ACC412
Management Accounting I
Module 4 (A)
Lease OR Buy Decisions
By:
E. P. Enyi, Ph.D, MBA, ACA, FAAFM, RFS, MFP, FIIA
Head, Dept of Accounting, Covenant University,
Ota, Nigeria
LEASE
• A lease is an agreement for the use of an
asset for a specified period of time.
• It is a method of credit finance for asset
acquisition.
• It is practiced mostly in financial and
financially conscious institutions where
there is need to conserve operational
funds in order to avoid tying down funds in
illiquid assets.
• Some organizations practice the selling of
their own assets in order to lease it back
from the buyer.
• Others finance the acquisition of assets for
clients in order to lease back from those
clients. This way both organizations
benefit from the cost of funding the
acquisition and lease. While the first
benefits from interests on loans used in
acquisition, then second benefits from the
interests on lease rentals.
Why do we Lease?
• To conserve operational funds.
• To take advantage of tax concessions on
lease rentals and capital allowances on
the leased assets.
• To get access to loans which ordinarily
would not have been made available in
cash or other normal sources.
• To acquire assets ordinarily out of the
reach of finances of the lessee.
Types of Leases
• Operating Lease: This is a short term
cancelable lease which risk of obsolescence is
borne by the lessor (ie the owner of the asset).
• Finance Lease: This is a long-term noncancelable lease with all risks borne by the
lessee (ie the user of the asset). This type of
lease involves fixed obligations in the form of
lease rentals; thus, it is like a debt and must be
evaluated that way.
Benefits of Leasing
• A lease can benefit both lessor and lessee
where tax rate differs;
• Leasing pays if the lessee’s marginal tax
rate is less than that of the lessor. In fact,
in a lease, the lessee sells his depreciation
tax shield to the lessor but gains with the
lease rentals which are tax deductible.
• It is a ready source of capital in a no-easy
loan situation.
Management Accounting
Dimension
• Given the lease rentals and tax shields on
depreciations, it is possible to find the amount of
debt which a given set of cash flows (lease
rental payments) can service. This is known as
the equivalent loan.
• If the equivalent loan is more than the cost of the
asset, then leasing is not advisable.
• A lessee is not entitled to claim depreciation on
the asset under lease as that is the right of the
lessor.
Net Advantage of Lease (NAL)
• The NAL is the value obtained from
comparing the benefits of the lease over
its costs.
• It can be calculated by discounting the
after-tax lease rentals and depreciation tax
shields using the after tax borrowing rate
and discounting the salvage value of the
asset and the operating costs using the
firm’s cost of capital.
Other Methods of Lease Valuation
Other methods of valuing the cost of lease
include:
• The Equivalent Loan (EL) method; and
• The Internal Rate of Return (IRR) method.
The Equivalent Loan (EL) Method
The Equivalent Loan (EL) is that amount of loan
which commits a firm to exactly the same
equivalent stream of fixed obligations as does
the lease liability. The outline of the method is
as follows:
1. Work out the incremental cash outflows from
leasing.
2. Determine the amount of equivalent loan such
cash outflow can service.
3. Compare the equivalent loan with the total cost
of the lease finance and make your deduction.
The process of EL computation can be
represented with the following formula:
n
EL = ∑ {((1-t)L+TDt) / (1-i(1-t))t}
t=1
Where;
t = Elapsed time
L= Lease rentals
T= tax rate
D= depreciation
i = interest rate or cost of capital
n = assets useful life
The IRR Method
The IRR method uses the equilibrium approach by
favoring lease proposals which produces a NAL
equal to zero at their terminal points. IRR is that
cost of capital which equates the NAL with the
cost of the lease. The method:
• Uses the NPV approach to appraise lease
proposals.
• Not a popular method and mostly ignored.
IRR Method Formula
The IRR method of computing NAL is given in the
following formula:
n
IRR = A – {∑[((1-T)L-O) +TD / (1-r) ] – [S /(1+r) ] }
t
t
t=1
Where;
n, t, L, T, D are as defined earlier
A = Assets Value
O = Operating Cost
S = Salvage Value
r = interest rate
t
n
n
Illustration
Mecholux Limited is considering whether to buy or
lease a special equipment which the off-the-shelf
value is put at N4million. The equipment has a
useful life of 10 years and would be sold as a
scrap for N500,000 at the end of its useful life.
The lease option carries a rental charge of
N850,000 per annum. Presently, the company’s
cost of capital is 20% and the current tax rate is
30%. If the cost of borrowing is fixed at 20%,
what option should the company pursue?
Solution
Using the NAL method we have:
i. After tax lease rentals = 850,000 x ((10030)/100) = 595,000
ii. After tax discount rate on the basis of
cost of debt = 20% X 70% = 14%
iii. Cumulative discount factors for 10 years
at 14% = 5.214; – this will be used to
calculate the present values of the after
tax lease rentals and the tax shields on
the lost depreciation of the asset should
it be leased and not purchased.
iv. The discount factor for year 10 at 20% cost of
capital = 0.161; - this will be used to calculate
the present value of the salvage value of the
asset.
NOTE: The opportunity cost of leasing the
equipment is the same as:
a. The loss of tax shields on depreciation (ie
capital allowances) forfeited to the lessor; and
b. The loss of the sales value of the asset’s
salvage value which is also forfeited to the
lessor as well.
These opportunity costs should either be added to the cost
of the lease or subtracted from the cost of purchasing the
asset off the shelf. Either way will give the same result.
We shall use the two methods described immediately
above to attempt the solution as follows:
First Method (subtract from cost of purchase):
Buy Option
Purchase Cost (Year 0)
Less: Discounted Salvage Value
Discounted Tax Shields
N
Note
N
4,000,000
80,500 (i)
547,470 (ii)
a) NET PURCHASE COST TO THE COMPANY
627,970
3,372,030
Lease Option
b) TOTAL DISCOUNTED LEASE RENTALS
c) NET LEASE ADVANTAGE (NAL) (a-b)
(iii)
3,102,330
269,700
Second Method (Add to the Cost of Lease)
Buy Option
a) Purchase Cost (Year 0)
N
Note
N
4,000,000
Lease Option
Total Discounted Lease Rentals
Add: Opportunity Costs
Lost Salvage Value
Lost Tax Shields
b)
c)
(iii)
3,102,330
N
80,500 (i)
547,470 (ii)
Net Cost of Leasing
NET ADVANTAGE LEASE (NAL) (a-b)
627,970
3,730,300
269,700
We can see that both methods produced the same positive
NAL figure of N269,700. This means that the company
will save costs up to N269,700 by leasing the
equipment rather than purchasing it.
Though it may seem that the company will spend
more on leasing from unenlightened point of
view given that 850,000 into 10 years will
amount to N8.5million (ie N4.5m higher than the
cost of the asset), it is the duty of the accountant
to show the effect of time value of money on
such investment decisions. For instance, it will
pay the company to spend 850,000 in year 0
and invest the balance of N3.15million in a
better interest yielding venture especially if the
rate of return on such investment is greater than
its cost of capital. That is to say that this unspent
amount when properly invested can generate
returns far exceeding the cost of the extra sum
of N4.5million spent on leasing over the period.
Notes
i.
ii.
Salvage value = 500,000 X 0.161 = N80,500
Tax Shields on Depreciation = ((4,000,000500,000) / 10) x 30% = 105,000; then 105,000
x 5.214 = N547,470
iii. Total Lease Rentals = 595,000 x 5.214 =
N3,102,330
Class Work: Assuming the yearly lease
payments were to be increased to N920,000
p.a.; with other data remaining as before, is it
still profitable to lease the equipment?