A Comparison Whether It Is Better to Lease or Buy - Research Paper Example

RUNNING HEAD: Lease vs Buy Lease vs Buy of Table of Contents Introduction This paper seeks to prepare a comparison whether it is better to lease or buy. This aims to conduct a financial analysis of a lease versus buy option for transportation equipment or two buses that ABC Company, a hotel operator will make use of for its clients for the next five years by assuming a given cost data for said options. This will therefore make use of cost benefit analysis by presenting the advantages and disadvantages for each option to buy or lease the building. Areas to be discussed include the source of financing, cost, and salvage values, tax benefits as a result of deductibility for each type of expense under each option and net present value methods. The acquisition or lease of the transportation equipment is critical to the nature of the company’s business of bringing its guests to different locations to areas which would further enhance the company’ s delivery of value to its customers. What should the company do? 1.1 Assumed facts ABC Company plans to acquire transportation equipment or two buses with a five year life and a total cost of $40 million which will transport clients to different areas as a way of adding value to its services. A bank is ready and will to provide a loan for the acquisition. The company can borrow the required $40 million, using a 10 percent loan to be amortized over five years. Therefore the loan will call for payments of $10.4 million per year as can be estimated using a financial calculator. As an alternative, ABC can lease the equipment for five years at a rental charge of $11.2 million per year, payable also at the end of the year. If it is lease, the equipment will not be owned and the risk of loss will belong still to the XYZ Company as lessor. However, ABC Company will be liable pay to annual rental for five years from which tax benefits can also be derived. If it decides to buy the equipment, ABC will be able to save on tax on depreciation for the equipment and maintenance cost. Since the lessor will own the two buses at the expiration of the lease, the company is somewhat confused on which is the better option. Relying on the comparative figures of $10.4 million payable yearly to the bank to finance acquisition and the rental payments of $11.2 million for yearly payments looks somewhat incomplete to ABC Company without including other factors which can be further quantified. The lease payment schedule is established by XYZ Company the potential lessor with the $11.2 million for five years was given to ABC Company and the latter is at present stage of contemplating on whether it should accept it, reject it or negotiate the same at the soonest since its business cannot keep waiting for long time. Per investigation by ABC Company from asking different sources, the equipment will be definitely be used for five years, at which time its estimated net salvage value will be $2.86 million as most likely one depending on how the bushes will be maintained. The company knows that after five years, the need will still be there for the two buses and as that it can continue using the equipment beyond the fifth year. If the decision was to purchase the equipment, and the company will just be keeping what it would have owned after payment of loan charges. On the other hand, if ABC Company leases the equipment, the company will need to exercise an option to buy it from XYZ Corporate at its estimated salvage value, $2.86 million. Thus an option to buy was part of terms of offer made by the lessor. The lease contract offers further stipulates, that the lessor will maintain the equipment. However if ABC Company borrows to buy, it will have to bear the cost of maintenance at an amount of $2 million per year. This amount can be taken from service as fixed by the equipment manufacturer to be made payable at year end. Assume that the equipment falls in the MACRS five-year class life, and company’s effective income tax rate is 30%. Also, the depreciable basis is the original cost of $40,000,000. The project’s final output and the revenue associated with either options will remain the same regardless of whether “Buy” or “Lease” is used by ABC Company since the number of guests is more or less estimated to be of the volume based on historical data, thus the only issue which would give a higher savings for the company in terms of cost. The cost of capital for the project is assumed at 10%. 