APPLIED MANAGEMENT ACCOUNTING AND FINANCE MAF 402

MANAGEMENT ACCOUNTING AND FINANCE DEPARTMENT

CERTIFICATE OF THEORY IN ACCOUNTING

LEASE VS BUY DECISION

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APPLIED MANAGEMENT ACCOUNTING AND FINANCE MAF 402

1. Introduction
A lease is a contract that provides a right to the use of assets,
legally owned by the lessor, in exchange for a specified rental paid
by the lessee. Leasing is a widespread form of medium-term and
long-term financing and the growth in lease financing has been
extraordinary. This chapter explores the use of a discounted cash
flow approach using the cost of debt as the relevant discount rate.

2. Study unit objective

At the end of the unit, students should be able to:

• Describe a direct lease, sale and lease-back and a leveraged lease

• Explain the advantages of leasing
• Evaluate the leasing decision and alternative sources of finance using discounted cash
flows
• Select and justify an appropriate discount rate, and
• calculate the net present cost of the various financing alternatives and the net
advantage of leasing

3. Prescribed study material

"Financial Management".9"Edition, Carlos Correia, Enrico Uliana & Michael Wormald
(2011), Juta – Chapter 15

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4. Study unit content

4.1. Types of leases

Operating lease

An operating lease is an arrangement which provides an alternative means of obtaining the

use of an asset without purchasing. These leases are normally characterised by the term of
the lease being short in relation to the useful life of the asset being leased. Owing to the short-
term nature of the lease, the lessor frequently intends to either lease the asset again or sell
it at the termination of the lease. It would not be the intention of the lessee to acquire the
use of the asset on a permanent basis. The lessor would normally assume responsibility for
the maintenance and insurance of the asset. Frequently, operating lease agreements make
provision for cancellation and a required notice period would be stipulated. This cancellation
could be at the option of the lessee or lessor.

Finance lease

A financial lease has the following characteristics. The lease payments provide the lessor with
reimbursement for the cost of the leased asset, plus interest. Often the lease agreement
allows the lessee the option of buying the asset at the termination of the lease. Maintenance
and insurance of the asset are usually the responsibility of the lessee. Financial leases are
most commonly used to finance the acquisition of motor vehicles, equipment, and plant.

4.2. Methods used to acquire assets under leases

Direct lease

In a direct lease, the lessor acquires an asset from the manufacturer in order to lease it to the
lessee. A direct lease is the most straightforward of the financial leases, and also the type
most frequently encountered.

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Sale and lease-back

A sale and lease-back form of lease can be employed in connection with existing or new
assets. A firm sells an asset under an agreement to lease it back from the buyer. In exchange
for the asset the selling firm obtains cash, and as the future lessee, the long-term right to the
use of the asset. On the other hand, the lessor pays out cash but obtains the legal right to the
asset and the right to lease instalments. At the end of the lease agreement there may be
provision for the lessee to repurchase the asset at a specified price.

Leveraged lease

With a leveraged lease, the lessor does not provide all the funds required to purchase the
asset that is to be leased. The balance of the funds would be obtained from other financial
institutions and the lease payments made by the lessee are then used to service these loans.
Any excess of the lease payment after the loan coverage is retained by the lessor.

4.3. Advantages of leasing

1. Changing technology - In some industries the rate of technological change is rapid, so

an advantage of leasing is that the term of a lease can be considerably shorter than
the life of the leased asset.
2. Tax advantages - Under certain conditions a lease can result in lower combined
taxation paid by the lessor and the lessee relative to the tax paid if the lessee were to
buy an asset.
3. Operating flexibility - Companies may be able to react more quickly to changes in
market conditions. For example, an airline may change routes more quickly and more
cost effectively if it is able to lease the right type of aircraft for certain routes.
4. Reduction in operating leverage - In some cases and for particular assets, a company
may be able to enter into an agreement that requires the company to pay an amount
per use rather than per period. This will result in changing a fixed cost to a variable
cost and lessors are able to charge a greater fee.

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4.4. Evaluating the leasing decision

There has been considerable debate as to whether the decision to lease is an investment
decision or a financing decision. The two schools of thought are based on the premise that
the evaluation is ‘lease versus purchase’ or ‘lease versus borrow’ respectively, which is a
financing decision.

The attractiveness of a lease proposal should thus be evaluated in terms of the present
value of the differential cash flows relative to the borrow-and-buy alternative. It should
be noticed that, once again, we are about to evaluate cash flows using the present-value
technique to consider the time value of money. To conduct such an analysis, we need to
identify firstly an appropriate discount rate, and secondly the relevant cash flows for the
analysis.

4.4.1. Selecting the appropriate discount rate

With a leasing decision, management are examining a financing decision and so the
appropriate discount rate is the after-tax cost of debt. As the cash flows associated with
leasing would be much more certain than those associated with the investment decision,
a lower discount rate is appropriate.

A general rule emerges that, when analysing investment cash flows, the
weighted average cost of capital is used as a discount rate, and when
analysing financing cash flows, the after-tax cost of debt is the
appropriate discount rate.

The present cost of leasing

The cash outflows, which are the lease payments are shown as negative cash flows, with
the discount rate being the after-tax cost of debt. The cash flows are discounted using
the after-tax cost of debt to obtain the net present cost of leasing.

