Lease or buy

decisions
Leasing is a commonly used source of finance.

We distinguish three types of leasing:

• Operating leases (lessor responsible for
maintaining asset)
• Finance leases (lessee responsible for
maintenance)
• Sale and leaseback arrangements
1.1 The nature of leasing
Rather than buying an asset outright, using either available cash
resources or borrowed funds, a business may lease an asset.

Leasing is a contract between a lessor and a lessee for hire of a specific asset
selected from a manufacturer or vendor of such assets by the lessee.

The lessor has ownership of the asset.

The lessee has possession and use of the asset on payment of specified rentals
over a period.

Outright: without restrictions

1.1.1 Examples of lessors
• Banks
• Insurance companies
1.1.2 Types of asset leased
• Office equipment
• Computers
• Cars
• Commercial vehicles
• Aircraft
• Ships
• Buildings
1.2 Operating leases

Operating lease is a lease where the lessor retains most of the risks
and rewards of ownership.
Operating leases are rental agreements between a lessor and a lessee.

a) The lessor supplies the equipment to the lessee.

b) The lessor is responsible for servicing and maintaining the leased
equipment.
c) The period of the lease is fairly short, less than the expected economic life
of the asset. At the end of one lease agreement, the lessor can either lease
the same equipment to someone else, and obtain a good rent for it, or sell the
equipment second-hand.
1.3 Finance leases

A finance lease is a lease that transfers substantially all of the risks

and rewards of ownership of an asset to the lessee. It is an agreement
between the lessee and the lessor for most or all of the asset’s
expected useful life.
There are other important characteristics of a finance lease.
a) The lessee is responsible for the upkeep, servicing and maintenance of the
asset.
b) The lease has a primary period covering all or most of the useful economic
life of the asset. At the end of this period, the lessor would not be able to lease
the asset to someone else, because the asset would be worn out. The lessor
must therefore ensure that the lease payments during the primary period pay
for the full cost of the asset as well as providing the lessor with a suitable
return on his investment.
1.3 Finance leases (cont’d)
c) At the end of the primary period the lessee can normally continue to
lease the asset for an indefinite secondary period, in return for a
very low nominal rent, sometimes called a ‘peppercorn rent’.
Alternatively, the lessee might be allowed to sell the asset on a
lessor’s behalf (since the lessor is the owner) and perhaps to keep
most of the sale proceeds.
In legal parlance, a peppercorn is a metaphor for a very small
payment, a nominal consideration, used to satisfy the
requirements for the creation of a legal contract. It featured
in Chappell & Co Ltd v Nestle Co Ltd ([1960] AC 87), which
stated that a "peppercorn does not cease to be
good consideration if it is established that the promisee does
not like pepper and will throw away the corn".
1.4 Example: A motor lease
A primary period of the lease might be 3 years, with an
agreement by the lessee to make 3 annual payments
of $6,000 each. The lessee will be responsible for
repairs and servicing, road tax, insurance and
garaging. At the end of the primary period of the lease,
the lessee may have the option either to continue
leasing the car at the nominal rent (perhaps $250 a
year) or to sell the car and pay the lessor 10% of the
proceeds.
1.5 Sale and leaseback
Sale and leaseback is when a business that owns an
asset agrees to sell the asset to a financial institution
and lease it back on terms specified in the sale and
leaseback agreement.

The business retains use of the asset but has the

funds from the sale, whilst having to pay rent.
1.6 Attractions of leasing
Attractions include the following.
a) The supplier of the equipment is paid in full at the
beginning. The equipment is sold to the lessor, and other
than guarantees, the supplier has no further financial
concern about the asset.

b) The lessor invests finance by purchasing assets from

suppliers and makes a return out of the lease payments
from the lessee. The lessor will also get capital allowances
on his purchase of the equipment.
1.6 Attractions of leasing (cont’d)
c) Leasing may have advantages for the lessee:
i. The lessee may not have enough cash to pay for
the asset, and would have difficulty obtaining a
bank loan to buy it. If so the lessee has to rent the
asset to obtain use of it at all.
ii. Finance leasing may be cheaper than a bank loan.
iii. The lessee may find the tax relief available
advantageous.
1.6 Attractions of leasing (cont’d)
Operating leases have further advantages.
a) The leased equipment does not have to be shown in the lessee’s
published statement of financial position, and so the lessee’s
statement shows no increase in its gearing ratio.
b) The equipment is leased for a shorter period than its expected
useful life. In the case of high-technology equipment, if the
equipment becomes out of date before the end of its expected life,
the lessee does not have to keep on using it. The lessor will bear
the risk of having to sell obsolete equipment secondhand.
The major growth area in operating leasing has been in computers and office
equipment (such as photocopiers & fax machines) where technology is continually
improving.
1.7 Lease or buy decisions
The decision whether to lease or buy an asset is a
financing decision which interacts with the
investment decision to buy the asset. Identify the
least-cost financing option by comparing the cash
flows of purchasing and leasing. The cash flows are
discounted at an after-tax cost of borrowing.
1.7 Lease or buy decisions (cont’d)
The decision whether to lease or buy an asset is made once
the decision to invest in the asset has been made.

