LEASING VERSUSBUYING

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1 LEASNG VERSUSBUYNG Conribued by James D. Blum and LeRoy D. Brooks Assisan Professors of Business Adminisraion Deparmen of Business Adminisraion Universiy of Delaware Newark, Delaware The auhors discuss facors ha mus be considered in a lease versus buying decision. Wih igh money and high ineres raes on borrowed funds, many reailers and wholesalers are looking more and more o equipmen leasing plans as an alernaive o,direcly purchasing equipmen. There are wo basic ypes of leasing, generally referred o as operaing and financial. The major disinguishing feaure beween an operaing and financial lease is cancelabiliy. An operaing lease can be cancelled by giving proper noice, whereas a financial lease canno be cancelled. An example of an operaing lease is he elephone service a company leases. This is an operaing lease because he lease may be erminaed a he desire of eiher pary. This aricle is concerned wih a reailer s or wholesaler s decision o employ financial leasing or borrowing in he acquisiion of permanen equipmen. As an example, he alernaive of leasing or purchasing (borrowing) an indusrial fork-lif ruck used in warehousing will be used in his aricle. Temporary equipmen needs, such as a lif ruck o handle an exra large shipmen of goods received or o be shipped, are ofen saisfied by operaing leases. Because of he non-cancelable Aaure of a financial lease conrac, i should be regarded as a form of financing. Financial leasing is ofen used insead of oher mehods of financing an asse. The mos common alernaive o a lease would be o borrow he money from a financial insiuion and repay he borrowed money over he same period of ime as you would if you had leased he asse. Therefore, under a financial lease he lessee s paymens are, in effec, equivalen o he principal and ineres paymen on deb. Advanages of Leasing over Borrowing The availabiliy of 00 percen financing is probably he mos widely purpored advanage of leasing over borrowing. Leases permi a firm o acquire he use of an asse wihou having o make a down paymen, or an iniial equiy invesmen. However, full financing via borrowing is generally available o a firm hrough one or a combinaion of: () he firm s pledging of fully owned asses; (2) a firm s pas credi repuaion; or (3) he firm s fuure earning power. A second advanage exiss in ha here are generally fewer resricive clauses wih leases han wih deb financing. Moreover, a firm s presen loan agreemens may resric fuure borrowing; herefore, leasing may be he only alernaive available o acquire he use of an asse. A hird advanage can be obained because of he way leases are reaed in bankrupcy and reorganizaion. The lessor can claim a maximum of one year s lease paymens in bankrupcy and hree year s in reorganizaion, while he deb-holder s full claim sands. Sepember 74/page 40 Journal of Food Disribuion Research

2 Anoher possible advanage of leasing over purchasing is he more favorable ax reamen consideraion. A lease paymen is deducible as an expense for income ax purposes. An asse purchased mus be capialized and depreciaed over is useful life. The RS ses up guidelines for useful life. Thu S, he lessee can obain a faser ax wrie-off, if he life of he lease paymens is less han he ax guideline life and if he lessee has use of he leased asse a a zero or nominal cos afer he original lease period. Therefore, he lessee would be able o delay ax paymens relaive o he depreciaion of a purchased asse over he guideline life. However, acceleraed depreciaion mehods have decreased he likelihood of his advanage. Finally, anoher imporan advanage of financial leases is ha ofen imes he firm acquires he use of an asse wihou he lease obligaion appearing as a liabiliy on he balance sheeo~/ The omission of he lease obligaion, or he deb ha migh have been incurred had he asse been direcly purchased, can have a favorable effec upon he financial raios of a firm. For example, wih a lease insead of a purchase he deb o equiy raio will indicae less financial leverage; he imes ineres earned will show a greaer average; and he curren raio will be biased owards a larger working capial posiion. A close analysis of he financial saemens and foonoes will ofen disclose his bias in he raios. However, since many analyss do no carefully examine he saemens, a firm ofen can obain greaer financial leverage han would oherwise be achieved. Disadvanages of Leases Because he asse being leased is owned by he lessor, any residual value a he end of he lease belongs o he lessor. Someimes his disadvanage is offse by a clause in he lease ha gives he lessee an opion o purchase he equipmen or renew he lease for a nominal cos a he end of he lease conrac. Anoher purpored disadvanage of leasing is ha he ineres rae on leases is higher han equivalen borrowing. However, his may or may no be he case. depends largely on he abiliy of he lessor o purchase he equipmen a a price and borrow (or raise equiy capial) a a rae, which are boh lower han he lessee s abiliy o do he same, The lessor may hen pass his economies of scale (purchasing power and credi sanding) on o he lessee. This disadvanage will be examined in our quaniaive analysis. Based solely on he pros and cons jus presened, one manager migh choose he lease alernaive while anoher migh find he borrowing alernaive preferable. A quaniaive analysis can add o he qualiaive facors jus covered by enabling he manager o come o a final decision. This is no mean o imply ha he decisions will only be based on he quaniaive analysis; he qualiaive advanages and disadvanages mus, alsoy be included in he final decision. Quaniaive Analysis of Leasing Versus Borrowing n order o deermine wheher an asse should be acquired by leasing or borrowing, he cos of each financing mehod should be calculaed. The cos, in our case he ineres rae on borrowing and he implici financial charges in he lease paymens, will depend upon he cash ouflow paerms for each financing mehod. Since mos firms have many invesmen opporuniies wih varying cash flow paerns, i is sandard procedure o adjus all invesmen opporuniies dollar flows from he differen projecs o one equivalen ime period s dollars for comparison and projec selecion purposes. For example, a firm migh require a 2 percen reurn or savings on is invesmens. n a simple case, a manager migh have a choice beween $.00 oday or $.0 a year from now. Since a 2 percen reurn is required, he manager would prefer he $.00 oday over $.0 one year from now. This is rue because he $.0 in one year only yields 0 percen, which, of course, is less han he required 2 percen. The mos common Journal of Food Disribuion Research Sepember 74/page 4

