1 Solution to Case 34 Lease Versus Buy Analysis Why B uy I t W hen Y ou C an L ease I t? 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 con sideration 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 leasin g (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%. 2 3. What typically happens to th e 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, technolo gical 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 sh ould 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. H ow 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 equipme nt 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. 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 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 afte r 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 forecas t 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 decisio n. 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 i s 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%. 4 10. If Paulo leases the equipment, what impact would it have on the firm’s debt capacity? If Paulo uses an operati ng 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 determinan t 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 asse t 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. So me 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 cons idered, 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