1
Solution to Case
34
Lease Versus Buy Analysis
Why
B
uy
I
t
W
hen
Y
ou
C
an
L
ease
I
t?
Questions:
1.
What are the different kinds of leases available and which one would be
best
suited for Paulo’s restaurant? Explain why.
Leases can be broadly categorized
into two types, financial and operating.
Financial leases are generally longer
term, fully amortized, and not cancelable
without a hefty termination penalty. Operating leases are usually shorter
term,
partially amortized, and cancelable on short notice.
Financial leases are required to
be reported on a firm’s balance sheet while operating leases are not. With
a
financial (operating) lease, the lessee (lessor) is usually responsible for
maintenance, taxes, and insurance.
Since the equipment under con
sideration involves heavy use and wear and tear, and
possibly technological developments that could improve operating
efficiency, Paulo
should go for an operating lease and let the lessor take care of the
maintenance.
2.
Calculate the net advantage to leasin
g (NAL) the restaurant equipment. It is
assumed that the old equipment has no resale value whereas the new
equipment would have a salvage value of $30,000 after 5 years. The
restaurant’s tax rate is estimated to be 40%.
2
3.
What typically happens to th
e leased equipment after the term of the lease
expires?
After the term of the lease expires the leased equipment is typically leased
out again
(in case of an operating lease) or sold in the used market. Its fate depends
on the
type of equipment, technolo
gical developments in the field, as well as the economic
and financial conditions of the market.
4.
After doing all the calculations, Paulo realizes that he underestimated the
cost savings that would result from improved efficiency by $1000 per year.
How sh
ould this error be handled? Is it relevant? Explain.
As can be seen from the cash flows in #2 above, cost savings are irrelevant
in the
case of lease versus purchase decisions since they would benefit both
alternatives
leaving a net advantage of zero.
5.
H
ow should depreciation and taxes be accounted for in the calculations?
Depreciation is a tax write
off available to the owner. It results in a tax saving
equal to the annual depreciation charge times the corporate tax rate of the
owner.
When the equipme
nt is leased, therefore, the lessee loses the depreciation tax shield.
Taxes must be adjusted for when calculating the salvage value (if any), the
lease
payments, and any operating cost savings. The analysis must be done net
of taxes.
Lease Versus Buy
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
LEASE
After-tax Lease Payment=25000(1-T)
($15,000)
($15,000)
($15,000)
($15,000)
($15,000)
Lost Depreciation tax shield=Dep(T)
($13,332)
($17,776)
($5,928)
($2,964)
$
Maintenance cost saving=Maint.Cost(1-T)
$1,200
$1,200
$1,200
$1,200
$1,200
Avoidance of upfront cost
$100,000
Loss of after-tax salvage value in year 5
($18,000)
Total Cash flows of leasing versus buying
$100,000
($27,132)
($31,576)
($19,728)
($16,764)
($31,800)
Cost of Lease
8.70%
After-tax cost of borrowing
6%
DECISION
BORROW AND BUY
Note: The cost savings and buy option ($40,000) would be irrelevant
3
6.
If the equipment
were to be leased, would the lease payments be tax
deductible? Explain.
Yes, lease payments are tax deductible just like interest payments on debt.
7.
If AAA Leasing Company’s tax rate is 40%, what is the minimum lease
payment that it would be willing to
accept? Explain.
The minimum lease payment that AAA Leasing Company would be willing
to
accept is $22,110. It can be calculated by first finding the present value of
the other
relevant cash flows that would be involved during years 0
–
5 using the afte
r
tax
discount rate of 6% (= $44,118.77). Next, we minus this value from
$100,000
(=$55881.23), and calculate the 5
year annuity which would equal $55881.23 at a
discount rate of 6% (=$13,266). Finally, we calculate the before
tax value of
$13,266 given
a tax rate of 40% (i.e. $13,266/(1
Tax rate)=$22,110).
8.
What is the maximum lease payment that Paulo should be willing to pay?
Explain.
The method to calculate the maximum payment that the lessor should be
willing to
pay is the same as explained in #5
above. If the lessor and lessee have the same tax
rate, the maximum lease payment that the lessee would be willing to pay
would be
equal to the minimum payment that the lessor would be willing to accept i.
e
$22,110
9.
How much of an impact does the forecas
t of the salvage value of the new
machine have on the lease versus buy decision?
The after
tax salvage value of the new machine is discounted for 5 years at 6% and
treated as a negative cash flow for the lessee, when analyzing the lease
versus buy
decisio
n. Thus, to figure out the impact of the salvage value on the lease versus
buy
decision we can do the following:
1.
Calculate the present value interest factor at the discount rate (6%)=.747
2.
Next multiply this factor by 60%, since 60% of the salvage value i
s
discounted and treated as a negative cash flow = 0.747*.6 = .4482
3.
Thus the forecast of the salvage value can affect the NPV by about 45%.
4
10.
If Paulo leases the equipment, what impact would it have on the firm’s debt
capacity?
If Paulo uses an operati
ng lease for the equipment, the $100,000 will not affect the
debt level or the debt ratios of the
firm.
11.
Does the size of the business play any role in lease versus buy decisions of
this
type?
Yes, the size of a business is often an important determinan
t of the amount and
interest rate of debt that a firm can get. Accordingly, as shown earlier, the
size of a
firm can help determine whether the cost of borrowing will be below the
cost of
leasing the equipment.
12.
Does the type of asset under consideration
have much effect on the lease
versus buy decision?
Once again, the type of asset can determine the rate and amount of
financing which
in turn will help determine whether it would be cost effective to lease the
asset or
not.
Additionally, the type of asse
t under consideration will determine the applicable
depreciable life of the asset, which in turn affects net after
tax cash flows.
13.
Are there any other factors that need to be considered in a lease versus
borrow and buy decision of this type? Explain.
So
me other factors that need to be considered include:
1.
Is there a need to circumvent capital expenditure systems?
2.
Are there any tax advantages?
3.
Is there a need to reduce uncertainty about future salvage
value?
4.
Transactions cost differences.
14.
All things cons
idered, should Paulo lease or borrow and buy the equipment?
Explain.
Based on the calculations shown above, Paulo should borrow and buy the
equipment because the after
tax cost of borrowing (6%) is less than the leasing cost