Should We Lease or Buy a Car - Assignment Example

DRAFT COPY Executive Summary Should we lease or buy a car? This is the managerial question that the company seeks to answer. Each of the two alternative methods has its advantages and disadvantages. There are a number of factors and costs associated with each of the methods, with these having a part in determining the suitability of the method. For the buying option, the costs and factors mainly include the interest rate, selling price, down payment, and loan duration. For the lease option, the factors considered include the selling price, capitalized (cap) cost, capitalized (cap) cost reduction, money factor, monthly payment, interest rate on lease, lease term, residual value, and lease charges. The total costs incurred in the three options analyzed form the basis of the choice preferred. As can be seen from the analysis, the buying option based on the chosen parameters and values is better considering especially if a higher deposit is given. It is recommended that one buys the car by paying a higher deposit amount. Should We Lease or Buy A Car Introduction Should we lease or buy a car? This is the managerial question that the company seeks to answer. Buying or leasing is a very familiar question in the present age. In the United States, leasing accounted for close to 42 percent of the total new cars purchased in 2000. It is important to note that the number is increasing at a considerable rate. It is estimated that more cars that are new will be leased in the future. Leasing is defined as the process renting for a particular period or amount of time. As a result, the individual pays only a portion of the item value and not its total value. Majority of the automobiles are leased and the lease generally lasts for 2 to 5 years. The individual or the organization puts up the initial security deposit and it is generally a one to two months advance lease expense (Royale Management Services, 2001). There are several benefits of buying or leasing a car. Benefits to buying include lack of restrictions as to how many miles per year the car can be driven, the car can be sold because it has some residual value, and the absence of insurance issues linked to premature termination. Other benefits include that the car be treated in any way the individual or the company wishes this were because there are no turn-in issues associated with the residual value. If an investment type loan like home equity is utilized to finance the purchase of the car, the interest charges can be deducted on the individual’s or the company’s tax return (Royale Management Services, 2001). Benefits to leasing include lower monthly payment but not generally lower total costs, lesser up-front money to get the car, and some leases are easier to receive than loans especially for companies that have weaker credit. Leasing is a type of an off-balance sheet financing thus it may fail to add up to the company’s borrowing maximums for the other loan qualifications. If the cost of the car and business use percentage is high, it is possible for the company to have tax advantages in certain situations (Royale Management Services, 2001). Definitions Leasing or buying a car? This is a managerial question that the company seeks to get answers. Leasing is defined as the process renting for a particular period or amount of time. As a result, the individual pays only a portion of the item value and not its total value. Majority of the automobiles are leased and the lease generally lasts for 2 to 5 years. The individual or the organization puts up the initial security deposit and it is generally a one to two months advance lease expense (Royale Management Services, 2001). Generally, leasing offers the company more practical and attractive options such as lower monthly payments than if it was buying a car. This is because when a car is leased, the payment is based on the usage of the car than on the total cost of the vehicle (Kala, 2002). Purchasing a car is the preference for most car owners in the United States. However, an increase in the cost of cars has increased the period of loans to maintain the monthly payments lower (Reed, 2001). The interest rate between buying and leasing a car differ considerably. The paper will attempt to find the alternative that is cheaper for a company that wants to lease or buy a car. Factors or Costs Leasing Factors and Costs The following are some of the important factors and costs that apply in leasing. The costs include: 1. Capitalized (Cap) Cost – It is defined as the total value of the car at the beginning of the lease. In the context of buying the car, this is a representative of what the company will be paying for the car. The capitalized costs affect the monthly payment and it can be negotiated. 2. Capitalized (Cap) Cost Reduction – This is similar to down payment and it is utilized to minimize the cap cost. An individual or the company has to pay the money at the time of signing the lease (Kala, 2002). 3. Residual Value – Residual value is defined as the car value at the culmination of the lease term. It is important to note that the company pays for time the car has been used. If the residual value is high, the outcome is lower payments and it is possible for the company to turn in the car at the culmination of the lease term. If the residual value is low, it indicates higher payments but it is possible to have some equity on the car at the end of the lease term. If the company plans to purchase the car at the culmination of the lease term, them a residual value that is low is the best option. 4. Money Factor – This is the number that identifies the monthly finance value of the lease. It is a representative of the cost of money and it can be equated to interest rate (Kala, 2002). 5. Selling Price – This is the price of car at which it is sold. The price is negotiable and it is supposed to be negotiated as much as both parties can. 6. Monthly Payment – Monthly payment is the money paid by the leasing company each month (Kala, 2002). 7. Interest Rate on Lease – This is the number that identifies the monthly finance cost of the lease. Interest rate on lease is determined by multiplying 2400 by the money factor. 8. Lease Charges – Lease charges are determined by the following formula: Lease Charges = ((Selling Price – Cap Cost Reduction) + Residual Value) * Money Factor (Kala, 2002). The lease factors include: 1. Term – Term is defined as the period of lease in terms of months. For instance, a 39 month lease requires 40 payments; the first payment is done during the signing of the lease and the rest in the extra 39 payments. 