leasing and nonleasing firms on the basis of operating risk, profit, expected growth, size, and liquidity, but they conclude that these factors do not explain their finding of higher debt-equity ratios for leasing firms.

The approach adopted here is to examine changes in, rather than levels of, lease and debt financing by individual firms. Focusing on changes provides a much stronger control for differences in capital structure across firms than that used by Ang and Peterson. Additionally, whereas Ang and Peterson




focus only on capitalized leases and long-term debt, we examine more comprehensive measures of leasing and nonleasing debt.

Theory suggests that proportionate increases in leasing should be accompanied by decreases in the use of nonleasing debt. For example, consider a firm that finances part of its total assets (A) with fixed obligations that can be in the form of leasing (L) or nonleasing debt (NLD). If nonleasing debt and leasing are substitutes, we would expect increases in the proportion of financing done by leasing to be accompanied by decreases in the proportion of financing done by nonleasing debt, assuming there are no major changes in operating risks. Regression (1) provides a test of this relationship.

(1) where nj and tj are the proportions of financing done by nonleasing debt and leasing for firm in a historical period, a and B are coefficients to be estimated, ej is a random error term with zero mean, and other terms are as defined previously. The change in assets (AA) represents new investment by the firm. As a result, njAAj and L,A~ represent the proportion of new investment financed by nonleasing debt and leasing, respectively, if the firm were to maintain prior financing ratios.

In Regression ( I ) , the left-hand side is the dollar increase in nonleasing debt relative to a policy of maintaining a constant proportion of financing from this source. The term in parentheses on the right-hand side is the dollar reduction in leasing relative to the policy of maintaining a constant proportion of financing via leasing. If leases and debt are substitutes, we would expect a positive value for B, implying that firms use debt capacity freed by reductions in leasing to increase their financing via nonleasing debt. A similar positive relationship would follow if firms were reducing nonleasing debt financing as they made greater use of leasing. A positive (negative) value of a signifies an increase (decrease) in nonleasing debt independent of changes in leasing. If nonleasing debt and leasing were perfect substitutes and firms maintained a constant leverage (n-t- t is held constant) policy over time, we would expect I3 = 1.0 and a = 0.4

(ANLDj - njAAj) = a + p (tjAAj - ALj) + ej

111. Sample and Methodology To estimate Regression ( l ) , measures of leasing (L), nonleasing debt

(NLD), and assets (A) are necessary. A theoretically proper measure of lease

4. See Bayliss and Diltz for a discussion of problems in interpreting financial statement data in terms of the underlying substitutability in cash flows. Note that if firms were to maintain both n and L

constant, both sides of Regression (1) would be zero and the coefficients could not be estimated. Regression (1) thus relies on firms’ actually shifting financing patterns between debt and leasing.




financing should include the present value of all noncancelable leases since these represent contractual obligations. However, given accounting regulations discussed below, financial statements on noncancelable lease data are not available for all firms. Thus, companies are initially screened based on whether or not they report the present value of noncancelable lease obligations. Major accounting pronouncements affecting such reporting are Accounting Principles Board (APB) Opinions 5 (1963) and 31 (1973) and Financial Accounting Standards Board (FASB) Statement 13 (1976).

Opinion 5 required leases that were in substance installment purchases (defined as containing bargain purchase or bargain renewal options) to be capitalized on a firm’s balance sheet. Noncancelable leases that were not in substance installment purchases, representing the majority of leases at that time, had only to be reflected as gross commitments in footnotes. Noncapitalized obligations were referred to as ‘ ‘minimum rental commitments. ’ ’

Opinion 31 had no effect on leases to be capitalized but clarified and increased disclosure requirements for gross minimum rental commitments. The opinion suggested that disclosure of the present value of these commitments might be helpful for users of financial statements; however, this disclosure was not required.

A major change in the reporting of leases came in 1976 when Statement 13 redefined a “capital” lease as any lease in which the risk and rewards of ownership were transferred to the lessee.’ Noncancelable leases that did not meet the criteria for capitalization were to continue to be disclosed in footnotes, but only in terms of gross commitments. The Statement was to be applied prospectively beginning in 1977 and retroactively by 1981. A major result of Statement 13 was a large increase in the amount of capital leasing reported.

