2 FIN team

Buy or Lease?

There are several reasons why a company might choose to lease rather than purchase an

asset. A purchase transaction often requires a significant cash outlay in the form of a

down payment at the date of purchase; leasing, therefore, can be used to minimize the

amount of cash paid initially to acquire the asset. For some types of assets, such as

computers, leasing could enable the lessee to avoid risks of obsolescence, if the

appropriate terms are written into the lease agreement.

Another potential advantage of leases is that, if the agreement can be recorded as an

operating lease, the lessee does not have to report any related liability. This is an

important consideration if a company is concerned about the effect of reporting additional

debt on the balance sheet (impact on ratios).

A capital or financing lease is in substance a purchase and must be reflected on a

company's balance sheet as an asset and corresponding liability. Generally, it is a lease

under which the lessee acquires all the economic benefits and risks of the leased property

as opposed to just paying for the use of the property and, consequently, must be treated as

a purchase by the customer and a sale by the lessor per GAAP.

The answer whether to buy or lease is never an easy one but the question must be

addressed quite frequently.

By calculating the after-tax outflows of both options and discounting them to their

present value, a company can determine the most cost effective choice (usually the

lowest present value).

Many lease vs. buy situations will only require you to compare the present values of the

various options and choose the lowest cost one. But there may be more difficult

decisions depending on the circumstances. Factors like the nature of the asset, the tax

situation, the working capital position, and the degree of leverage of the company, make

the situation less straightforward. In these cases, you must also factor in all the

qualitative inputs in addition to keeping an eye on the present value numbers.

Questions to be answered:

What is the economic life of the asset under consideration?

What is the rate of obsolescence?

What will the impact of its acquisition be on the balance sheet and on the cash flows?

An operating lease is a particularly good option when you are unlikely to use the asset

through its entire economic life. If you can utilize the asset for its entire economic life, a

capital lease or a buy transaction may be a better option.

An important distinction between buying and an operating lease is that, since the

operating leases are short-term in nature, the asset acquired is not reflected in the balance

sheet. This means that there is no depreciation expense on an operating lease. Instead

you have the rental payments.

Both capital leases and buy transactions are recorded on the balance sheet. In a capital

lease, the depreciation expense is deducted from the outflows of the lease, after adjusting

for the tax. The net effect is the after-tax outflows are lower when compared to an

operating lease because in the operating lease the depreciation is claimed by the lessor,

not the company. In either capital lease or buy transactions, the benefits of depreciation

can be claimed for tax purposes.

If you have a pressure on cash flows, you might have to decide in favor of a lower

monthly payment rather than a lower overall present value cost.

One of the advantages of owning an asset instead of leasing it is that it gives you the

option of selling the asset in return for cash. If the asset is critical to the operation of the

business, it can then be leased back. Exercising a sale and leaseback option will provide

immediate cash while at the same time the company may continue using the asset.

A sale-leaseback can be used by businesses in situations where they are short of cash.

Selling the asset can unlock large amounts of cash. The problem of retaining use of the

asset, can be solved by a sale-leaseback arrangement.

Remember that buying an asset can also offer the company important benefits. If the

asset is required for the long-term and there is no threat of obsolescence, the company

could utilize the asset for its entire economic life and may fare better with an outright

purchase.

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Over the years a number of potential benefits have been offered for lease financing.

Some of the more frequently cited advantages are enumerated and commented upon here.

1. Flexibility and convenience. It is often argued that lease financing is more

convenient than other forms of financing because smaller amounts of

funds can be raised at lower cost. In addition, it is often argued that lease

payment schedules can be made to coincide with cash flows generated by

the asset. These may or may not be real advantages. It depends on the

actual circumstances faced by the lessee firm.

2. Lack of restrictions. It has been argued that leases require fewer

restrictions on the lessee than do debt agreements.

3. Avoiding the risk of obsolescence. This argument is generally conceded to

be fallacious because the lessor includes his or her estimated cost of

obsolescence in the lease terms.

4. Conservation of working capital. Here it is argued that leasing involves no

down payment. However, the borrower could obtain the same effect by

borrowing the down payment.

5. 100-percent financing. The lease involves 100% financing but purchasing

the asset would surely involve some equity. As we noted above, the down

payment could be borrowed to produce 100% financing via a loan. In

addition, it is not clear that 100% lease financing is desirable because it

represents 100% non-owner financing. Finally the lease agreement does

not entitle the lessee to the asset's salvage value. Thus, the lease provides

100% financing for the "use value" of the asset but not its "salvage value."

6. Tax savings. The difference in tax shelters between leasing and other

forms of financing should be evaluated using a “net advantage of lease

model”.

7. Ease of obtaining credit. Lease financing may be more or less difficult to

obtain than other forms of financing. This advantage (or disadvantage) can

only be evaluated on a case-by-case basis.

Sources:

Commentary to simulation “Analyzing Lease vs. Buy Decisions”. Albrecht, J. et al “Accounting

Concepts & Applications” pp. 468-469.

Keown, A.J., Martin, J.D., Petty, J.W., Scott, D.F. (2005). Financial management: Principles and

applications (10 th

ed.). Chapter 24- Term Loans and Leases