Foundations of Financial Management: An Analysis (part 64)

It's how you deal with failure that determines how you achieve success. 

David Feherty

Long-Term Debt and Lease Financing

(Part C)

by

Charles Lamson

Lease versus Purchase Decision

If you will remember from last post, the Statement of Financial Accounting Standards (SFAS) No. 13, issued by the Financial Accounting Standards Board (FASB) in November 1976, says certain types of leases must be shown as long-term obligations on the financial statements of the firm. Before SFAS No. 13, lease obligations could merely be divulged in footnotes to financial statements, and large lease obligations did not have to be included in the debt structure (except for the upcoming payment).

Again, note (from last post) that a capital lease is a contract entitling the renter to the temporary use of an asset, and such a lease has the economic characteristics of asset ownership for accounting purposes. The classic lease versus purchase decision does not fit a capital leasing decision given the existence of SFAS No. 13 and the similar financial accounting and tax treatment accorded to a capital lease and borrowing to purchase. Nevertheless, the classic lease versus purchase decision is still appropriate for the short-term operating lease.

As shown in Table 8 from Part 48 of this analysis and reintroduced below, assets are classified according to nine categories that determine the allowable rate of depreciation write-off. Each class is referred to as a "MACRS" category. MACRS stands for modified accelerated cost recovery system.

Again, remember from last post that an operating lease is usually short-term and is often cancelable at the option of the lessee. Furthermore, the lessor (the owner of the asset) may provide for the maintenance and upkeep of the asset, since he or she is likely to get it back. An operating lease does not require the capitalization, or presentation, of the full obligation on the balance sheet. Operating leases are used most frequently with such assets as automobiles and office equipment, while capital leases are used with oil drilling equipment, airplanes and rail equipment, certain forms of real estate, and other long-term assets. The greatest volume of leasing obligations is represented by capital leases.

Bearing all this in mind, assume a firm is considering the purchase of a $6,000 asset in the 3-year MACRS category (with a four-year write-off) or entering into two sequential operating leases, for two years each. Under the operating leases, the annual payments would be $1,400 on the first lease and $2,600 on the second least. If a firm purchased the asset, it would pay $1,893 annually to amortize (write off) a $6,000 loan over 4 years at 10 percent interest. This is based on the use of Table 1 for the present value of an annuity from Part 41 of this analysis (and reintroduced below).

The firm is in a 30 percent tax bracket. In doing our analysis we look first at the aftertax costs of the operating lease arrangements in Table 1. The tax shield in column (2) indicates the amount the lease payments will save us in taxes. In column (3) we see the net aftertax cost of the lease arrangement.

Table 1 Aftertax cost of operating leases

For the borrowing and purchasing decision, we must consider not only the amount of the payment but also separate out those items that are tax-deductible. First we consider interest and then depreciation.

In Table 2, we show an amortization table to pay off a $6,000 loan over 4 years at 10 percent interest with $1,893 annual payments. In column (1) we show the beginning balance for each year. This is followed by the annual payment in column (2). We then show the amount of interest we will pay on the beginning balance at a 10 percent rate in column (3). In column (4) we subtract the interest payment from the annual payment to determine how much is applied directly to the repayment of principle. In column (5) we subtract the repayment of principal from the beginning balance to get the year-end balance.

Table 2 Amortization table

After determining our interest payment schedule, we look at the depreciation schedule that would apply to the borrow purchase-decision. Using the 3-year MACRS depreciation category (with the associated 4-year write-off), the asset is depreciated at the rates indicated in Table 3. 

Table 3 Depreciation schedule

We now bring our interest and depreciation schedules together in Table 4 to determine the after-tax cost, or cash outflow, associated with the borrow-purchase decision.

The interest and depreciation charges are tax-deductible expenses and provide a tax shield against other income. The total deductions in column (4) are multiplied by the tax rate of 30 percent to show the tax shield benefits in column (5). In column (6), we subtract the tax shield from the payments to get the net after-tax cost, or cash outflow.

Finally, we compare the cash outflows from leasing to the cash outflows from borrowing and purchasing. To consider the time value of money, we discount the annual values at an interest rate of 7 percent. This is the aftertax cost of debt to the firm, and it is computed by multiplying the interest rate of 10 percent by (1 - Tax rate). Because the costs associated with both leasing and borrowing are contractual and certain, we use the aftertax cost of debt as the discount rate, rather than the normal cost of capital. The overall analysis is presented in Table 5.

Table 5 Net present value comparison

The borrow purchase alternative has a lower present value of after-tax costs ($4,422 versus $4,646), which would appear to make it the more desirable alternative. However, many of the previously discussed qualitative factors that support leasing must also be considered in the decision-making process. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 502-504*

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