In order to capture all noncancelable leases whether capitalized for reporting purposes or not, only firms that complied with the optional disclosure suggested by Opinion 31 and reported the present value of minimal rental commitments were included in the sample. From this pool, any firm that was involved in a major merger6 during the sample period was excluded

5. Specifically, Statement 13 defined a capital lease as one under which any one of the following conditions is met:

a. The lease transfers ownership of the property to the lessee by the end of the lease term. b. The lease contains a bargain purchase price. c. The lease is equal to 75 percent or more of the estimated economic life of the leased property. d. The present value at the beginning of the lease term of the payments not representing executory

costs paid by the lessor equals or exceeds 90 percent of the fair value of the leased asset. 6. Major mergers were screened using Compustat footnote information. A major merger, as




since the probability of change in operating risks and capital structure would be high for such companies. Additionally, firms that had negative equity at some point during the sample period (10 firms total) were excluded. Such firms, most of which subsequently went bankrupt, were undoubtedly forced to use more debt-like financing rather than making a voluntary choice. The final screen required that data be available (Compustat Expanded Industrial File) for all variables during the period 1974-1982. All 4 screens were passed by 271 firms spanning many industries.’

Compustat financial statement data for the period 1974-1982 are used to derive measures of leasing, nonleasing debt, and assets. Tables 1 and 2 summarize variable definitions and descriptive statistics. Leasing is defined as the sum of total capital leases reported on the firm’s balance sheet and the present value of minimum rental commitments reported in footnotes to financial statements.’

Three different measures for nonleasing debt are used to examine the sensitivity of the estimates to the definition of debt. The first measure

defined by Compustat, is one in which the nonsurviving company contributes greater than one-third of the total revenue of the new or surviving company in the year the merger occurs.

7. The greatest single concentration of firms was in some form of retailing. Retailing and whole- sale firms used roughly the same amount of total debt (leasing plus nonleasing) as did the rest of the sample, though they used more leasing.

8. Minimum rental commitments (noncapitalized leasing) meet none of the conditions given by Statement 13. As a result, it can be argued that noncapitalized leases should be treated as a separate variable rather than being combined with capitalized leases. Furthermore, since it is widely believed that many firms construct leases to barely miss the FASB criteria and thus not be capitalized, there may not be substantial economic differences between the two types of leases (capitalized and noncapitalized). Unfortunately, the data for this study do not permit segregation of the leasing variable since much of the change in capitalized and noncapitalized leasing resulted from mere reclassification due to Statement 13 rather than to planned financing by firms. This question is left for future research.

For firms that reported the present value of minimum rental commitments, this information is generally only available for 1973-1976, the effective period of Opinion 31. Gross minimum rental commitment information for the next five years is accessible via Compustat, however, starting in 1974. The present value of noncancelable, noncapitalized leasing after 1976 was estimated as follows: For each firm in the sample, the average ratio of present value of minimum rental commitments (total) to gross minimum rental commitments (for the next five years) was computed for the years 1974-1976. For the years subsequent to 1976, this average was then multiplied by reported gross minimum rentals in those years to obtain a dollar estimate of present value. Note that the ratio used equals average present value to rord minimum rental commitments for leases with remaining terms less than or equal to five years. For lease terms greater than five years, present value to gross minimum rental commitments for the next five years (the ratio calculated, based on available data) overstates present value to roral rental commitments. One stipulation of Statement 13 is that leases with lease terms greater than or equal to 75 percent of the estimated economic life of the asset must be capitalized. Prior to 1977, however, such a lease could have been disclosed solely in the footnotes if it did not contain a bargain purchase or bargain renewal option. To the extent that Statement 13 may have resulted in a shorter average life for leases disclosed in the footnotes, the estimated ratio will be biased upward from the true post-1976 ratio. Also, our procedure provides no control for possible changes in appropriate discount rates, which given the rise in nominal interest rates during 1981-1983 may also tend to overstate the leasing values. To address this issue, regressions were re-estimated after adjusting the estimated ratio downward by 30 percent. The regression results are quite similar to those reported in the paper.