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The present cost of borrowing and buying

The first step in the determination of the present cost of borrowing is the calculation of
the equal annual repayments required on a loan. This can be done using a financial
calculator and a loan amortisation schedule can be prepared. Having calculated the loan
amortisation schedule, it is then necessary to discount the cash flows to obtain a present
cost associated with the loan payments.

4.4.2. The net advantage of leasing and NPV

The net advantage of leasing is the difference between the present value of the lease costs
and the present value of borrowing and purchasing. If the net advantage of leasing is
positive, we would lease the asset, while if it is negative, we would borrow and purchase.

Source: Financial Management by Correia and Flynn

4.5. Summary
− This decision comprises a choice between a lease option and the purchase option.
− The discounting rate used for such decisions is always the after-tax cost of debt
(cost of the normal loan). This is to ensure comparability.
− Only relevant cashflows must be taken into account (only those cashflows that
differ between the two options).

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− Refer specifically to the following: amortisation schedule, assessed loss

treatment, relationship between the investment decision and the financing
decision. Also take note of the case of asset specific financing.

4.6. Exam technique

− Do a separate cash flow analysis for each option.

− Only include cash flows which are relevant to each option
• Generally income would be excluded, as it is the same regardless of
how the project is financed.
• Lease – lease payments will be relevant.
• Purchase via loan – the loan repayments will be relevant.

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APPLIED MANAGEMENT ACCOUNTING AND FINANCE MAF 402

5. End of Unit Questions

Question

Volvo Ltd is a manufacturing company. They urgently need new machinery that would
dramatically decrease personnel members’ down time. The saving due to this ‘down time’
retrieved amounts to $324,000 a year. You are the newly appointed CFO and were asked to
make a presentation to the board concerning on whether to buy or lease the machinery. You
want to make a good impression and started gathering information straight away. The
cheapest price you could find on the machinery was $2,500,000. If Volvo buys the machinery,
the maintenance cost per year would amount to $60,000. During your search you found a
manufacturing company leasing out the same machine for $510,000 per year for 5 years. The
lease payments are payable in advance. If the machine is leased there is no need to pay for
the maintenance cost per year. The company’s after-tax cost of debt is 7%. The company also
depreciates their assets over 5 years.

Required

a. Calculate whether Volvo Ltd should buy or lease the machinery. Please show all
your calculations
b. Provide some of the good reasons for leasing

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Suggested Solution

Lease Cash flows

Year 0 Year 1 Year 2 Year 3 Year 4

Lease Payment -$510,000 -$510,000 -$510,000 -$510,000 -$510,000

Total Cash Flow -$510,000 -$510,000 -$510,000 -$510,000 -$510,000

NPC @ 7% ($2,091,100.69)

Buy Cash Flows

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cost of machine -$2,500,000

Maintenance Cost -$60,000 -$60,000 -$60,000 -$60,000 -

$60,000

Total Cash Flow -$2,500,000 -$60,000 -$60,000 -$60,000 -$60,000 -

$60,000

NPC @ 7% ($2,566,366.21)

Net Advantage of Leasing (NAL)

NAL = NPC (buy) - NPC (lease)

= $2,091,100.69 - $2,566,366.21

= ($475,265.52)

Conclusion

Volvo should lease the machine

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Required b:

• Taxes may be reduced

• May reduce some uncertainty concerning the residual value

• May have lower transaction costs (mainly operating leases)

• May require fewer restrictive covenants

• May encumber fewer assets than secured borrowing

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Question 2

Carrera Ltd is a large and profitable company that processes canned fish. The management of
Carrera is keen to expand and is continuously searching for suitable investment opportunities.

In the past Carrera had always outsourced their canning processes at a cost of 50 cents per
tin. A new mini-canning plant was recently introduced to the market and the management of
Carrera is keen to determine whether it would be to their advantage to use their own canning
plant rather than outsourcing the canning processes. The canning plant will cost $200 000 and
will qualify for a tax write-off of 50%, 30% and 20% in years one to three respectively. It is
estimated that the plant’s useful life will be five years. It is further estimated that at the end
of five years the plant will have a residual value of $40 000. This residual value will not be
considered in determining depreciation. It is estimated that 300 000 cans will be prepared
annually. A compulsory maintenance contract will cost $1 000 while other expenses, including
depreciation, will amount to 40 cents per can.

In addition to the special introductory price of $200 000, the manufacturer also offers two
special introductory financing packages:

• A loan at 10% per annum which is payable in arrears in five equal annual installments.
• A lease with five annual lease installments of $43 000 which is payable annually in
advance. The lease installments include the maintenance contract.

If the machine is obtained with a lease, the lessee does not gain possession of the asset at the
end of the lease contract.

You may assume a company tax rate of 40%. Carrera’s cost of debt before taxation is 15% and
its weighted average cost of capital is 20%.

Required

Calculate the net present costs of both the lease contract and the alternative of 10% loan.

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Suggested Solution

10% Loan

Cash Flow Analysis 0 1 2 3 4 5

Loan (52,760) (52,760) (52,760) (52,760) (52,760)

Proceed on disposal 40,000

Maintenance (1,000) (1,000) (1,000) (1,000) (1,000)

- (53,760) (53,760) (53,760) (53,760) (13,760)

NPC @ 9% = ($183,110.40)

Lease Contract

Cash Flow Analysis 0 1 2 3 4 5

Lease instalments (43,000) (43,000) (43,000) (43,000) (43,000)

(43,000) (43,000) (43,000) (43,000) (43,000)

NPC @ 9% = ($139,307.95)

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