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This article proposes a model for evaluation of leasing and buying based on the costs and benefits
associated with each options. The cost associated with leasing is the lease rentals to be paid and the
maintenance costs if any. The cost associated with buying through borrowing and using the machine
is the value of the asset itself and the interest charges to be paid to the banker or financier. There is
an important benefit associated with the buying option. That is the use of the Accumulated
Depreciation Funds. The accumulated depreciation funds could earn an interest in par with the cost
of capital at which the company is operating. Earlier models suggested the calculation of the present
value in the form of before tax and after tax cash flows occurring at the year ends.
In this model the author proposes to calculate the benefits in the form of interest earned by the
depreciation funds (at the rate equal to the cost of capital or at the rate less than the lender’s rate) that
are accumulated for N-1 years where N is the life of the equipment or asset under consideration.
In this model the author argues that there is no impact of tax on the lease rentals and the after tax
cash outflow is the same as that of before tax cash flow. The reason being the lease rentals are
expenses going out of company. i.e out-of-pocket cost has no tax impact. The depreciation is an
expense not going out of a company but deducted as expense for corporate tax purposes and retained
in the company till the funds are used for replacing the asset. The benefit associated with retaining
the depreciation funds are worked out separately in this model.
The model is explained through an example problem and attempting to find its solution through the
basic present value approach. This model is not contrary to any of the earlier models as it
supports the simulation concept. Hence the evaluation of lease versus buying should be a case by
case approach. Considering the costs and benefits associated with each situation and the tax brackets
under which the companies are operating one has to decide whether to go for leasing or buying.
In conclusion the author says that leasing is always costlier than buying. But the buying option is
less beneficial as the corporate tax increases. The buying option is suitable for companies having
only good investment avenues and for those who can utilize the depreciation funds beyond the
average cost of capital.
Further research is required on the life of the asset and its survival beyond the depreciated period as
chances are more that the depreciation claims are speeded up by companies to enjoy tax advantage.
Assets of such kinds may be available in the market for low lease rentals which may beat the buying
option of a new equipment entry.
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SIMULATION MODEL FOR LEASE- OR –BUY DECISION
By Prof. S.Padmanaban & Dr. R.Gayatri
1.0 Introduction
Firms often have a choice between buying assets and leasing them. Leasing is a contract in
which an asset is taken for use by paying rentals instead of buying. An obvious advantage of leasing
is that one need not invest in the full value of the asset. To enjoy this advantage the lessee is
obligated to make periodical lease payments and as agreed upon should bear the maintenance costs
and repair costs in keeping the asset under usable condition.
Deciding, whether to go for Buying or Leasing depends on the level of Taxation the
Depreciation treatment/ tax advantage arising out of depreciation in comparison with the lease rental.
Most of the evaluation methods and calculations are based on Present Value approach and this
method is widely accepted as we can see in many text books.
In this article same present value approach is adopted but the tax treatments and approach to
the benefits of depreciation are different from the conventional one. The author explains the reason
for such treatment with some logical arguments. It is up to the readers to judge the approach and
accept as there are several ways and means to evaluate a lease. The simulation approach argues for
the use of depreciation funds at the interest rate equal to the cost of capital- an important benefit
enjoyed by the owner of the asset (Buying Option) and also argues that there is no such cash flow
called as after tax cash flow when there is no impact of tax on the before tax cash flows such as lease
rentals being out-of- pocket costs. The author calls this model as simulation model as it adopts the
costs and benefits associated with the options and simulates the situation.
The simulation model is explained with a hypothetical example problem and situation in
which a company has to decide whether to go for leasing or buying.
2.1. Solution
Table 1 Present value of Lease Rentals to be paid
Year Before Tax After Tax Discount Rate Present Value of the
End Lease Rentals Lease Rentals @ 12% ( PVn i) Lease Rentals to be Paid
1 150000 150000 0.893 133950
2 150000 150000 0.797 119550
3 150000 150000 0.712 106800
4 150000 150000 0.636 95400
5 150000 150000 0.567 85050
6 150000 150000 0.507 76050
7 150000 150000 0.452 67800
Total Present value of all payments 684600
The same amount may be arrived at by using:
The present value of annuity factor of Rs.1 for 7 years @12% = 4.564
Annuity Payment =Rs. 150000/-
The present value of all Lease payments = 4.564 x Rs.150000 = Rs.684600/-
2.1.1 Tax Treatment on Lease Rental Payments
An operating or service lease is usually signed for a period much shorter than the actual life
of the asset, and the present value of lease payments are generally much lower than the actual price
of the asset. A financial or capital lease generally lasts for the life of the asset, with the present
value of lease payments covering the price of the asset.