L =

NLD, =

NLD, =

NLD, = E =

A, = c, = n, = e, =

CI c2 c3

AL ANLD, ANLD, ANLD,

AE AAi AAz AA3

TABLE 1

Definitions and Descriptive Statistics for Variables Definitions

Total leasing = Capitalized leases plus present value of noncapitalized, noncancelable leases Total nonleasing debt (defined as sum of short-term debt, long-term debt, other liabilities,” deferred taxes, and minority interests) Nonleasing debt excluding minority interests and deferred taxes = (NLD, - minority interest-deferred taxes) Long-term debt Stockholders’ equity Assets = L + NLD, + E; i = 1, 2, 3 Leverage ratio = (L + NLD,); i = 1, 2, 3 Nonleasing debt ratio = (NLDJA,; i = 1, 2, 3 Leasing ratio = L/A,; i = 1, 2, 3

Sample Statisticsb

= Leverage ratio (leasing plus total nonleasing debt) = Leverage ratio = Leverage ratio (leasing plus long-term debt) = Change in leasing = Change in nonleasing debt = Change in nonleasing debt = Change in nonleasing debt = Change in equity = Change in assets = Change in assets = Change in assets

Standard Average Deviation

.629 ,619 ,482

$60.82 $286.66 $239.71 $62.95

$247.88 $595.36 $548.40 $371.64

.130 ,134 ,176

$141.74 $768.54 $577.15 $221.60 $173.67

$1,549.59 $1,341.84

$956.02

a. Other liabilities include accounts payable due after one year, contingent liabilities, customers’ deposits, negative goodwill, and reserves.

b. Changes are measured from year-end 1976 to year-end 1982. The leverage ratio is calculated as the average of the yearly ratios for the three years 1974, 1975, and 1976. Dollar figures are in millions.




TABLE 2

Capital Structure Characteristics A. Composition of Leasing and Leverage Ratios" for Sample Companiesb

Entries: Mean (Standard Deviation)

Composition of Leasing Ratio of capitalized to total leasing

Leasing to Total debf Ratio of leasing to total debt [L/(L+ NLD)]

Average for I976 1982 Sample Period .065 ,354 ,210

(.155) (.253) (.165)

Debt Measure Used

NLD2 NLD, ,224 .234 ,434

(.159) (.161) (.251)

Asset Measure Used

Leasing to Total Assets' Ratio of leasing to total assets (UA)

AI A2 . I43 ,146

(.117) (.118)

A3 ,198

(.153)

B. Comparison of Leasing and Leverage Ratios during Pre-sample (1974-1976) and Sample (1977-

Entries: Meand (Standard Deviation)

1982) Periods.

Variable 1974-1976 1977-1982

.I55 (.128) ,474 (.138) ,629 (.130)

.I58 (.129) ,461 (.140) ,619 (.134)

,144 (.117) ,478 (.124) .622 (.121)

,147 (.117) ,464 (.124) .611 (.126)

e3 ,211 (.102) ,201 (.152) n3 ,271 (.159) ,255 (.146) c3 .482 (.176) .456 (.166)

a. All variables are defined in Table 1. b. Averages for the sample period are calculated as the simple average of the statistic in the

c. Average for sample period. d. Averages in Panel B for each firm are the simple average of the variable in each of the years

beginning (year-end 1976) and ending years (1982).

covered by the pre-sample and sample periods. All variables are defined in Table 1.




includes all nonleasing debt reported on the balance sheet. The second excludes deferred taxes and minority interests as these items are not contractual obligations. The third measure excludes short-term debt and ‘‘other liabilities” (defined as accounts payable due after one year, contingent liabilities, customers’ deposits, negative goodwill, and reserves) as well as deferred taxes and minority interests and is comparable to the measure of nonleasing debt employed by Ang and Peterson.

Total assets for each total debt measure are calculated as the sum of leasing debt, nonleasing debt, and equity, where equity for each measure is total equity as reported on the balance sheet. The ratios n and L are calculated as the average values of NLDIA and LIA, respectively, during 1974-1976 since a measure of the present value of minimum commitments is available for each of these years (see footnote 8).9 Additionally, the ratio, c, is calculated as the sum of n and L as a summary measure of financial leverage. lo

Whereas capital structure theory is typically couched in terms of market values, actual market values sometimes fluctuate dramatically. As a result, such market value figures can be difficult to use both in empirical research and in management’s implementation of financial policy. Furthermore, empirical work by both Marsh (1982) and Taggart (1977) incorporating “target” financing ratios suggests that results are very similar whether market or book value formulations are used. In our work, use of book value levels allows us to

9. Debt and equity are measured in terms of book rather than market value. Fluctuations in market values and difficulties involved in determining market values for many forms of debt make use of book values a practical matter for both empirical researchers and financial managerslfinancial statement users in analyzing capital structure. Since the substitutability argument is based on expected behavior of financial managers, the use of book values may be justified from a methodological perspective as well. Additionally, book values of newly issued debt or leasing will closely approximate their market values. Finally, changes in book values indicate levels of incremental funding, whereas changes in market values cannot be interpreted in this fashion.