2.1 The option to buy. To buy the equipment at $40 million is for the ABC Company to own the same equipment and with is include the advantages of having not to pay for annual rentals for the company. The company however has to pay for the amortization of loan that will be used to finance the acquisition. It has also to pay for maintenance cost which is fixed at $2 million by the equipment manufacturer. Since maintenance cost is tax deductible it has a tax benefit of $600,000 per annum through the five year period. Since the equipment will have to be depreciation using MACRS, the tax benefit will be computed accordingly. MACRS is the current tax depreciation system (MACRS) in the United States where the capitalized cost is recovered with specified life. The option to buy therefore has the advantage of tax benefit that would arise from depreciation the equipment which is assumed to be used in five years, the same as period of time to fully pay the loan used in financing the acquisition. It can also consider as benefit the salvage value that is expected to be derived from the old asset after five years. The projected cash outflows of this option can be generated and discounted at cost of capital of 10%. The net present value of cash flows is computed at the amount of $34.2 million. See Table A below. Note that the discounted rate used is 7% since the 30% of which is tax, and therefore the after-tax cost of capital is more realistic. This would mean that the net present value of the investment to buy is lower than the cash price of $40 million but said amount cannot be the sole basis of deciding now in favour of buying over that of renting the equipment. 2.2 The option to lease. To lease would avoid the risks of ownership since the company would not be making it a headache to coordinate with the bus manufacturer in case of problems arising from the vehicle or equipment to be lease for the next five years. ABC will no spend any maintenance cost but will also be forfeiting the tax benefit from such maintenance cost and depreciation that does with owning the equipment. The obligation of ABC under the lease option would just be to pay the rental payments when due. The same will entitle the company to tax benefit as rental payments are tax deductible (Higgins, 2007). It must be quite interesting to note on why would leasing as business could exist when users of equipment could just buy the same. It is may be argued that any prospective lease must be evaluated by both the lessee and the lessor. Before the lessee who ABC for this particular case would decide to have the lease with an outside lessor, it must determine whether leasing assets will be less costly than buying (Brigham and Houston, 2002). At the same time, the lessor must decide whether or not to leasing will provide a reasonable rate of return. For the purpose of this paper, XYZ Company the lessor is presumed to be benefit from its offer to lease. It could be taken from the case facts that the rental payments would be $11.2 million, which is simply higher than the $10.4 million that ABC Company may have to pay as amortization of the loan for five years. Thus it can be argued that XYZ Company could borrow at the same rate as ABC and pay also $10.4 million as loan amortization. As such it can be assumed that XYZ may have benefited from depreciation and maintenance cost in terms of tax savings. Since this paper is evaluating from the point of view of the lease, the focus of this paper is primarily on the lessee and whether the lessor wins or losses in the lease transaction is irrelevant to the lessee. The most important concern to the lessee is whether lease is a better option than buy. Normally, the events leading to a lease arrangement may follow a sequence or process. First, ABC decides to acquire the particular pieces of equipment. Its decision has to be based on regular capital budgeting procedures and the decision to acquire the assets is can considered a done thing already the lease option analysis can come in to the picture. Therefore in analyzing the lease option, ABC must be concerned simply with whether to the finance the transportation equipment by lease or by a loan. Since ABC is assumed to be maximizing its use of cash, it would be assumed that it has no extra cash for investments in equipment. This is based on the premise that if it is a professionally managed business it may not have surplus cash lying around, which should prompt the company to finance the decision in some manner. ABC funds for the acquisition of the equipment could be obtained by borrowing, by retaining earnings, or by issuing new stock and in this particular case, a bank was ready to provide $40 million at 10% interest rate with an annual loan amortization of $10.4 million. Alternatively, the asset could be leased by ABC but with a higher amortization of $11.2 million. Thus the issue could just be like asking: “Is the difference between loan amortization and annual rental payment, necessarily favoring acquiring the same?” Without the tax benefits of the expenses and the salvage values as well the sweetener of option to buy at end of the term, the answer would be yes. There is therefore the need to proceed with the analysis. As computed, the projected cash outflows of this option can be generated and discounted at cost of capital of 7% after the 30% tax. The net present value is computed at the amount of $34.18 million, which is lower than computed present value of option to buy at $36.2 million. See Table A above. The company should proceed with the lease rather buy decision because of the net difference in present