The Determinants of Synthetic Lease Financing and the Impact on the Cost of Future Debt

Abstract:     
The synthetic lease is a hybrid financing structure that allows a company to obtain many of the benefits of asset ownership, including capital lease treatment for tax purposes, while treating lease payments as operating expenses on the firm's income statement. Proponents of these off balance sheet transactions argue that the economic benefits to the firm and its shareholders outweigh the costs of complexity and opacity, while critics argue that the benefits of these transactions are the result of short-sighted opportunistic behavior by managers that lead to wealth extraction at the expense of other groups of stakeholders. I jointly examine (1) whether the structure of the synthetic lease provides favorable financing terms for firms that choose this type of transaction, and (2) the economic and financial accounting incentives that influence the manager's financing choice. I find evidence that supports both economic benefits associated with the lease, as well as managers using synthetic lease financing for opportunistic gains. Tests examining the role of the board of directors in the financing decision help to reconcile these two findings, as strong boards serve as a substitute for the opacity of the transaction, and prevent managers from opportunistic behavior. I also find that synthetic lease users have lower costs associated with future bank debt, and these savings do not appear to be the result of withholding information about the synthetic lease from lenders.

Number of Pages in PDF File: 47

Keywords: leasing, off-balance sheet financing, governance, disclosure

JEL Classification: G12, G32, G34, M41, M43, M46, M25

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