10. If the operating risks of qew investments differ from those of the firm’s existing assets, n and L measured on the firm’s existing assets would not be the appropriate leverage ratios for new investments. Since we have excluded firms with major mergers and study a large sample of firms, on average we do not expect dramatic shifts in operating risk. Calculating n and L over the period 1974-1976 implicitly assumes that firms were then operating at (roughly) their target debt ratios which were not expected to change over time.

If, however, in 1974-1976 a firm was using less-than-optimal leverage (due to lags in adjusting capital structure or as-yet-unrecognized policy errors) the n and L would understate debt capacity available for new financing for two reasons. First, unused debt capacity on existing assets would be available. Second, a higher leverage ratio may be applied to new investments. If most firms fit this description, this would likely result in an estimated value of D less than unity-not necessarily because leases consume debt capacity less than dollar for dollar but because the firm’s debt capacity was currently underutilized. The reverse effect on p would hold if firms were systematically “overleveraged” in the 1974-1976 period. Over a large sample of firms, such effects on 6 would likely cancel out (especially since n and L are averaged over a three-year period). Table 3 shows that there were changes in the composition of lease and debt financing of assets for individual firms; Table 2 reports that similar degrees of “overall” leverage were maintained on average in the historic and sample periods. For example, C, is ,619 in the pre-sample. (1974-1976) and ,611 in the sample.




directly relate changes in balance sheet asset figures (investment) to changes in balance sheet liability figures (financing). Such a sources-and-uses inter- pretation is not possible using market values since changes in the market value of equity generally do not represent flows of funds to a company.

Given the variable definitions, Regression (1 ) is estimated using ordinary least squares. As a control for possible heteroskedasticity, all variables are normalized by total assets. Regressions are estimated for each year during the period 1977-1982 as well as for the entire six-year period 1976-1982. In the six-year analysis, changes in nonleasing debt (AhJLD), leasing (A,!,), and assets (AA) represent actual changes for the period 1976-1982. The six-year horizon is used to control for possible deviations from target capital structure that can occur from year to year but average out over time.

IV. Results Ang and Peterson study only capitalized leases versus long-term debt,

the rationale being that both are long-term contractual commitments. ” Panel A of Table 2 shows, however, that in the sample period noncapitalized leases make a much larger contribution to total financing than do capitalized leases. Although the proportion of capitalized leases has increased significantly since the issuance of FASB Statement 13 in 1976, capitalized leases account for only about 35 percent of total leasing in 1982. This is true even after the retroactive application of the Statement, which was effective in 198 1 . Due to the large role played by such noncapitalized but noncancelable leases, it is important to look at a comprehensive measure of leasing to assess its substitutability with debt.

Table 2 also shows that our first two measures of nonleasing debt (NLD, and NLD,) yield almost identical pictures of firms’ use of leasing and debt. For example, the average ratio of leasing to debt is .224 using NLD, and .234 using NLD,. Additionally, these two alternate definitions of nonleasing debt produce essentially identical results in the regression analysis. These similarities show the minor role played by minority interests and deferred taxes for the sample firms. In the rest of the paper, we report results based on only our second and third measures of nonleasing debt.

1 1 . Ang and Peterson measured noncapitalized leasing debt through the footnote disclosure of the present value of noncancelable leases. However, this disclosure has virtually disappeared under Statement 13, which was issued in 1976, shortly after the commencement of the sample period in their study. As a result, the present value of noncancelable leases must now be derived from gross minimum rental commitment disclosures (see footnote 8). It is possible that a number of the “nonleasing” firms in their study had noncapitalized leases, which would tend to distort their comparison of nonleasing and leasing companies and may explain their counterintuitive findings that leasing and nonleasing debt are complements. Our thanks to Pam Peterson for her comments on this issue.




