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 broad ly categorized into two types, financial and operating. o perating. Financial leases are generally longer-term, fully amortized, and not cancelable without a hefty termination termination penalty. Operating leases are are usually shorter-term, shorter-term, partially amortized, amortized, and cancelable on short notice. Financial leases are required required to be reported on a firm¶s firm¶s balance sheet while operating leases 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 co uld improve operating efficiency, Paulo should go for an operating o perating lease and let the lessor take care o f 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%.
1
Lease
Vers s B y
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
LEASE After-tax Lease
ayme t=25000(1-T) De reci atio tax shiel =De (T) M ai te ance cost sav ing=M aint.Cost(1 -T)
($15,0 ($15 ,000 00)) ($15 ($15,0 ,000 00)) ($15 ($15,0 ,000 00)) ($15 ($15,0 ,000 00)) ($15 ($15,0 ,000 00)) ($13, 33 332) ($17, 77 776) ($5, 92 928) ($2, 96 964) $ $1, 200 $1, 200 $1, 200 $1, 200 $1, 200
Lost
Avoi
ance of f ront cost Loss of afte r-tax salvag e val e i n year 5
$100,000
Tot al Cash flo s of leasing vers s b ying
$100,000
Cost of Lease After-tax cost of borro ing
DECISIO
($18,000) ($27 ($ 27,1 ,132 32)) ($ ($31 31,5 ,576 76)) ($ ($19 19,7 ,728 28)) ($ ($16 16,7 ,764 64)) ($ ($31 31,8 ,800 00))
8. 70 6
BORROW
AN D
BU Y
Note: Note : The cost savings and buy option ($40,000) ($40,0 00) would be irrelevant
3. What typically happens to t he 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 operating lease) or sold in the used market. Its fate fate depends on the type of equipment, technological techno logical 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 f rom imp roved efficiency by $1000 per year. How should this error be handled? Is it relevant? Explain.
As can be seen from the cash cas h flows in #2 above, cost c ost savings are irrelevant in the case of lease versus purchase decisions since they t hey 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 write-off available to the owner. It results in in a tax saving equal to the annual depreciation charge times the corporate tax rate of the owner. When the equipment is leased, therefore, t herefore, the lessee loses the depreciation tax shield. Taxes must be adjusted for when calculating calculat ing the salvage value (if any), the t he lease payments, and any operating cost savings. savings. The analysis must must be done net of taxes.
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6. If the equipment we re to be leased, would the lease payments be tax deducti ble? 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 le ase 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 calculated by first finding the present 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). ext, 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 we calculate the before-tax 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 t he maximum payment that the lessor should be willing to pay is the same as explained in #5 above. If the lessor lessor and lessee have the same tax rate, the maximum lease payment that t hat the lessee would be willing to pay would be equal to the minimum minimum payment that t hat 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 figure out the impact of the salvage value value on the lease versus buy buy decision we can do the t he following: 1. Calculate the present value interest factor at t he discount rate (6%)=.747 2. ext 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 forecast of the salvage salvage value can affect affect the PV 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 t his type?
Yes, the size of a business is often o ften an important determinant of the amount and interest rate of debt that a firm firm can get. Accordingly, as shown shown earlier, the size of a firm can help determine whether the cost of borrowing will be below the co st of leasing the equipment. 12. Does the type of asset under conside ration 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 co nsideration will determine the applicable depreciable life of the asset, which in turn affects net after-tax cash flows. 13. Are there any other f actors that need to be considered in a lease versus borrow and buy decision of t his type? Explain.
Some other factors that need to be considered include: 1. 2. 3. 4.
Is there a need to circumvent capital expenditure systems? Are there any tax advantages? Is there a need to reduce uncertainty about future salvage value? 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 a fter-tax cost of borrowing (6%) is less than the leasing cost (=8.7%)
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