2. Mile Limitations – Majority of the lease agreements or programs have stringent mileage limitations. The mile limitations depend on the contract made and it is usually between 12,000 and 15,000 miles per year (Kala, 2002). Buying Option Factors and Costs For the buying option, the following costs and factors apply: 1. Interest Rate – This is the number that identifies the monthly finance cost of the lease. a. The following are important factors and costs used in buying. Costs include: 2. Selling Price (After Tax) = Selling Price + Tax 3. Down Payment (deposit) 4. Total Money Paid = Down Payment + Monthly Payment * Loan Duration a. Factors include: 5. Interest Rate on Loan 6. Loan Duration (in months) – the duration of loan is generally 60 months. Measurement Buying Assumption and Values In order to evaluate the suitability of the two options, quite a number of assumptions. It will be assumed that the vehicle to be purchased is a Toyota sedan with its cash price set at $18,000 (selling price + tax) when new. This figure is chosen based on research conducted on various Toyota models and from various car dealers. The value is a reasonable figure and is rounded off to the nearest thousands. The hire purchase price will be higher considering the interest rate charged on the amount not paid. For the buying arrangement, it is assumed that the vehicle will be bought on hire purchase. The down payment value normally may change depending on what the customer has or is willing to pay initially to have the car. Generally, the buyer will pay a lower amount in interest rate holding other factors constant when they give a higher amount in down payment. For this analysis, it will be assumed that the buyer pays between $ 10,000 and $12000 in down payment. These are also reasonable figures considering that the customer may not wish to spend more in the long run. The interest rate that the buyer is charged for purchasing an item depends on a number of factors. The seller may set a standard value in percentage or may negotiate the interest rate with the customer considering the loan duration. A higher interest rate may be charged if the duration of pay is longer. For this case, it will be assumed that the interest rate is set at 5%. The loan duration depends on the customer’s ability to pay a given amount of money on monthly basis. Assuming that the customer is willing to pay the $500 per month, the duration of pay will vary depending on the down payment value. Leasing Assumption and Values The Capitalized (Cap) Cost of the car is equal to the cash price of the car which is set at $18000 as posited in the section above. In this case, it is also assumed that the capitalized cost is equal to the negotiated selling price of the car. The Capitalized (Cap) Cost Reduction set by the leaser is set at $1000. This is also based on average requirement by a number of leasing companies in the United States. For the leasing arrangement, it will be assumed that the vehicle is to be leased for a total of 4 years (48 months). So as to calculate the residual value, a depreciation rate of 10% is assumed. This value is chosen considering that most fixed assets have their depreciation rates set at a compromise of 10%. In this respect, the salvage value may be calculated as follows: original value minus total depreciation. It is also reasonable, based on average industry values, to assume the cost of leasing per month to be $ 300 per month. Since most customers are more comfortable with open-ended lease arrangement as opposed to the closed-ended one, the former option is assumed to apply for this case. For ease of analysis, the case assumes that the buyer will not exceed the 12000 mile per year limitation set by the leaser. This assumption is taken considering that the leaseholder does not intend to travel long distances everyday. Assuming an interest rate of 5%, the monetary factor can be determined based on the formula below: Monetary factor = Interest rate/ 2400 = 5.0/2400 = 0.00208333 Analysis In order to establish the suitability of one method of ownership over the other, the total costs incurred will be considered. Three analyses will be done. The logic behind these methods is to Choice 1 – Returning the leased car after leasing period Choice 2 – Buying the car with a down payment of 10,000 Choice 3: Buying the car with a down payment of 12,000 Analysis - In this section you use the measurement from the above and apply good economic reasoning and solve the problem. Explain what method you're going to apply and why this method is appropriate (This is to demonstrate that you understand the economic concepts). Lease Analysis Selling price = 18000 Capitalized (Cap) Cost = 18000 Capitalized (Cap) Cost Reduction = $1000 Money Factor = 0.00208333 Monthly Payment = $300 Interest Rate on Lease = 5% Lease Term = 4 years (48 months) Residual Value = Lease Charges = (Selling Price – Cap Cost reduction) + Residual Value) * Money Factor) Buying Analysis Cash Price = $18,000 Selling Price (After Tax) = Selling Price + Tax = $18,000 Down Payment (deposit) = $ 10,000/$12000 Interest Rate on Loan = 5% Monthly Payment = $ 500 Loan Duration (in months): Variable Total Money Paid = Down Payment + Monthly Payment * Loan Duration In order to determine the amount in i Summary - This section states your observations about the process. You have an answer, based upon the reliability of the measurement of the factors or costs how likely is that answer to change. You may want to identify some (not more that three) assumptions that if their value were different would give a different answer. For example, buying a house versus renting may the choice when interest rates are 5%, but if they go to 20%, renting may be the better choice. Writing the Final Project Recommendations References Kala, C. M. (2002). Economics behind buying versus leasing a car. Retrieved from http://www.ewp.rpi.edu/hartford/~stoddj/BE/BuyLeaseCar.htm Reed, P. (2001, September 14). Compare the costs: Buying vs. leasing vs. buying a used car. edmunds.com. Retrieved from http://www.edmunds.com/car-buying/compare-the-costs-buying-vs-leasing-vs-buying-a-used-car.html Royale Management Services. (2001). To buy or lease? Lauderdale, FL: Author. Read More