3 procedure for adjusmen is o discoun all fuure cash flows o equivalen presen value dollars a ime period zero. One could adjus all cash flows o some fuure equivalen dollars; however, his is quie cumbersome because mos projecs have differen cash flow life expecancies, differen ending daes. Thus, in our example, discouning he $.0 received a ime period one o an equivalen presen value a ime pe iod zero equals $0.98 ($.OX.893).2 7 Since his is less han $.00, he invesmen should no be made. This above approach, presen value dollars, can also be used o deermine which alernaive is leas expensive. The presen value dollar approach will now be used o illusrae he analysis of a lease versus buy decision on a large indusrial fork-lif ruck. Three examples are provided. The firs is inroducory. assumes no axes and annual renal paymens. The firs example assumes hese simplificaions so ha he analysis procedure can be undersood more easily. Though he assumpion of no axes migh be desired, one quickly realizes i is unrealisic. The second example includes he affecs of axes on he evaluaing procedure. The final example provides an acual operaing decision siuaion where boh lease paymens and loan paymens are made on a monhly paymen basis. The inclusion of ax affecs is again included in his final example. llusraive Examples A company can purchase an indusrial fork-lif ruck for $i 0,000 cash from he CTY Corporaion. The company can also lease he same lif ruck from CTY S Credi Corporaion for five years a an annual renal charge of $2,400.~/ Oher relevan facs are:. The lessee can purchase he lif ruck from he lessor for $500 a he end of he lease conrac. 20 The lessee mus pu up he equivalen of wo monhs ren as a securiy deposi. This securiy deposi will be reurned a he end of he lease conrac, 3. The firm can obain a loan from a local financial insiuion for any fixed asse requiremens. The ineres charge would be 2 percen. There are no oher financial charges for he loan, and i may be paid back over he same period as he lease. Therefore, our yearly paymens in order o repay principal and ineres would be +2,774.>/ 4. Finally, he company is in he 50 percen marginal ax bracke. The RS guidelines call for his company o depreciae he lif ruck over a en (0) year period. The company uses an acceleraed depreciaion mehod (double declining balance). An illusraion assuming no income axes. Since he firm can borrow money a 2 percen, one can assume ha his is he cos of funds o a firm. Therefore, all fuure disbursemens and savings should be discouned o ime period zero a 2 percen. This is done o resae he disbursemens or savings in ime period zero coss in order o obain comparable cos figures on he lease and borrow alernaive. Table presens he quaniaive informaion necessary o ascerain which alernaive, lease or borrow, is leas expensive. The acual period coss ha are paid are shown in column 2 of Table. The periods in which each cos will be paid are indicaed in column. Column 3 gives he ineres facor ha discouns he coss of column 2 over he years in column o a period zero comparable cos, presened in column 4. From Table i is apparen ha in ime period zero he lease alernaive s cos, $909, is less han he borrowing alernaive s cos, $0,000, when one has o pay 2 percen ineres on borrowed funds. Sepember 74page 42 Journal of Food Disribuion Research

4 Table Cos of Lif Truck a Time Period 2ero (No Taxes) () (2) (3) (4) Cos a Yearly neres Time Period Financing Time Loan or Lease Facor Zero Mehod Period Paymens (r = 2%) (2) x (3) hrough Borrowing: 5 $2.774* 3.60~/ $0,000 Leasing: o $ 400*.000.$ ,400fi* , $*** 0567k/ 57 Ne Cos of Leasing $ 9.09 ~ Annual loan paymen *X TWO monhs deposi when he lease is signed ~ ~ Annual lease paymen ~~~ Opion price, $500, less reurn of deposi Table Cos of Lif Truck a Time Period Zero (No Taxes) () (2) (3) (4) Yearly neres Cos a Time Lease Facor Time Period Period Paymens (8%) Zero Leasing o $ $ , $ 9, Ne Cos of Leasing $0,05 f one could borrow a 8 percen he cos o borrow a ime period zero would be $0,000. The cos o lease a ime period zero would change o $0,05, see Table for cos of leasing. Therefore, if one can borrow a 8 percen or less, direc purchasing would be favored over leasing in our illusraion. An illusraion assuming income axes. Analysis of leasing or borrowing coss assuming income axes is he same as shown in Table excep he cash flows mus be modified for he effecs of income ax on period cash coss. Taxes are assumed o be paid a he end of each year. Table shows he cos of borrowing versus leasing a ime period zero. Noe ha he analysis is now over a en year period, raher han five years, since he RS requires depreciaion charges o be exended over his longer period. n our example wih he ax-shields, leasing is preferred o borrowing. The afer-ax cos o borrow is $5,303 whereas he cos o lease is $4,67, However, Journal of Food Disribuion Research Sepember 74/page 43