In the conventional approach we apply tax treatment to these lease payments and the after tax
cash flow will be equal to Rs.150000 x (1-tax rate). That will be Rs.150000 x 0.65 = Rs.97500/-
every year and the present value of those payments will be Rs.97500 x 4.564 = Rs.444990/- .
How can the present value of the lease payments will be less than that of the value of the
equipment at point in time zero? If the present value of the lease payments are less than the value or
cost of the equipment it is contrary to the view point of the lessor.
In finding the present value what discount factor should be applied is an important question.
Some authors use the cost of debt and some authors use cost of debt adjusted for the tax rebate. (13;
14; 15). Both are not acceptable to this author from the view point of cost of capital. All projects and
their cash flows are to be discounted at a rate equal to the weighted average cost of capital or at the
cost of equity from the view point of wealth maximization objective.
Hence the author argues that the after tax and before tax cash flow of lease rentals are the
same and these payments have no tax advantage or tax gain in reality. The conventional approach
was based only on an opportunity cost view point. Hence the author concludes that there is no tax
advantage on the lease rental payments. More over the IRS - Internal Revenue Service (for tax
purposes) is wary of lease arrangements designed purely to speed up tax deductions.
The present value from Table 1 derived at Rs. 684600/- is real and acceptable from the lessor’s view
point also. That is any one willing to accept 12% as expected rate of return will be ready to lease the
equipment as the rental values yield a PV of Rs.684600/- which is above the cost of equipment Rs.
625000/-.
The Financial Accounting Standards Board (FASB) has specified that firms must treat leases as
capital leases if the present value of the lease payments exceeds 90% of the initial value of the asset
and the life of the lease is at least 75% of the asset’s life. Hence this model suggests that in lease
valuation of any kind the present value of lease rentals should be relevant to the life of the asset.
While the differences between operating and financial leases are obvious, some lease arrangements
do not fit neatly into one or another of these extremes; rather, they share some features of both types
of leases. Firm valuation can be impacted by how we deal with operating leases. While the
accounting distinction between capital and operating leases may seem reasonable, there seems to be
no reason, from a financial standpoint, to maintain that distinction when it comes to estimating
operating income, capital and profitability.(16) Hence in this model the lease valuation is also
assessed from the view point of profitability.
2.1.2. The Buying Option
Buying the same equipment through borrowing and using has the following costs and benefits.
Costs:
1. The present value of the equipment itself Rs.625000
2. The Present Value of the interest payments made discounted at the rate
of 12% cost of capital of the company Rs.302995
Pv of Total Costs Rs. 927955
Benefits:
3. Present value of Tax advantage on depreciation at 35% of corporate tax
discounted at the rate of 12%- cost of capital Rs.136235
Note: Even though the interest rates are charged at 15% the amount paid are discounted at the rate of
12% which is the average cost of capital of company to arrive at the present value of cost involved in
borrowing and using the equipment.
Note:
1. Even though the company is borrowing at 15% interest rate it is assumed that the company can
utilize or lend only at 12% which is less than the banker’s lending rate (assumed for illustration
purpose). Also the amount earned is discounted at 12% to arrive at the present value which is the
cost of capital of the company.
2. There is no interest earned at the last year because the project ends and the accumulated
depreciation funds are needed to replace the equipment.
3. The depreciation amount Rs. 89286/- is arrived at by dividing Rs. 625000 by 7 years which is the
life in years of the equipment.
Note:
1. The same present value can be arrived at by multiplying the Present Value of
Annuity of Rs.1 which is equal to 4.564 by the tax advantage amount Rs.29850
= Rs.136235.
Hence the total present value of profits earned from buying operation = Rs.167373/-
The buying option is more profitable by the present value of Rs.50210/-
Table .9 shows the present value of the lease evaluation at different tax rates.
Tax at “0” % Tax at “35%” Tax at “50%”
PV PV Discounted PV Discounted
Discounted at 20% at 26%
at 13%
Rs. Rs. Rs.
Leasing Option
Present value 221150 117163 77075
Buying Option
Total Present Value 328987 167373 104393
The benefit Ratio 1.4876 1.4285 1.3544
between Options
Table .10 shows the present value of the Buying Option –Details at different tax rates.
