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 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 consideration 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 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%.
3. What typically happens to the 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, technological 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 should 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