24546213-Lease-or-Buy
Content
This is my paper on Leasing – Published in
ICWA ‘s Research bulletin Volume XXXII , August- December 2008.
Please send your comments to [email protected]
SIMULATION MODEL FOR LEASE- OR –BUY DECISION
By Prof. S.Padmanaban & Dr. R.Gayatri This article proposes a model for evaluation of leasing and buying based on the costs and benefits associated with each options. The cost associated with leasing is the lease rentals to be paid and the maintenance costs if any. The cost associated with buying through borrowing and using the machine is the value of the asset itself and the interest charges to be paid to the banker or financier. There is an important benefit associated with the buying option. That is the use of the Accumulated Depreciation Funds. The accumulated depreciation funds could earn an interest in par with the cost of capital at which the company is operating. Earlier models suggested the calculation of the present value in the form of before tax and after tax cash flows occurring at the year ends. In this model the author proposes to calculate the benefits in the form of interest earned by the depreciation funds (at the rate equal to the cost of capital or at the rate less than the lender’s rate) that are accumulated for N-1 years where N is the life of the equipment or asset under consideration. In this model the author argues that there is no impact of tax on the lease rentals and the after tax cash outflow is the same as that of before tax cash flow. The reason being the lease rentals are expenses going out of company. i.e out-of-pocket cost has no tax impact. The depreciation is an expense not going out of a company but deducted as expense for corporate tax purposes and retained in the company till the funds are used for replacing the asset. The benefit associated with retaining the depreciation funds are worked out separately in this model. The model is explained through an example problem and attempting to find its solution through the basic present value approach. This model is not contrary to any of the earlier models as it supports the simulation concept. Hence the evaluation of lease versus buying should be a case by case approach. Considering the costs and benefits associated with each situation and the tax brackets under which the companies are operating one has to decide whether to go for leasing or buying. In conclusion the author says that leasing is always costlier than buying. But the buying option is less beneficial as the corporate tax increases. The buying option is suitable for companies having only good investment avenues and for those who can utilize the depreciation funds beyond the average cost of capital. Further research is required on the life of the asset and its survival beyond the depreciated period as chances are more that the depreciation claims are speeded up by companies to enjoy tax advantage. Assets of such kinds may be available in the market for low lease rentals which may beat the buying option of a new equipment entry. *****
SIMULATION MODEL FOR LEASE- OR –BUY DECISION
By Prof. S.Padmanaban & Dr. R.Gayatri
1.0 Introduction
Firms often have a choice between buying assets and leasing them. Leasing is a contract in which an asset is taken for use by paying rentals instead of buying. An obvious advantage of leasing is that one need not invest in the full value of the asset. To enjoy this advantage the lessee is obligated to make periodical lease payments and as agreed upon should bear the maintenance costs and repair costs in keeping the asset under usable condition. Deciding, whether to go for Buying or Leasing depends on the level of Taxation the Depreciation treatment/ tax advantage arising out of depreciation in comparison with the lease rental. Most of the evaluation methods and calculations are based on Present Value approach and this method is widely accepted as we can see in many text books. In this article same present value approach is adopted but the tax treatments and approach to the benefits of depreciation are different from the conventional one. The author explains the reason for such treatment with some logical arguments. It is up to the readers to judge the approach and accept as there are several ways and means to evaluate a lease. The simulation approach argues for the use of depreciation funds at the interest rate equal to the cost of capital- an important benefit enjoyed by the owner of the asset (Buying Option) and also argues that there is no such cash flow called as after tax cash flow when there is no impact of tax on the before tax cash flows such as lease rentals being out-of- pocket costs. The author calls this model as simulation model as it adopts the costs and benefits associated with the options and simulates the situation. The simulation model is explained with a hypothetical example problem and situation in which a company has to decide whether to go for leasing or buying.
2.0 Example Problem
A company can take on lease an equipment for rental at Rs.150000 per annum for 7 years. The company operates at 12% cost of capital and borrows at 15% from its bankers. The equipment can be bought for Rs.625000/- and has no salvage value. The department of taxation allows Straight Line depreciation and the corporate tax at present is 35%. The bankers are ready to finance the equipment for an equated annual payments for 7 years. Evaluate the options and decide whether to go for leasing or buying.