As a preliminary assessment of the degree of substitutability between leases and debt, we partition the sample firms according to increases and decreases in the proportion of assets financed via either leasing or nonleasing debt. Results are presented in Table 3. If the two forms of financing are substitutes, firms that increase their use of nonleasing debt would tend to decrease their use of leasing, and vice versa. Table 3 illustrates that this is clearly the case. Based on a chi-squared test, the distribution is significantly different from a uniform distribution across cells which would be expected if leasing and nonleasing debt had no degree of substitutability. Additional tests show a significant dependence between changes in leasing and nonleasing debt, and that the number of firms (63.8 percent of the sample) along the diagonal is significantly larger than the proportion of the sample in the off diagonal. The evidence from Table 3 thus supports the notion that firms view leasing and nonleasing debt as substitutes.

Table 4 makes additional use of the shifts in debt and leasing financing and reports results of estimating Regression (1). Results using NLD, (both long-term and short-term nonleasing debt obligations) are presented in Panel A and those using only long-term debt (NLD,) in Panel B. Regression results are displayed for each year as well as for the period 1976-1982. In all cases, there is significant explanatory power as measured by the F statistic for the model, and the coefficient B is significantly positive. This supports the view that leasing and nonleasing debt are substitutes.

Panels A and B of Table 4 show, however, that 0 is significantly below unity. To some degree this could be due to a downward bias resulting from measurement error in the leasing variables (ti and AL,) which appear on the right-hand side of the regression. Nonetheless, the results cast doubt on the hypothesis of perfect substitutability between leasing and nonleasing debt at least as measured by balance sheet data. For example, the B estimate of .629 for the 1976-1982 period using NLD2 would suggest that leasing displaces debt only partially and that a dollar increase in leasing would lead to only about a 60-cent reduction in nonleasing debt.

The results in Table 4 also support the appropriateness of using a comprehensive measure of nonleasing debt (NLD,) along with our comprehensive measure of leasing (all contractual lease obligations, whether capitalized or not). Table 4 reports a closer substitutability between leasing and NLD, (long- and short-term debt obligations) than between leasing andNLD, (long- term debt). In all but one period, the coefficient of substitution (B) is closer to unity using NLD,. Furthermore, the explanatory power of the regression drops dramatically when only long-term debt is included in nonleasing debt.

Ang and Peterson find higher debt-equity ratios for leasing firms and interpret this finding as conflicting with the substitutability of leasing and




TABLE 3

Changes in Proportion of Financing Done by Leasing and Nonleasing Debt"

Proporiion of Asseis Financed by Leasing (t = LIA)

Proporiion of Asseis Financed by Nonleasing Debt (n = NLDJA) Decrease Increase

Increase 1 04' 40 Decrease 58 69'

a. Nonleasing debt is defined as NLD,, which includes both long-term and short-term contractual liabilities. Increases and decreases are determined by comparing the period 1977-1982 (average of annual ratios) to the period 1974-1976 (average of annual ratios).

b. The chi-squared statistic calculated to test an equal proportion in each of the four cells is 32.319, which exceeds the critical value of 7.815 (3 degrees of freedom, .05 significance). The calculated chi- squared statistic to test for dependence between changes in n and t is 79.79 and exceeds the critical value of 3.841 (1 degree of freedom, .05 significance). The 63.8 percent of firms (173) on the diagonal is significantly larger than the proportion of firms on the off-diagonal: calculated Z-statistic of 6.69.




TABLE 4

Results of Regression Analysis for Shifts in Leasing and Nonleasing Debt Financing" Model is (ANLD, - NAAj)

= a + p(tj AA, - AL,) + el

A. Nonleasing Debt Measure Is NLD,

Period

1976- 1977

1977- 1978

1978-1979

1979-1980

1980-1981

1981-1982

1976- 1982

Period

1976- 1977

1977-1978

1978- 1979

1979-1980

1980- 198 1

198 1-1982

1976-1982

Intercept, a (t

-.096 (-.72)

,061

,101

-.329

(. 34)

(.56)

(-1.52) -.125

(-.59)

(-2.20)* -.431

-.429 (-.81)

Coefficient of Substitutability, p

(t value)b

.714 (9.99)*

,663 (6.77)*

,839 (9.43)*

,652 (4.87)*

,477 (4.32)*

.661* (5.14)

,629 (5.86)*

t value for Hypothesis'

p = I.0

4.00*

3.44*

1.81

2.60*

4.74*

2.64*

3.46*

B. Nonleasing Debt Measure Is NLD,

Coefficient of t value for Intercept, a Substitutability, p Hypothesis'

(t value)b (t value)b p = I.0

-.136 (-1.14)

