Purchase versus Lease Decision

When deciding on whether to purchase or lease an asset, a firm should compare after-tax cash outflows associated with each option. The option with the lowest present value of after-tax cash outflows should be selected.

To make a decision between purchase and lease alternatives, we need to do the following:

  • Determine after-tax cash outflows for lease alternatives.
  • Determine after-tax cash outflows for purchase alternatives.
  • When completing steps 1 and 2,  the purchase option at the end of the lease should be incorporated into analysis in step 1 and sale of purchased asset at the end of the term (equivalent to the lease term) should be incorporated in analysis in step 2. This will ensure that we compare assets of equal lives.
  • Find the present value of the cash outflows under lease and purchase. The after-tax cost of debt should be used as a discount rate. One can use a financial calculator to find present value of the mixed stream of outflows or find the present value of the annuity.
  • Select an option with the lowest present value.

It is also important to remember that financial manager must always attempt to find options with the lowest cost of capital to ensure maximization of the owners’ wealth.

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Financial Lease (Capital Lease)

Finance lease (also called financial lease or capital lease) refers to the lease of the asset where the useful life is closely aligned to the term of the lease. The lease term is longer than operating lease. Finance leases are usually leases for an asset which does not become technologically obsolete. Under a capital lease, the lessee is usually responsible for all maintenance and other costs. Comparatively, under an operational lease, lessor is usually responsible for such costs.

A lessor purchases an asset selected by the lessee. The lessee will be able to use the asset during the duration of the lease agreement as long as contractual, periodic and timely payments are made by lessee to the lessor.

At the end of the term, the lessee may have a purchase option which allows the lessee to acquire an ownership of the asset. The lessee is not allowed to cancel the lease which makes a financial lease similar to long-term debt. If a lessee misses contractual or periodic payments, the lessee may be forced into bankruptcy.

Because under a finance lease, the lessee may have some ownership of the asset with some risks and benefits that comes with ownership, a finance lease must be recorded as a capitalized lease. This refers to recording the present value of all contractual payments and assets and corresponding liabilities on the balance sheet.

Under a finance lease, the firm benefits from the tax-deductibility of the interest paid on the leased asset as well as from depreciation of the leased asset which is recorded as an expense on the firm’s income statement.

This leads to increases in the debt/equity ratio and therefore an increase in financial leverage compared to an operational lease. It also leads to a decrease in working capital due to an increase in current liabilities.

Moreover, part of the payments due to a financial lease are recorded as a reduction in lease liability under operating cash flows and part is recorded as lease interest payments under financing cash flows. This leads to an increase in operating cash flow compared to records under operating lease where only operating cash flow is affected.

Because firms have an incentive to report leases as operational leases, certain regulatory rules were established by Financial Accounting Standards Board (FASB) which specify which assets can qualify for operational leases. The following is a list of characteristics of financial leases. If even one of such characteristic is met than an asset should be recorded as financial lease.

  • A lease term is 75% or more of the useable life of the asset.
  • At the commencement of the lease agreement, the present value of the lease payments is equal to 90% or more of the fair market value of the leased asset.
  • Ownership of the asset is transferred to the lessee at the maturity of the lease agreement.
  • A lease agreement contains an option to purchase the asset at the “bargain price” which must be the fair market value.

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Operating and Financial Leases (Capital Leases)

Within an accounting context, a lease can be classified as an operating lease or a financial lease.

Operating lease (service lease) refers to a short-term lease of an asset with a useful life longer than the term of the lease. For example, this applies when fixed assets with a useful life of 15 years are leased for 3 years. This type of lease is common for fixed assets with a longer useful life but which become less efficient and even technologically obsolete relatively fast, such as computer systems and office equipment.

Operating leases usually can be cancelled but generally a cancellation penalty will apply. They also usually include maintenance clauses which require the lessor to conduct maintenance of the asset as well as tax and insurance payments.

Operational leases usually include a renewal option since the economic life of the asset is generally relatively longer than the lease term. This allows the lessee to renew the lease of the asset at the end of the term of the lease. A purchase option may be included at the end of the lease which will allow the lessee to acquire the asset.

