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Buy or Lease? An Introduction to Lease Analysis

CEO@tekmarsis.biz

Introduction

This short article is an introduction to how to make a buy versus lease decision. I begin with basic leasing terminology and build on it by adding concepts that are relevant. I then present what is considered the textbook model of the buy versus lease decision, illustrate it with an example, and conclude by discussing real-world factors that should have an impact on the buy versus lease decision. By some accounts, one-third of all capital assets such as real-estate, equipment, and rolling-stock such as cars, trucks, and aircraft that are put to use by U.S. corporations are leased. Despite the large numbers involved, the literature on the analysis of the buy versus lease decision is sparse and mostly relegated to textbooks. This short article brings together the main concepts related to this decision and presents a basic model of how to make the buy versus lease decision. The entity that will use the asset but lease it instead of buying is called the lessee. The organization that buys the asset and makes it available for the lessees use is called the lessor. The lessee and the lessor enter into an agreement that allows the lessee to use the asset for a xed term in exchange for regular lease payments. At the end of the term, the asset is returned to the lessor and the lessor can either lease it again, sell it, or put it to another use. The lessee avoids having to make a large up-front investment in the asset in return for smaller regular payments over the life of the lease term. The lessee also gives up the economic value of the asset at the end of the lease term. Additionally, if the lease is structured as an operating lease the lessee gives 1

up the right to depreciate the asset. Depreciation expense is a non-cash, taxdeductible expense that reduces the tax bill of the organization that receives the right to depreciate the asset. For the lessor, the situation is exactly reversed: the lessor makes a large up-front investment in the asset, receives regular lease payments over the term of the lease, receives the economic value of the asset at the end of the lease term, and gets to depreciate the asset. These are the key items that will appear in the model that is presented below.

The Model

The textbook model of leasing that is presented here is based on the dierence in the cash ows or incremental cash ows that the lessee will experience under leasing versus buying the asset. Once all the incremental cash ows are identied, the net present value of these cash ows will tell us whether it is worthwhile for the lessee to lease the asset or whether the lessee is better o by purchasing the asset. Let the purchase price of the asset be P0 . Had the lessee purchased the asset, P0 would have to be paid by the lessee to the seller of the asset. Under leasing, this cash ow does not occurr. Therefore, eectively the lessee receives P0 right now. Let Lt be the lease payment at time t, t = 0, 1, ..., T , where T is the length of the lease. The lease payments that the lessee incurs are a tax-deductible expense for the lessee. If the tax rate of the lessee is subject to is , every dollar of lease payment will reduce the lessees taxable income by a dollar and taxes will fall by . Therefore, eectively, the lessees cash outow toward lease payments is Lt (1 ). Let Dt be the depreciation expense at time t. Every dollar of depreciation expense reduces the lessees taxable income by a dollar. Since the lessees tax rate is , the lessees opportunity cost, at time t, of not being able to depreciate the asset is Dt . Finally, let ST be the economic value or the salvage value of the leased asset at the end of the lease. For simplicity I will let it be equal to the book value of the asset at time T so there are no tax considerations related to capital gains or losses. The net present value of the lease generally referred to as the Net Advantage to Leasing (NAL) for the lessee is
T

NALLessee = +P0
t=0

Dt ST Lt (1 ) )t )t (1 + r (1 + r (1 + r )t t=0 r = r(1 )

where and r = the interest rate at which the lessee can borrow capital necessary to purchase the asset. While the conventional wisdom on leasing correctly identies the incremental cash ows, it does not arrive at the correct rate at which cash ows should be discounted. The correct rate at which cash ows should be 2

discounted is the lessees after-tax borrowing rate on secured debt. There are two important characteristics of this rate: 1. it is the lessees borrowing rate on secured debt, and 2. it is the after-tax rate. The lessees borrowing rate on secured debt is the relevant rate because in many ways leasing an asset is like borrowing money to nance the purchase of the asset. The timing and magnitude of lease cash ows is xed and known much like payments on a loan. Further, if the lessee defaults on lease payments, the asset reverts to the lessor much like what happens with a default by the borrower on a secured loan. Additionally, when an entity borrows a dollar, its ability to borrow more dollars is reduced, i.e., borrowing reduces debt capacity. Likewise, when an asset is leased by a lessee, the xed payments that the lessee agrees to make to the lessor reduces the lessees debt capacity. Debt capacity is valuable for a number of reasons, but if we conne ourselves to the tax advantages of debt it can be shown that discounting a xed cash ow such as a lease payment by the after-tax cost of borrowing accounts for the loss of debt capacity.

An Example

I illustrate the basic model of leasing with a simple example here. Happy Valley Farms is interested in investing in solar panels to help reduce their energy costs. The company has already determined that this is a protable project. Can the company make this project more protable by leasing the solar panels? The company that makes these solar panels, Sun Energy, has a leasing division that has provided Happy Valley with the following estimates: If purchased, the solar panels would cost Happy Valley $100,000. They have a life of eight years. Sun Energy would require an annual lease payment of $20,100 due at the end of each of the next six years. Happy Valley can depreciate the solar panels under the MACRS ve-year property class. Under this class, the portion of the asset that can be depreciated each year is given in Table 1. Table 1 MACRS Depreciation Schedule for 5-year Property Year Portion 1 0.2000 2 0.3200 3 0.1920 4 0.1152 5 0.1152 6 0.0576 Happy Valleys bank is willing to lend $100,000 toward the purchase of the solar panels provided they are secured by the loan. The loan would be subject to an interest rate of 6 percent. At the end of eight years, the solar panels would