,015 (.lo) ,029

(.187) -.342

(-2.02)* ,091

(.45) - ,157 (-.92) -.045 (-. 10)

-.533

-.515 (-7.07)* 6.20*

(-5.55)* 5.23*

(-7.94)* 3.69*

(4.95)* 3.99*

(-4.07)* 3.80*

-.683

-.553

-.517

-.540

-.349 (-5.82)* 4.97*

(-3.52)* 6.56*

R2

,265

,142

,244

,079

.058

.088

,107

RZ

.152

,097

,184

.086

.05 I

,106

,038

a. All regressions have variables normalized by assets. b. t value for hypothesis that coefficient equals zero. c. Since p may be either less or greater than one, a two-tailed test is appropriate. *F value or t value (two-tailed test) is significant at the 95 percent confidence level.

F value for

Model

50*

23*

45 *

13*

9*

14*

17*

F Value

Model for

25.3*

15.5*

31.6*

13.7*

8.4*

17.1*

6.3*




nonleasing debt. Table 5 shows that in our sample high-debt firms use more of both leasing and nonleasing debt than do their low-debt counterparts. Table 5 partitions the sample based on financial leverage as measured by the proportion, c, of assets financed by leasing plus nonleasing debt. The partitioning uses 1974- 1976 leverage ratios. For the period 1976- 1982, the high debt sample financed over 50 percent of its assets via nonleasing debt and almost 20 percent with leasing, as opposed to comparable figures of about 42 percent and less than 10 percent for the low-debt sample. This parallels Ang and Peterson’s findings that use of leasing tends to be associated with use of nonleasing debt.

Taking the evidence together, there is support for Smith and Wakeman’s observation that certain firm characteristics simultaneously provide for use of both leasing and nonleasing debt (Table 5). Importantly, however, the estimated coefficient of substitution (13) between leasing and nonleasing debt is significantly positive, demonstrating that at the margin use of lease financing substitutes for other forms of both short- and long-term debt (Table 4). Although high-debt firms often also do more leasing, they do so at a cost of reducing their capacity for using nonleasing debt as measured by balance sheet data.

V. Conclusions The empirical results of this study support the hypothesis that leasing

and nonleasing debt are substitutes. It is also shown that comprehensive measures of leasing (capitalized plus noncapitalized) and nonleasing debt (short- plus long-term debt) display a closer substitutability than is found using less comparable measures of the two categories of debt-like financing. The apparent “leasing puzzle” posed by earlier research is resolved by comparing changes (rather than levels) of lease and debt financing and explicit recognition of different debt capacities across corporations. High- debt firms often do more leasing than low-debt firms, but they do so at a cost of reducing their ability to finance with nonleasing debt.

Questions about the exact nature of the trade-off between leasing and nonleasing debt are less well answered by the results. The approach adopted here uses firms’ observed financing behavior to ascertain the trade-offs made between nonleasing debt and leasing. On average, it appears that firms reduce nonleasing debt with increases in leasing, but they do so on less than a dollar-for-dollar basis, at least as measured by financial statement data. This behavior may be value creating if firms are able to expand their debt capacity. On the other hand, it may simply reflect inherent differences in risk characteristics of the two instruments, which are properly priced in the market.




TABLE 5

Descriptive Statistics for High-Debt and Low-Debt Firms Entries Are Mean Values

High Debt" Low Debt" Variable N = 136 N = 135

Total assets ($millions) c2 = Leverage ratio (1974-1976) LJ(L, + NLD,) = Leasing to total debt L / A Z = Leasing to assets NLDJA, = Nonleasing debt to assets

$698 ,728 ,275 ,196 ,505

$1,267 ,510 ,192 ,096 ,416

a. The sample firms were ranked by the value of c (1974-1976 average). The high-debt group contains the 136 firms with the highest values of c; the low-debt group makes up the remainder of the sample.

b. Average for period 1976-1982 unless otherwise noted. Averages are defined as the simple average of the variable in the beginning (1976) and ending (1982) periods.




More evidence on these issues must await research making direct use of financial market valuation of corporations. It is clear, however, that managers’ behavior in choosing capital structures on average is consistent with substitutability between leasing and nonleasing debt.

