Are Leases and Debt Substitutes? Evidence from Belgian Firms

Financial Management (Financial Management Association), Summer, 1999 by Marc Deloof, Ilse Verschueren

Finance theory suggests that leases and corporate debt are substitutes. Both leases and debt are fixed, contractual obligations that reduce the firm's debt capacity. Greater use of lease financing should therefore be associated with lower conventional debt financing. However, the empirical evidence on this issue is mixed. Ang and Peterson (1984), applying Tobit analysis to a cross-sectional sample of 600 large US firms over the 1976-81 period, find that leases and debt are complements. Adedeji and Stapleton (1996) find a positive but insignificant relationship between leases and debt for a sample of about 570 UK firms over the 1990-1992 period. For a restricted sample of only the firms using lease financing, however, they detect a significantly negative relationship, which confirms the substitution hypothesis. The results of other studies (Mukherjee, 1991; Krishnan and Moyer, 1994; and Sharpe and Nguyen, 1995) also indicate that leases and debt are substitutes.

The contribution of the present article is to test the substitution hypothesis for a sample of 1,066 large Belgian non-financial firms for the 1992-1994 period. The dataset distinguishes several different debt categories, including intra-group loans, which play a significant role in the financing of fixed investments in Belgium (see Deloof, 1998).

Most existing studies of leasing concern countries where the lessor is treated as the owner of the assets. This has tax consequences, which may influence choices about leases and debt. In the US, for example, the lessor can deduct depreciation on the leased assets from its taxable income, while the lessee is allowed to deduct rental payments as operating expenses, If, for example, the lessee pays little or no corporate tax, it can pass on the depreciation deductions to the lessor in return for lower rental payments. If lessee firms can sell excess tax shields through leasing, the tax benefit of debt financing increases; therefore, debt and leases may well be complements (Lewis and Schallheim, 1992).

In the Belgian leasing system, by contrast, the lessee is considered to be the fiscal owner of the assets, and thus the lessee may write off these assets for tax purposes. The interest part of the lease payments is also deductible from the lessee's taxable income. Thus tax differences between lessor and lessee do not matter (see Durinck, Jansen, Laveren, and Van Hulle, 1990 for a comparison of the impact of taxation on leases in Belgium and the US). A further contrast with the Anglo-Saxon world is that in Belgium capital markets play only a minor role in corporate finance. Bank loans and intra-group financing are the main forms of long-term external financing.

I. Data and Methodology

Our sample draws on the National Bank of Belgium's database containing the financial statements of the 2,000 most important non-financial Belgian firms. The sample is constructed as follows. Because of the specific nature of their activities, firms in NACE-industries I ("energy and water"), 8 ("banking and finance, insurance, business services, renting"), and 9 ("other services") are excluded.(1) Firms with missing data and/or with extreme values of the variables in our model were also removed from the sample, as were firms reporting zero sales during the period considered, firms with extreme changes in sales or total assets, and firms without assets that can be leased. The final sample contains 1,066 firms.

Following Ang and Peterson (1984) and Adedeji and Stapleton (1996), we estimate a model of the determinants of the lease ratio (defined as financial leases as a share of total assets), which includes long-term debt ratios and a set of factors determining the overall debt ratio of a non-leasing firm. In order to investigate whether leases and long-term debt are substitutes, we consider five different long-term debt categories: three types of financial debt, trade debt, and other debt. The financial debt categories are bank debt, "other loans," and "other financial debt," which includes subordinated loans and debenture loans. Bank debt and "other loans" are the most important types of financial debt in Belgium. "Other loans" are almost exclusively intra-group loans (see Deloof, 1998). All debt variables are expressed relative to total assets.

The specification of the factors determining the debt ratio of a non-leasing firm is based on our model of the capital structure of Belgian non-financial firms, as estimated in Deloof and Verschueren (1998). Profitability is calculated as income before taxes, extraordinary income and charges, and indebtedness expenses, expressed as a proportion of total assets. Variability of income is measured by the standard deviation of profitability over the 1989-94 period. Size is measured as the natural logarithm of total assets. As a measure of investment opportunities, we use the average percentage rate of total assets growth during the 1992-94 period. Finally, in order to account for the differences in the nature of assets among firms in our sample, we include the ratio of current assets to total assets and the ratio of fixed financial assets to total assets. Fixed financial assets are mainly shares in affiliated firms and receivables from these firms. For some firms such assets are a significant part of total assets. In Deloof and Verschueren (1998), we found that both the current assets ratio and the fixed financial assets ratio have a significant influence on capital structure. All variables, except the variability measure, are averages from the balance sheets or income statements for the 1992-94 period. In order to check for industry influence, we included six NACE-code-based industry dummies in our regressions but found no significant industry influence (results not reported).