Harvard Summer School

Financial Modeling (SSAM S-409, 31834) Summer 2006

Instructor: Miranda Lam, Ph.D. CFA

Lease versus Buy

Description
Lease versus buy is a common financing decision faced by financial managers. There are three major
types of leases: sales-and-leaseback arrangements, operating leases and capital leases. The lease examined
in this exercise is an operating lease. This type of lease arrangement usually provides both financing and
maintenance but is not fully amortized. In other words, the payments required under the lease contract
are not sufficient to recover the full cost of the equipment and the contract is written for a period
considerably shorter than the expected economic/mechanical life of the equipment. A final feature of
operating leases is that they frequently contain a cancellation clause, which gives the lessee the right to
cancel the lease before the expiration of the basic agreement usually with a penalty.
Modeling Goal
In this example, we will apply financial functions, the Data Table command and the Goal Seek command
in Excel.
Instructions
Your company needs to replace a machine and your responsibility is to decide which is the better financial
option: leasing or buying the machine with a loan. The machine has a useful life of 8 years but the lease
contract is only 4 years. For tax purposes, the machine falls into the 3-year class life under MACRS. If
you purchase the machine, you will finance the entire purchase price with an amortized loan over 4 years.
Since the cash flows of the two options differ each year, the easiest way to compare the two is to
summarize the cash flows into present values.

(Excel Tip: Start with the workbook you created for MACRS. Save it under a new name.)
Assumptions (Part A)
Lease term
Machine Cost
Marginal tax rate
Interest on Debt
Inflation Rate
Estimated resale value at the end of the lease
Revenue
Operating Expenses
Maintenance Cost
Lease Payment

4 Years
$90,000 Today
40%
15%
5%
$35,000 (in year 4)
$80,000 In year 1
$40,000 In year 1
$9,000 In year 1
$25,000 Per year

Model Structure
Cash flows if the machine is purchased with a loan:
For years 1 through 3
Revenue, operating costs, and maintenance costs grow with inflation and occur at the end of
each year
Depreciation expense: use your user-defined function ACRS3
EBIT = revenue all costs - depreciation
Interest expense: use EXCELs IPMT function
EBT = EBIT interest expense

Taxes = EBT * Marginal tax rate

Net Profit = EBT Taxes
Operating Cash Flow (OCF) = EBIT Taxes + Depreciation
Principal payment: use EXCELs PPMT function
Total Net Cash Flows = OCF - Interest expense Principal payment
For year 4
Net proceed from machine sale at the end of the project = resale value tax on capital
gain/loss
Tax on capital gain/loss = (Resale value book value) * marginal tax rate
Book value: use your user-defined function.
Total Net Cash Flows = OCF interest expense Principal payment + Net proceed from
machine sale

Cash flows if the machine is leased:

Revenue and operating costs grow with inflation and occur at the end of each year.
Lease payments are fixed through out the contract. Regular lease payments are due at the end
of each year plus a one-year non-refundable deposit due when the contract is signed at year 0.
EBT = revenue all costs
Taxes = EBT * Marginal tax rate
Operating Cash Flow (OCF) = Net Profit = EBT Taxes
Decision Variables:
For simplicity, we will use one discount rate for all cash flows. Since the alternative to
leasing is borrowing, the discount rate (opportunity cost) is the after-tax interest rate.
NPV of Buy
NPV of Lease
Bottom-line Variable:
Net Advantage to Leasing (NAL) = NPV of Leasing - NPV of Buy
To obtain more information before we decide on the financing strategy, we will perform sensitivity
analysis on two input parameters: lease payments and the estimated resale value at the end of the lease.
Use the DATA TABLE command in Excel to perform sensitivity analysis on the Net Advantage to
leasing. Vary lease payments from $20,000 to $30,000, in increments of $1,000, and resale values from
$0 to $40,000, in increments of $5,000. Challenge: Present your analysis in words rather than numbers.
Display the word Lease if leasing is the better option and display the word Buy if buying is the better
option.)
Break-even or indifference analysis is another important analytical tool in finance. Since we are choosing
between two options, it is useful to know what lease payment makes you indifferent between buying and
leasing. Use the GOAL SEEK or the SOLVER command to find the break-even lease payment.