Case #34: Lease versus Buy Analysis Why Buy It When You Can Lease It? David Bajak Katrina Bishop Gary Hsieh
What are the different kinds of leases available and which one would be best suited for Paulo’s restaurant? Explain why? There are two major types of leases: operating lease and financial lease. An operating lease places the responsibility of maintenance and repairs on the lessor, has a life span of no more than 5 years, and is usually cancellable. A financial lease places the responsibility of maintenance and repairs on the lessee and is usually noncancellable and fully amortized. Tax‐ oriented lease, sale‐and‐leaseback lease, and leverage lease are all examples of financial leases. • A sale‐and‐leaseback lease is a form of temporary borrowing, which allows the owner of an asset to sell the asset to another company and lease it back for a specified period. • Under a tax‐oriented lease the lessor will be treated by the IRS as the owner of the leased property for federal tax purposes and permitted to take tax benefits. • A leveraged lease allows the lessor to borrow a portion of the funds needed to buy the equipment to be leased. An operating lease would be best suited for Paulo’s restaurant. Under an operating lease, Paulo would be able to return the equipment and cancel the contract if needed. The equipment would not have to be listed as a liability or asset on his balance sheet. Also, he would not have to consider maintenance cost.
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%. In order to properly compare the lease vs. buy decision we must be able to distinguish between the situations of owning and not owning the assets at the end of year five. A lease vs. buy comparison where you are the owner in one situation and not the owner in the other is much like comparing apples with oranges. The cash flows from leasing and buying for scenarios of owning and not owning the assets are below. In these comparisons cash flows for lease payments were assumed to be in arrears in order to line up with the estimated savings and maintenance costs for each end of year. Maintenance fees were included in the buying decision since they are accounted for in the leasing scenario and we are interested in comparing “apples to apples”. Estimated savings were included in the NPV calculation since it is a cash flow does affect our NPV of each project. We calculated discount rate of 6% given our interest rate and tax rate and this value was used in our present value (PV) calculation as our after tax cost of borrowing. This allows us to compare all after tax cash flows (ATCF) to one standard rate that is related to our borrowing rate.
If you intend on not being the owner of the assets the lease vs. buy decision is in favor of buying since the net advantage to leasing (NAL) is negative number. The NPV of leasing and buying were found to be negative indicating the projects will cost money rather than make money for the company. The NPV of leasing is ($53,075.79) however, for buying the costs are not as high showing an NPV of ($45,771.27). These values lead us to an NAL of ($7,304.27) which indicates buying is better than leasing. 2. Net Advantage to Leasing (NOT OWNING ASSET) NPV (LEASE & DON'T OWN) Lease ‐ Don't Purchase (G) (D) (E) (F) Taxable Income Maintenance BTCF Depreciation (E‐F) Cost (A+B+C+D) $ ‐ $ ‐ $ ‐ $ ‐ $ ‐ $ (21,000.00) $ ‐ $ (21,000.00) $ ‐ $ (21,000.00) $ ‐ $ (21,000.00) $ ‐ $ (21,000.00) $ ‐...
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