Tax at “0” % Tax at “35%” Tax at “50%”
PV PV Discounted PV Discounted
Discounted at 20% at 26%
at 13%
Rs. Rs. Rs.
Details of Buying
PV of Profits from
Operations 194233 97549 60373
PV of Interest Earned
by Accumulated 134754 69824 44020
Depreciation
The benefit ratio 1.4414 1.3970 1.3715
between Operations
and Interest earned
Note: The present values are found by discounting at 13% and 20% and 26% assuming
a 13% dividend for the prevailing cost of capital of 12%.
The values in table above suggest that buying option is supported only because of the
depreciation funds and its utilization. Otherwise Leasing is always the best option. The
theoretical literature on corporate leasing also predicts that the economic gains from leasing are
negatively related to the lessee’s effective tax rate and positively related to the lessee’s external
financing costs. Previous empirical studies have examined the valuation effects of leasing and the
relation between a firm’s propensity to lease its assets and its tax rate and external financing costs.
(6) The values in the table is in accordance with the theoretical works and evidence already done.
6.0 Conclusion
The leasing option is always costlier than buying. Leasing is costly even in an environment where
there is no corporate tax. The buying has two important advantages over leasing. The first one is the
use of depreciation funds. The second one is the tax advantage or tax gain arising from deducting
depreciation for calculating the corporate tax. The same tax advantage is not real for lease rentals as
it is an out-of –pocket cost and it has no impact on the tax calculations.
Even though the buying option always lead in number terms over leasing option as the tax rate
increases the benefit ratio between the buying option and the leasing option decreases indicating
that the lease rentals are preferred in a situation where corporate taxes are higher.
Moreover those companies capable of utilizing the depreciation funds effectively only can enjoy the
benefits of buying option. Companies having idle/ low investment projects for depreciation funds
cannot make out great benefits over buying. They should go for leasing. We need to dig further with
the life of the asset and the leasing option. The leasing options may still be preferred because of the
defender’s strength (old machines long life higher than the depreciation period) over new
equipment’s price and the borrowing rate to replace the same.
The discount rate the expected rate of return the cost of capital and the interest earned are all the
same for all practical purposes.
7.0 Bibliography
1. Bower .R.S “ Issues in Leasing” Financial Management Winter 1973 pp 25-34.
2. Miller. M.H. and C.W.Upton “Leasing Buying and the Cost of Capital Services” Journal of
Finance 1976 .31. pp 761-86
3. Schall.L. “ Lease –or-Buy and Asset Acquisition Decision” Journal of Finance September 1974
pp 1203-14.
4. Myers, S. C., Dill, D. A., & Bautista, A. J. (1976). “Valuation of financial lease contracts”.
Journal of Finance, 31,799–819.
5. Modigliani.F and M.H.Miller “Corporate Income Taxes and the Cost of Capital” American
Economic Review June 1963 pp 433-443.
6. John R.Ezzell and Premal P Vora “Leasing Versus Purchasing: Direct Evidence on a
Corporation’s Motivations for Leasing and Consequences of Leasing” The Quarterly Review of
Economics and Finance 41 (2001) pp 33-47.
7. Brealey, R. A., & Young, C. M. (1980). “Debt, taxes and leasing–a note”. Journal of Finance, 35,
1245–1250.
8. Handa, P. (1991). “An economic analysis of leasebacks”. Review of Quantitative Finance and
Accounting, 1, 177–189.
9. Krishnan, V. S., & Moyer, R. C. (1994). Bankruptcy costs and the financial leasing decision”.
Financial Management, 23, 31–42.
10. Schallheim, J. S. (1994). Lease or buy? Principles for sound decision making. Boston: Harvard
Business School Press.
11. Smith Jr., C. W., & Wakeman, L. M. (1985). Determinants of corporate leasing policy. Journal
of Finance, 40,895–908.
12. Sharpe, S. A., & Nguyen, H. H. (1995). Capital market imperfections and the incentive to lease.
Journal ofFinancial Economics, 39, 271–294.
13. “Financial Management” I.M.Pandey 7th Revised Edition 1995 Vikas Publishing House (P) Ltd.
New Delhi. Pp 942-963
14. “Financial Management” –Text and Problems- 2nd edition. M.Y. Khan P.K. Jain. 1994 3rd
Reprint. Tata McGraw Hill Publishing Company Ltd. Newdelhi. Pp 395 -413
15. “Financial Management” –Text and Problems- 4th edition. M.Y. Khan P.K. Jain. 1994 Tata
McGraw Hill Publishing Company Ltd. Newdelhi.
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