be completely spent and would have no salvage value. Happy Valley is currently making losses; therefore, its tax rate is zero. Now I frame the lessees cash ows in terms of the model that was formulated above. The purchase price of the asset, P0 = $100,000. The annual after-tax lease payment is Lt (1 ) = $20,100 (1 - 0) = $20,100, for t = 1, 2, ..., 6. The annual depreciation expense varies according to the MACRS schedule in Table 1. However, because this lessee is currently making losses and its tax rate is zero, it has no opportunity cost associated with giving up the depreciation tax shield generated by the solar panels. It is still useful to know what the loss of the depreciation tax shield would have been had this lessee been in a tax-paying position. According to Table 1, 20% of the value of the asset can be depreciated in the rst year. Therefore, 20% of $100,000 or $20,000 is the depreciation expense generated by the solar panels in the rst year. Suppose this lessee were paying taxes at a rate of 35%. In the rst year, the lessee would have lost 35% of $20,000 or $7,000 in opportunity costs. Because the solar panels are spent at the end of eight years and have no salvage value, S8 = 0. Finally, the lessees borrowing rate is 6 percent. While, for most lessees, the after-tax borrowing rate will be lower than their pre-tax borrowing rate, for this lessee they are identical. Therefore, the NAL for Happy Valley Farms is
8

NALHappy

V alley F arms

= +$100, 000
t=1

$20, 100 = $1, 162 (1.06)t

Because the NAL is positive, Happy Valley Farms will choose to lease the panels instead of buying them. Leasing the solar panels instead of buying them makes this project $1,162 more protable. I can also calculate the interest rate implied by the lessees cash ows. Because the NAL is positive, the interest rate implied by the cash ows will be lower than the 6 percent lessee borrowing rate. The implied rate, r, is the interest rate that makes the NAL = 0. Therefore,
8

NALHappy

V alley F arms

= +$100, 000
t=1

$20, 100 = $0 (1 + r)t

The r that makes NAL = 0 is 5.63%. The NAL as well as the implied interest rate suggest that leasing is benecial for the lessee.

The Lessors Perspective

For this lease to materialize, the lessors NAL must be positive or at the minimum be zero. The lessors pre-tax cash ows are exactly equal and opposite of the lessees cash ows. If lessee and lessor tax rates are equal, no leasing arrangement that is motivated purely by taxes will have a positive NAL for both parties. 4

In this particular example, lets assume that the lessor is protable and pays taxes at a rate of 35%. The lessors NAL is
8

NALLessor

= $100, 000 +
t=1

$20, 100(1 0.35) (1 + 0.06(1 0.35))t

$20, 000(0.35) $5, 760(0.35) + + ... + 1 (1 + 0.06(1 0.35)) (1 + 0.06(1 0.35))6 = $208 The lessors NAL is positive even though it is smaller than the lessees. For most commodity-like assets, lessors operate in competitive markets. Thus, it is typical that the lessors NAL is small or even zero. Even with a zero NAL, the lessor is making an appropriate rate of return on their investment. For truly unique assets, lessees and lessors will negotiate a leasing agreement that is benecial to both parties but the gains from the agreement will be divided between the two parties depending on their relative bargaining positions.

Further Considerations

The illustrative example here is very simple. For most operating leases, the life of the asset is much longer than the term of the lease contract. At the end of the lease, the asset will have some value. Frequently, the lessor provides the lessee with an option to purchase the asset at a xed and pre-determined price. This option can turn out to be attractive to the lessee depending upon the specics of the contract and can have a signicant impact on whether the asset is leased or bought. A further tax-related complication arises when there is a dierence between the price at which the lessor sells the asset to the lessee and the book value of that asset. Additionally, most leases will require the lessee to deposit a xed amount with the lessor at the inception of the lease. The deposit acts as security to ensure that the lessee uses the asset carefully; if the asset is found to have been over-used the lessor will subtract an appropriate amount before returning the net amount to the lessee. Many leases are also metered, e.g., most automobile leases allow the lessee to drive the car for a certain number of miles for the duration of the lease, with any additional mileage incurring a xed charge per mile. In the example above, the NAL is positive for both parties essentially because a non-tax-paying lessee transfers the depreciation tax shield to the lessor. While conventional wisdom would suggest the organization that has legal title to some asset would be able to depreciate that asset, it turns out that this is not necessarily true. In the U.S., for instance, a lease must be considered an operating lease before the lessor can depreciate the asset. There are a number of requirements a lease must meet before it can be deemed an operating lease.

Concluding Remarks

This short article on leasing has introduced basic leasing terminology and concepts. I also presented what is considered to be the textbook model of leasing and illustrated it with a simple example. One of the conclusions that emerged from this analysis is for a purely tax-motivated lease, the lessee and lessor tax rates must dier. However, leasing is not necessarily motivated purely by taxes. Other reasons why leasing may make sense are: The lessor bundles a maintenance contract with the lease. While the lessee may have only one or only a few units of a particular asset in use, the lessor may have leased many units of that asset. The lessor will have substantial economies of scale for servicing that asset and the lessee receives the benet of such economies. The contract contains an option to cancel. Options are always valuable and if the user of the asset is faced with uncertainty about how long that asset will be put to use, the user will be better o by leasing the asset under a contract that contains an option to cancel. The organization is strapped for cash and is nding it dicult to raise capital through its usual channels. Because the lessor has a higher priority over other lenders, cash-strapped organizations nd it easier to lease assets than to have them nanced by raising capital.

Tekmarsis, Inc. specializes in analytics based on accounting and nancial data. We can help potential lessees decide whether leasing makes economic sense. Some of our clients have realized substantial cost savings by leasing assets. Other clients have realized substantial savings by canceling leases that were nancially burdensome based on the analytics that we provided them. We also consult with lessors on lease pricing decisions. For further information please contact us by email at CEO@tekmarsis.biz.