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6 Table V neres Calculaion - Borrowin? () (2) (3) (4) (4) x 2% $2,774- (2) neres Principal Loan Time Period Paymen Paymen (beginning of period) $,200 $,574 $0,000 2,0,763 8, ,974 6, ,2 4, ,478 2,478 $3,870 $0,000 Table V Depreciaion Calculaion - Borrowing () (2) (3) (4) Ne Asse Balance Depreciaion Accumulaed Time Period (beginning of period) (2) x.20 Depreciaion $0,000 $2,000 $ 2, ,000,600 3, ,400,280 4, ,20,024 5, , , , , ,62 656>k 8,034 8, , , ;000 Depreciaion Calculaion - Lease Purchase a end of Lease Period ~ $:When he depreciaion charges from sraigh-line (SL) on he remaining book value exceed he charges from double-declining balance, (DDB) he RS allows one o swich from DDB o SL. This allows a greaer deducion. if we had borrowed a 87.or less, schedule corresponds o he general pa.yborrowing would be he seleced aler- men period in acual long erm lif ruck naive. lease-purchase agreemens. An illusraion assuming axes and The monhly paymen soluion, ha monhly renal paymens. This secion leasing is cheaper han borrowing a 2 demonsraes a monhly renal paymen percen, agrees wih our previous illusraagreemen. This is an expansion from ion ha used annualized disbursemens. he previous illusraion and is included since he monhly paymen Journal of Food Disribuion Research Sepember 74/page 45

7 Analysis of Leasing or Borrowing Coss - Assuming Monhly Paymens The following assumpions are used: Leasing - Monhly lease paymens (5 years) Securiy Deposi Purchase opion (end of lease) Renal paymens made a firs of monh $ Borrowing - neres rae Monhly principal and ineres paymen % monhly $ Boh - Marginal ax rae Depreciaion guideline life Taxes are paid a he end of 2 periods 5o% 0 years Conclusion The quaniaive evaluaion of he lease versus borrowing decision will aid he manager in making a decision. Objecive and verifiable evidence from he quaniaive approach is used wih he qualiaive evaluaion in arriving a a final decision. The recen increase in he use of financial leases by businesses focus on he need for he manager o formulae his own approach o evaluaing financial leases. A possible approach was provided o give he manager an improved decision making capabiliy in he base versus borrowing siuaion. Sepember 74/page 46 Journal of Food Disribuion Research

8 . m G d w- H 0:$ 0+-m... r++- < -4 m u G L -5: 4. aj x 2 C/2- cocha3maa3cou3a)l= mmcommwmlfxww mmmr=.mmmmrn a. u a w o u )G,+.C5 L Gw 00 sm 4- C/l 6 : 3 $4 0. u- G H 8 JJ!-+ -w- Journal of Food Disribuion Research Sepember 74/page 47

9 FOOTNOTES ~/ Accouning Principles Board, Disclosure of Lease Commimens by Leasees~l Opinion No. 3 (New York, American nsiue of Cerified Public Accounans, June, 973). This Opinion requires disclosure of financial lease commimens no capialized and should allow he reader o deermine he effecs of leasing on fuure fixed obligaion. ~/ The presen value facor a 2 percen of.893 may be obained from any presen value ineres ables. suggesed reference is Financial Compound neres and Annuiy Tables, Financial Publishing Company. ~/ mplici in he assumpion is ha he lif ruck is jusified as a capial expendiure. if A more realisic illusraion of monhly lease paymens made in advance on leased equipmen is given in he las secion. ~/ $0,000/ The was obained from he Presen Value of $ Received Annually for N Years Table, where N=5 and r=2%. See foonoe 2 for reference. The is where N=5 and r=8%. ~/ Obained from Presen Value of $ N Years Hence Table. See Foonoe 2 for reference. ~/ $0,000 =% / (.2), where = is =l a specific monh, of he 60 monh life of he loan and p is he monhly paymen. This could be obained from presen value ables 2 percen annual or percen monhly. See foonoe 2 for reference. ~/ $0,000/ The was obained from he Presen Value of $ Received Annually for N Years Table; where N = 60 and r = % monhly or 2% annually. Sepember 74/page 48 Journal of Food Disribuion Research

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