Under an operating lease, a lessor transfers to lessee only the right to use the asset. The lessee does not have any level of ownership over the asset. Under an operating lease, periodic payments, as per the lease agreement, are recorded as expenses in the income statement. Operating lease expense is not recorded in the balance sheet.

Consequently, under an operating lease (compared to capital lease), financial ratios present misleading results. For example, leverage ratios are understated because no liability is recorded associated with the lease. For example, the debt-equity ratio is lower and so is the debt ratio. The times interest earned ratio is higher because under an operating lease, depreciation is not recorded.

Liquidity ratios are also affected. Both, the current ratio and quick (Acid-Test) ratio are overstated because the lease is not reflected in current liabilities. Moreover, the ROA profitability ratio is overstated because total assets are not affected under an operating lease.

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Advantages & Disadvantages of Leasing

Advantages of Leasing

  • Businesses avoid large capital outlays when acquiring the use of an asset, thereby freeing up cash for more productive uses.
  • In the case of the start ups, leasing also helps to ascertain a business’s asset requirements before purchase of assets is made. As an example, a business can rent a building space for a year to obtain a better understanding of the business’s building requirements before committing to purchasing a space.
  • Leasing offers flexibility, especially with assets which tend to become obsolete very fast.
  • Leasing does not result in restrictions on company’s financial operations due to loan covenants.
  • If firm experiences liquidity problem, it can lease back an asset to the lessor that the firm already owns. Sale-leaseback arrangements consist of selling an asset to the lessor and leasing it back. Such action can the improve liquidity of the firm.
  • If the firm will go bankrupt or if it is undertaking reorganization, the firm is better off if assets are leased because the lessor can claim a maximum of 3 years worth of lease payments. Lenders, on the other hand, can claim the entire outstanding debt.
  • Leases usually do not require down payment. Therefore, lease provides 100% financing. In comparison, when an asset is purchased, lenders often usually require down payment of 10% or at least 5% of the asset.
  • Under operational lease some financial ratios look better because the asset is not capitalized, which refers to asset not being recorded in the balance sheet as an asset and corresponding liability.
  • Lease can be undertaken as a hedge against rapid obsolescence of equipment.
  • Leasing allows the revenue generated by the asset to provide funds for the payment for the asset. This benefit is especially relevant for start ups which usually have very limited resources.
  • Organizations can adjust the term of the lease for the duration of time when the leased asset is planned to be used and then update the asset when required.
  • Leasing provides organizations with options. Under a lease agreement the organization may have options of returning the asset, renewing the lease or purchasing the asset.
  • It is usually easier to obtain a lease that to obtain a loan to purchase the asset.
  • Leases may offer tax advantages which depend on how the lease is structured.

Disadvantages of leasing

  • Purchase is likely to be preferred to lease if the asset is planned to be used for a long duration of time without renewal of asset.
  • If the business no longer requires an asset or if the asset becomes obsolete before the end of the lease term, it may be expensive and very difficult to terminate the lease before the end of the contract. If asset is owned, it may be easier to make appropriate arrangements to sell or rent out the unnecessary or obsolete asset.
  • Although the initial large cash outlay is avoided, over the long-term the lease may account for a larger capital outlay than if firm purchased an asset instead.

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A lease is a contract between tenant (a lessee) and owner (a lessor) of the asset which allows the tenant to use owner’s property over specified period of time in exchange for periodic payments which the lessee makes to lessor. The contract must be signed by both lessee and lessor and is usually called a lease agreement.

Leases can be arranged for both tangible and intangible assets. Lease of tangible assets is lease of assets that one can see and touch and includes assets such as automobiles, buildings and equipment. Lease of intangible assets is a lease of assets that one cannot see and touch. An example will be a lease of use of a radio frequency.

Leasing is a substitute for purchase of a fixed asset. It is one of the ways in which an organization can finance its assets. It allows the firm to make use of an asset in exchange for contractual periodic payments which are tax deductible.