The results have important implications for both financial managers and researchers. It is apparent that leases consume debt capacity. Decisions ignoring this relationship will be suboptimal. This substitutability between debt and leasing implies that measures of corporate capital structure, both for corporate decisions and for research, should incorporate such lease commitments (capitalized and noncapitalized) as forms of contractual obligations. Interesting areas for future research include testing for differences in substitutability between debt and lease financing across different firms and industry groups or across different types of leases (capitalized versus noncapitalized) and examining the effect of leasing and nonleasing debt substitution on the financial market valuation of corporations.

1.

2. 3.

4. 5. 6.

7.

8.

9.

10.

11.

12.

13.

14.

15.

16.

17.

18.

REFERENCES

Abdel-Khalik, A,, The Economic Effects on Lessees of FASB Statement No. 13, “Accounting for Leases” (Stamford, Conn.: FASB, 1981). Ang, J., and P. Peterson, “The Leasing Puzzle,” Journul of Finunce (September 1984). Bayliss, M., and J. Diltz, “An Empirical Study of the Debt Displacement Effects of Learning,” Finuncial Management (Winter 1986), pp. 53-60. Bower, R., ‘‘Issues in Lease Financing,” Finuncial Management (Winter 1973), pp. 25-34. Brealey, R., and S . Myers, Principles ofCorporate Finunce (New York: McGraw Hill, 1981). Brealey, R. A., and C. M. Young, “Debt, Taxes and Leasing-A Note,” Journul of Finance (December 1980). pp. 1245-1250. Cooper, I., and J. Franks, “The Interaction of Investment and Financing Decisions When the Firm Has Unused Tax Credits,” Journul of Finance (May 1983), pp. 571-583. Crawford, P., C. Harper, and J. McConnell, “Further Evidence on the Terms of Financial Leases,” Finuncial Manugement (Autumn 1981). pp. 7-14. Franks, J., and S. Hodges, “Valuation of Financial Leases: A Note,” Journal of Finance (May

Hodges, S . , and J. Franks, “Lease Valuation When Taxable Earnings Are a Scarce Resource,” London Business School Working Paper (March 1985). Jalilvand, A., and R. Harris, “Corporate Behavior in Adjusting to Capital Structure and Dividend Targets: An Econometric Study,” Journul of Finunce (March 1984), pp. 127-144. Klein, B., R. Crawford, and A. A. Alchian, “Vertical Integration, Appropriable Rents, and the Competitive Contracting Process,” Journul of Law and Economics (October 1978), pp. 297-326. Lewellyn, W., M. Long, and J. McConnell, “Asset Leasing in Competitive Capital Markets,” Journul of Finunce (June 1976), pp. 787-798. McGugan, V., and R. Caves, “Integration and Competition in the Equipment Leasing Industry,” The Journal of Business (July 1974), pp. 382-396. Marsh, P., “The Choice between Equity and Debt: An Empirical Study,” Journal ofFinance

Miller, M., and C. Upton, “Leasing, Buying, and the Cost of Capital Services,” Journal of Finunce (June 1976), pp. 799-818. Myers, S., D. Dill, and A. Bautista, “Valuation of Financial Lease Contracts,” Journal of Finunce (June 1976). pp. 799-818. Offer, A., “The Evaluation of the Lease versus Purchase Alternatives,” Finuncial Manugement (Summer 1976), pp. 67-74.

1978). pp. 657-669.

(March 1982), pp. 121-144.



164 19.

20.

21.

22.

23.

24.

JOURNAL OF ACCOUNTING, AUDITING & FINANCE

Roberts, G., and A. Gudikunst, “Equipment Financial Leasing Practices and Costs: Comment,” Financial Management (Summer 1978), pp. 79-81. Schall, L., “The Lease or Buy and Asset Acquisition Decisions,” Journal of Finance (September 1974), pp. 1203-1214. Smith, C., “Alternative Methods for Raising Capital: Rights versus Underwritten Offerings,” Journal of Financial Economics (December 1977). pp. 273-307. Smith, C., and L. Wakeman, “Determinants of Corporate Leasing Policy,” Journal of Finance

Sorensen, I., and R. Johnson, “Equipment Financial Leasing Practices and Costs: An Empirical Study,” Financial Management (Spring 1977). pp. 33-40. Taggart, R., “A Model of Corporate Financing Decisions,” Journal ofFinance (December 1977),

(July 1985), pp. 895-908.

pp. 1467-1484.



Substitutability of Leases and Debt in Corporate ... - CiteSeerX

Documents

Transcript of Substitutability of Leases and Debt in Corporate ... - CiteSeerX