Lease–Buy Analysis: The Lessee’s Perspective - Financial Management

Financial theorists and model builders have devoted a substantial amount of time and effort to developing an analytical framework within which the differential costs associated with leasing versus buying can be compared.At least 15 different approaches to the problem have been suggested, and there is considerable disagreement as to which one is the best.

In spite of this abundance of models, the perplexed financial manager can take some comfort in the fact that the practical effects resulting from the differences in the models tend to be small because few real -world decisions are changed as a result of which lease –buy model is chosen. One of the most commonly used approaches to the analysis of a lease versus purchase decision assumes that the appropriate comparison should be between leasing and borrowingto buy. Advocates of this approach argue that a financial lease is much like a loan in that it requires a series of fixed payments. Failure to make lease payments, like failure to make loan payments, may result in bankruptcy.

The basic approach of the lease–buy analysis model is to compute the net advantage to leasing(NAL). The net advantage to leasing compares the present value cost of leasing with the present value cost of owning the asset. If the cost of owning the asset is greater than the cost of leasing the asset, the NAL is positive and the model indicates that the asset should be leased.

The net advantage to leasing calculation is as follows:

Installed cost of the assetLess Present value of the after-tax lease paymentsLess Present value of depreciation tax shieldPlus Present value of after-tax operating costs incurred if owned but not if leasedLess Present value of the after-tax salvage valueEquals Net advantage to leasing

The installed cost of the asset equals the purchase price plus installation and shipping charges. The installed cost forms the basis on which depreciation is computed.

The present value of the after -tax lease payments that are made if the asset is leased reduces the NAL; hence, they are subtracted when computing the NAL. These lease payments are discounted at the firm’s after-tax marginal cost of borrowing to reflect the fact that lease payments are contractually known in advance and thus are not subject to much uncertainty.

The present value of the depreciation tax shield is equal to the depreciation claimed each year if the asset is owned times the firm’s marginal tax rate. The depreciation tax shield reduces the cost of ownership and hence is subtracted when computing the NAL. Because the depreciation amounts are also known with relative certainty, they are also discounted at the firm’s after -tax marginal cost of borrowing.

Sometimes operating costs are incurred if the asset is owned but not if it is leased. These may include property tax payments, insurance, or some maintenance expenses. If these do exist, they represent a benefit of leasing and increase the NAL. Hence, the after -tax amount of these costs is added in the NAL calculation. These operating cost savings are also discounted at the after-tax marginal cost of borrowing, reflecting their relative certainty.

Finally, if the asset is owned, the owner will receive the after-tax salvage value. This is lost if the asset is leased.Hence the after-tax salvage reduces the NAL and must be subtracted when calculating the NAL. Because asset salvage values are generally subject to substantial uncertainty, they are normally discounted at a rate equal to the firm’s weighted (marginal) cost of capital.

Example of Lease–Buy Analysis

Consider the following example to illustrate the lease –buy analysis procedure just described. Suppose that the Alcoa Corporation is trying to decide whether it should purchase or lease a new heavy -duty GMC truck. (The firm has already computed the net present value of this proposed asset acquisition and found the project to be acceptable.) The truck can be purchased for $50,000, including delivery. Alternatively, the truck can be leased from General Motors Acceptance Corporation for a 6-year period at a beginning -of -the -year lease payment of $10,000. If purchased, Alcoa could borrow the needed funds from Mellon Bank at an annual interest rate of 10 percent.

If the truck is purchased, Alcoa estimates that it will incur $750 per year of expenses to cover insurance and a maintenance contract. These expenses would not be incurred if the truck is leased. The truck will be depreciated under MACRS guidelines as a 5-year asset. Alcoa expects the actual salvage value to be $20,000 at the end of six years. Alcoa’s marginal tax rate is 40 percent, and its weighted after-tax cost of capital is 15 percent.Which alternative —leasing or buying —should be chosen? In order to answer this question, we need to compute the NAL. This is shown in Table.

The calculation in Table indicates a net advantage to leasing of -$1,296. Because the NAL is negative, the asset should be owned rather than leased.

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