Discounted cash flow techniques are used to evaluate the

lease or buy decision so that the least-cost financing
option can be chosen.
1.7 Lease or buy decisions (cont’d)
The cost of capital that should be applied to the cash flows for the financing
decision is the cost of borrowing. We assume that is the organization
decided to purchase the equipment, it would finance the purchase by
borrowing funds (rather than out of retained funds). We therefore compare
the cost of purchasing with the cash flows of leasing by applying this
cost of borrowing to the financing cash flows.

The cash flows of purchasing do not include the interest repayments on

the loan as these are dealt with via cost of capital.
1.8 A simple example
Brown Co has decided to invest in a new machine which has a 10
year life and no residual value. The machine can either be
purchased now for $50,000, or it can be leased for 10 years with
lease rental payments of $8,000 per annum payable at the end of
each year.

The cost of capital to be applied is 9% and taxation should be

ignored.
Solution
Present value of leasing costs

PV = Annuity factor at 9% for 10 years x $8,000

= 6.418 x $8,000
= $51,344

If the machine was purchased now, it would cost $50,000.

The purchase is therefore the least-cost financing option.
1.9 An example with taxation
M&M has decided to install a new milling machine. The machine costs
$20,000 and it would have a useful life of 5 years with trade-in value of
$4,000 at the end of the fifth year. A decision has now to be taken on the
method of financing the project.

a) The company would purchase the machine for cash, using bank loan
facilities on which the current rate of interest is 13% before tax.
b) The company could lease the machine under an agreement which
would entail payment of $4,800 at the end of each year for the next 5
years.

The rate of tax is 30%. If the machine is purchased, the company will be
able to claim a tax depreciation allowance of 100% in year 1. Tax is
payable with a year’s delay.
 Solution
Cash flows are discounted at the after-tax cost of borrowing, which is at
13% x 70% = 9.1%, say 9%.
The present value (PV) of purchase costs

Year Item Cash flow Discount factor PV

$ 9% $
0 Equipment cost (20,000) 1.000 (20,000)
5 Trade-in value 4,000 0.650 2,600
2 Tax savings from allowances 6,000 0.842 5,052
30% x $20,000
6 Balancing charge 30% x $4,000 (1,200) 0.596 (715)
NPV of purchase (13,063)
 Solution
The PV of leasing costs
It is assumed that the lease payments are fully tax-allowable.
Year Lease payment Savings in tax Discount factor PV
$ (30%) 9% $
1-5 (4,800) pa 3.890 (18,672)
2-6 1,440 pa 3.569 5,139
NPV of leasing (13,533)
Working
6 year cumulative present value factor 9% 4.486
1 year present value factor 9% (0.917)
3.569

The cheapest option would be to purchase the machine.

 Solution
An alternative method of making lease or buy decisions is to carry out a single financing calculation with the
payments for one method being negative and the receipts being positive, and vice versa for the other method.
Year 0 1 2 3 4 5 6
$ $ $ $ $ $ $
Saved equipment cost 20,000
Lost trade-in value (4,000)
Balancing charge 1,200
Lost tax savings from allowance (6,000)
Lease payments (4,800) (4,800) (4,800) (4,800) (4,800)
Tax allowances 1,440 1,440 1,440 1,440 1,440
Net cash flow 20,000 (4,800) (9,360) (3,360) (3,360) (7,360) 2,640
Discount factor 9% 1.000 0.917 0.842 0.772 0.708 0.650 0.596
PV 20,000 (4,402) (7,881) (2,594) (2,379) (4,784) 1,573
NPV = ($467)
The negative NPV indicates that the lease is unattractive and the purchasing decision is better, as the net saving
from not leasing outweigh the net costs of purchasing.
 1.10 The position of the lessor
So far, we have looked at examples of leasing decisions from the
viewpoint of the lessee. You may be asked to evaluate a leasing
arrangement from the position of the lessor. This is rather like a mirror
image of the lessee’s position.

The lessor will receive tax allowable depreciation on the expenditure,

and the lease payments will be taxable income.
 1.11 Example: Lessor’s position
Continue the same case of M&M,
suppose that the lessor’s required rate of
return is 12% after tax. The lessor can
claim 25% reducing balance tax
depreciation. The lessor’s cash flows will
be as follows.
1.11 Example: Lessor’s position
Cash flow Discount factor PV
$ 12% $
Purchase costs
Year 0 (20,000) 1.000 (20,000)
Year 5 trade-in 4,000 0.567 2,268
Tax savings
Year 2 1,500 0.797 1,196
Year 3 1,125 0.712 801
Year 4 844 0.636 537
Year 5 633 0.567 359
Year 6 698 0.507 354
Lease payments: Y1-5 4,800 3.605 17,304
Tax on lease payments: Y2-6 (1,440) 3.218 (4,634)
NPV (1,815)
The proposed level of leasing payments are not justifiable for the lessor if it seeks a required rate of return of 12%, since the
resulting NPV is negative.
Lease or buy
The management of a company has decided to acquire Machine X
which costs $63,000 and has an operational life of four years. The
expected scrap value would be zero. Tax is payable at 30% on
operating cash flows one year in arrears. Tax allowable depreciation is
available at 25% a year on a reducing balance basis.
Suppose that the company has the opportunity either to purchase the
machine or to lease it under a finance lease arrangement, at an annual
rent of $20,000 for four years, payable at the end of each year. The
company can borrow to finance the acquisition at 10%. Should the
company lease or buy the machine?