Financial Lease Evaluation under Conditions of Uncertainty: A Comment

Author(s): M. Chapman Findlay, III

Source: The Accounting Review, Vol. 49, No. 4 (Oct., 1974), pp. 794-795
Published by: American Accounting Association
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 Financial Lease Evaluation Under Condi-
tions of Uncertainty: A Comment
M. Chapman Findlay, III
H AROLD WYMAN'S recent article on
lease evaluation' reviewed the one-
parameter, after-tax interest cost
equivalent model of Beechy and Mitchell,
which computed an internal rate of return
by equating the cost of the asset leased
with (1) the after-tax lease payments
minus operating costs saved;2 (2) the de-
preciation tax shield lost; and (3) the after-
tax residual value lost.3 Wyman then
demonstrated that, by depicting the oper-
ating costs saved and residual value with
probability distributions, it was possible to
simulate a cumulative probability distri-
bution of interest cost equivalents. Finally,
various methods of employing the dis-
persion information so generated in com-
parison with debt or other leasing alterna-
tives were discussed. Although we have no
criticisms with the use of simulation to
obtain mathematical expectations for use
in the one parameter model, it is our con-
tention that Wyman's extension of the
model into uncertainty (i.e., Knightian
risk) is seriously flawed.
It must first be borne in mind that the
savings on operating costs and the loss of
the residual value are included in the cost
of leasing model because they represent
cash flows which would occur if the asset
were owned and, as such, are opportunity
costs of leasing. The greater the dispersion
of operating costs to be absorbed by the
lessor or residual value, the greater the
794
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risk of owning the asset and, accordingly,
the greater the desirability of a lease which
would relieve the firm of these risks. Un-
fortunately, Wyman's technique attributes
these risks to the lease.4 Thus, if a lease
were offered on a piece of equipment with
wildly uncertain operating costs and re-
sidual value, the Wyman model would
show the lease to be highly risky. Further-
more, although he is very careful to avoid
the endorsement of any selection criterion,
the possible criteria which he mentions
would invariably penalize such a lease in
I would like to thank my colleague, G. A. Whitmore,
for helpful suggestions on this comment.
1 Harold E. Wyman, "Financial Lease Evaluation
Under Conditions of Uncertainty," THE AccOUNTING
REVIEW (July 1973), pp. 489-93.
2 The term "operating costs saved" refers to those
costs which would be borne by the owner of the asset
and included in the capital budgeting decision but,
under the terms of a given lease, are absorbed by the
lessor. Possible examples would include insurance,
maintenance, and property taxes. Ibid., p. 490.
3 Thomas H. Beechy, "Quasi-Debt Analysis of Finan-
cial Leases," THE ACCOUNTING REVIEW (April 1969),
pp. 375-81. G. B. Mitchell, "After-Tax Cost of Leas-
ing," THE AccOUNTING REVIEW (April 1970), pp. 308-
14. Thomas H. Beectly, "The Cost of Leasing: Com-
ment and Correction," THE AccOUNTING REVIEW
(October 1970), pp. 769-73.
4Because opportunity cost models in general involve
the analysis of differential cash flows, variation in either
the alternative under analysis or the opportunity fore-
gone will cause the opportunity cost to vary. Great care
must thus be employed in the allocation and interpre-
tation of this "risk."
M. Chapman Findlay, III, is Associate
Professor, Faculty of Management, McGill
University.
Findlay: Lease Evaluation: Comment I
relation to other leases or borrow-buy
options. Yet, the situation posited is the
ideal case for leasing by any risk-averse
firm.
Not only is the implied interpretation of
the output of the Wyman model at best
misleading, but also it appears that no
correct economic interpretation can be ap-
plied to the data. In terms of the output of
the model, a lease would increase in its de-
sirability to a risk-averse firm to the extent
its cost distribution exhibited (1) a low
mean, (2) a large variance, and (3) left-
ward (in the direction of lower costs)
skewness. Although the first and third cri-
teria conform to the received theory of
choice, the second criterion is exactly re-
versed. It would appear that no decision
models exist which trade lower cost off
against lower variance, nor is it at all clear
how such models would be derived.
Finally, we must conclude that the
above difficulties reflect a misconceptual-
ization of the problem at hand. Under the
going concern assumption, a firm must
presume that it will pay its own debts (at
least at the time such debts are con-
tracted). Thus the cash flows for which the
firm is obligated under a financial lease
are essentially certainties from the stand-
point of the firm, and the entire discussion
of the risk to the firm of leasing as a source
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795
of finance is suspect.5 This suspicion is
strengthened by the fact that the sources
of risk in the Wyman model are operating
(i.e., operating costs and residual value)
flows, not financial (i.e., lease payment)
flows.6
To the extent that the terms of a lease
significantly alter the risk of a proposed
investment, then, in effect, a second in-
vestment proposal has been created. One
provisionally-appropriate analytical ap-
proach would be to remove the equivalent
financing costs (computed at the cost of
debt or another appropriate rate) from the
lease cash flows and then treat the
purchase-lease decision as a mutually ex-
clusive capital budgeting decision under
uncertainty. More sophisticated approaches
would also consider portfolio and capital
structure effects, and it appears from on-
going research that ultimate resort must
be made to the capital asset pricing model
(or even time-state-preference theory) for
a truly theoretically satisfying treatment
of the topic.
I Of course, the use of leasing will affect
the risk of,
and thus the cost of funds from, other sources of finance,
but Wyman does not address the capital structure prob-
lem of leasing.
6 Thus, just as much of the earlier literature on leas-
ing was filled with charges of mixing the investment and
financing decisions, the model discussed here could be
liable of confusing investment and financial risk.