values of cash for each proposal as generated using the cost of capital of 7% as discount rate. Calculations are summarized in Table A and some of the highlights that must be pointed here is the fact the depreciation tax benefit, maintenance tax benefit are included. The depreciation as presented assumes a method the under MACRS. The tax benefit from depreciation would come from multiplying the 30% rate with the yearly depreciation with different rates of 20%, 32%, 19%, 12% and 11% (Brigham and Houston, 2002). Note that that salvage value of $2.86 million of at the end of five years could actually be considered as cash inflow at year 5 but this paper assumes that the amount is least certain as management would be conservative to assume that it will realize such amount. Should the amount be included the analysis could change. See Table B below. The next effect is that to lease is still more advantageous. 3. Other Factors in decision making The information that the decision may need may involve non-financial ones like the support of those who will actually approve or disapprove the proposal. For the purpose of this paper, the focus is on financial issues. Note that the computation of net present value of the cash flows uses a discount rate of 7% after tax. This is actually the borrowing rate of 10% in the case the equipment is purchased. In this case there is no need to compute for the same. Companies do however make investment decision on whether they would venture into a certain project on the basis of the expected returns as against the risks associated with such investment decision (Brigham, & Ehrhardt, 2010; Fridson and Álvarez, 2002; Gitman, 2006)). In this case, ABC Company has decided to make investment by acquiring equipment by loan or lease based on prior evaluation of alternatives. The decision therefore is assumed to provide a return more than the company’s cost of capital of 10% which is assumed to be based on the borrowing rate. Companies do have also different cost capital or WACC specific to each of them. Companies with low-risk normally have lower WACC while those with higher risks have higher WACC. The true WACC of a company is normally associated with the hurdle rate of the company is choosing projects. However projects do provide or promise some rates of return and the ABC must be assumed to have evaluated that the expected return from bus acquisition will increase wealth of the shareholders (Khan & Jain, 2007; Correia, et al 2007,Van Horne & Wachowicz , 2008). Given that WACC is most of the times estimated, a sensitivity analysis could be best made to see the possible effects if estimate cost of capital and the level of cash flows are project will vary. Such cost of capital is just an estimate and an allowance for error could be brought to a minimum with the preparation of sensitivity analysis. Increasing the cost of capital may change the net present value of a project which may result to having the project not acceptable (Higgins, 2007; Kieso, et al, 2007, Bernstein, 1993). By attempting to change the cost of capital the values in Table A could change. The discount rate used was 7% since the money to purchase could be borrowed at 10% after deducting the 30% tax rate. The value could therefore vary depending on the cost of capital that could be used. However, it may be noted the discount rates for both options are assumed to be at 7% and there was no need to assume a different rate of the other option. Thus for purposes of comparing the two options, assuming the same cost of capital and same tax rate that would the same rate for tax savings involving depreciation, maintenance cost if acquired and rental expense if lease is chosen. 4. Conclusion To lease is better than to buy for the company. The company would increase wealth of stockholder by choosing to lease, although the rental payments appear higher than the loan amortizations. Even if the cost of capital for discounting the cash flows will be increase, the decision stays that to lease is better than to buy. A sensitivity analysis which includes the salvage value for decision to buy was made but it did not change the advantage of having to lease. 5. References: Bernstein, J. (1993). Financial Statement Analysis, , Sydney: IRWIN Brigham, E. and Houston, J. (2002) Fundamentals of Financial Management, London: Thomson South-Western Brigham, E. & M. Ehrhardt (2010). Financial Management: Theory and Practice Correia, C. D. Flynn, E. Uliana - (2007). Financial Management. Juta and Company Ltd Fridson and Álvarez (2002). Financial statement analysis: a practitioners guide. John Wiley and Sons Gitman, L. (2006). Principles of Managerial Finance. London: Addison Wesley Higgins (2007) Analysis for Financial Management, Eighth Edition. Front Matter Quick Reference URL Guide. he McGraw−Hill Companies Khan & Jain (2007). Financial Management. Tata McGraw-Hill Education Kieso, et al (2007). Intermediate Accounting. John Wiley and Sons Van Horne, J. & J. Wachowicz (2008). Fundamentals of financial management. Financial Times/Prentice Hall Read More