Solution to Case 34

Lease Versus Buy Analysis

Why Buy It When You Can Lease It?

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 consideration 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 leasing (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%.

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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. What typically happens to the 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, technological 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 should 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. How 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 equipment 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.

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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 after-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 forecast 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
decision. 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 is
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%.

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10. If Paulo leases the equipment, what impact would it have on the firm’s debt
capacity?

If Paulo uses an operating 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 determinant 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 asset 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.

Some 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 considered, 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
(=8.7%)