THE LEASE OR BUY

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• THE LEASE OR BUY
• DECISION

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Leasing versus Buying (Figure 25.1)
Buy
Lease
Sass Co. buys asset and uses asset financing
raised by debt
Sass Co. leases asset from lessor the lessor
owns the asset
Manufacturer of asset
Manufacturer of asset
Sass Co. arranges financing and buys asset from
manufacturer
Sass Co. leases asset from lessor
Lessor 1. Owns asset
2. Does not use asset
Lessee (Sass Co.) 1. Uses
asset 2. Does not own asset
Sass Co. 1. Uses asset
2. Owns asset
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Types of Leases

• Operating leases
• Financial leases

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Leasing and the Balance Sheet (Table 25.1)
A. Balance Sheet with Purchase (co. finances
100,000 truck with debt) Truck 100,000 Debt
100,000 Other assets 100,000 Equity
100,000 Total assets 200,000 Debt plus
equity 200,000
B. Balance Sheet with Operating Lease (co.
finances truck with an operating lease) Truck
0 Debt 0 Other assets
100,000 Equity 100,000 Total
assets 100,000 Debt plus equity 100,000
C. Balance Sheet with Capital Lease (co. finances
truck with a capital lease) Assets under
capital Obligations under lease 100,000 cap
ital lease 100,000 Other assets
100,000 Equity 100,000 Total
assets 200,000 Debt plus equity 200,000
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Criteria for a Capital Lease

• A capital lease must be disclosed on the balance
  sheet if at least one of the following criteria
  is met
• Ownership transfer
• Bargain purchase option
• Lease term/Asset life
• PV lease payments/FMV

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Incremental Cash Flows for Tasha Corp. (Table
25.2)

• Lease
• versus buy Year 0 Year 1 Year 2
  Year 3 Year 4 Year 5
• Aftertax -1,650
  -1,650 -1,650 -1,650 -1,650
• lease
• payment
• Lost - 680
  - 680 - 680 - 680 -
  680
• depreciation
• tax shield
• Cost of
• machine 10,000
• Total cash 10,000 -2,330 -2,330
  -2,330 -2,330 -2,330
• flow

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Reasons for Leasing

• Good reasons for leasing
• Bad reasons for leasing

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Solution to Problem 25.1

• You work for a nuclear research laboratory that
  is contemplating leasing a diagnostic scanner
  (leasing is a very common practice with
  expensive, high-tech equipment). The scanner
  costs 1,000,000 and it would be depreciated
  straight-line to zero over four years. Because of
  radiation contamination, it will actually be
  valueless in four years. You can lease it for
  300,000 per year for four years.
• Assume that the tax rate is 35 percent. You can
  borrow at 8 percent pretax. Should you lease or
  buy?

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Solution to Problem 25.1 (concluded)
Year 0 Year 1
Year 2 Year 3 Year
4 Aftertax lease payment Lost depreciation tax
shield Cost 1,000,000 Cash flow
1,000,000 Discounting at 8(1-.35) 5.2, the
NAL
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Solution to Problem 25.2

• Refer to the previous problem. What are the cash
  flows from the lease from the lessors viewpoint?
  Assume a 35 percent tax bracket.

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Solution to Problem 25.2 (concluded)
Year 0 Year 1
Year 2 Year 3 Year
4 Aftertax lease payment Lost depreciation tax
shield Cost -1,000,000 Cash flow
-1,000,000 Discounting at 8(1-.35) 5.2, the
NAL
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Solution to Problem 25.3

• What would the lease payment have to be for both
  lessor and lessee to be indifferent about the
  lease?
• Solving for LP gives ____________