2.1. Solution
Table 1 Present value of Lease Rentals to be paid Year Before Tax After Tax Discount Rate Present Value of the End Lease Rentals Lease Rentals @ 12% ( PVn i) Lease Rentals to be Paid 1 150000 150000 0.893 133950 2 150000 150000 0.797 119550 3 150000 150000 0.712 106800 4 150000 150000 0.636 95400 5 150000 150000 0.567 85050 6 150000 150000 0.507 76050 7 150000 150000 0.452 67800 684600 Total Present value of all payments The same amount may be arrived at by using: The present value of annuity factor of Rs.1 for 7 years @12% = 4.564 Annuity Payment =Rs. 150000/The present value of all Lease payments = 4.564 x Rs.150000 = Rs.684600/-
2.1.1 Tax Treatment on Lease Rental Payments
An operating or service lease is usually signed for a period much shorter than the actual life of the asset, and the present value of lease payments are generally much lower than the actual price of the asset. A financial or capital lease generally lasts for the life of the asset, with the present value of lease payments covering the price of the asset. In the conventional approach we apply tax treatment to these lease payments and the after tax cash flow will be equal to Rs.150000 x (1-tax rate). That will be Rs.150000 x 0.65 = Rs.97500/every year and the present value of those payments will be Rs.97500 x 4.564 = Rs.444990/- . How can the present value of the lease payments will be less than that of the value of the equipment at point in time zero? If the present value of the lease payments are less than the value or cost of the equipment it is contrary to the view point of the lessor. In finding the present value what discount factor should be applied is an important question. Some authors use the cost of debt and some authors use cost of debt adjusted for the tax rebate. (13; 14; 15). Both are not acceptable to this author from the view point of cost of capital. All projects and their cash flows are to be discounted at a rate equal to the weighted average cost of capital or at the cost of equity from the view point of wealth maximization objective. Hence the author argues that the after tax and before tax cash flow of lease rentals are the same and these payments have no tax advantage or tax gain in reality. The conventional approach was based only on an opportunity cost view point. Hence the author concludes that there is no tax advantage on the lease rental payments. More over the IRS - Internal Revenue Service (for tax purposes) is wary of lease arrangements designed purely to speed up tax deductions. The present value from Table 1 derived at Rs. 684600/- is real and acceptable from the lessor’s view point also. That is any one willing to accept 12% as expected rate of return will be ready to lease the equipment as the rental values yield a PV of Rs.684600/- which is above the cost of equipment Rs. 625000/-. The Financial Accounting Standards Board (FASB) has specified that firms must treat leases as capital leases if the present value of the lease payments exceeds 90% of the initial value of the asset and the life of the lease is at least 75% of the asset’s life. Hence this model suggests that in lease valuation of any kind the present value of lease rentals should be relevant to the life of the asset. While the differences between operating and financial leases are obvious, some lease arrangements do not fit neatly into one or another of these extremes; rather, they share some features of both types of leases. Firm valuation can be impacted by how we deal with operating leases. While the accounting distinction between capital and operating leases may seem reasonable, there seems to be no reason, from a financial standpoint, to maintain that distinction when it comes to estimating operating income, capital and profitability.(16) Hence in this model the lease valuation is also assessed from the view point of profitability.
2.1.2. The Buying Option
Buying the same equipment through borrowing and using has the following costs and benefits. Costs: 1. The present value of the equipment itself Rs.625000 2. The Present Value of the interest payments made discounted at the rate of 12% cost of capital of the company Rs.302995 Pv of Total Costs Rs. 927955 Benefits: 3. Present value of Tax advantage on depreciation at 35% of corporate tax discounted at the rate of 12%- cost of capital Rs.136235 4. Present value of the use of accumulated depreciation funds @12% (i.e Interest earned by the depreciation funds discounted) Rs. 139758 Pv of Total Benefits Rs. 275993 The Net Present Value of Buying option The details are given below. Rs. 651962
2.3 The Annual Installment payments to be made
The annual installment payments to be made to the banker financing the equipment will be calculated as follows: The interest rate = 15% The present value of annuity of Rs.1 @15% for 7 years = 4.160 The cost/ value of the equipment = 625000 Therefore the Equated Annual installment To be paid to the banker = Rs.625000/4.160 = Rs.150240/-
2.3.1 The Break up of Interest Payments and Principal Payments made
Table No.2 Year Installment End Amount Rs. Details of the Break up in the Principal Amount installment Outstanding at the Interest Paid Principal Paid end of year . Rs @ 15% for the Rs. O/s 1 150240 625000 93750 56490 568510 2 150240 568510 85277 64963 503547 3 150240 503547 75532 74708 428839 4 150240 428839 64326 85914 342925 5 150240 342925 51439 98801 244124 6 150240 244124 36619 113621 130503 7 150240 130503 19575 *130665 0 * Approximation or round off error of Rs.162/- which is negligible. Principal Amount Outstanding at the Beginning of year. Rs.
2.3.2 The Present Value of Interest Payments made
One of the cost of buying option- Table 3. Year Interest Payments Present Value Present Value of the End Made to the Banker factor @12 % Interest Payments Made 1 93750 0.893 83719 2 85277 0.797 67966 3 75532 0.712 53779 4 64326 0.636 40911 5 51439 0.567 29166 6 36619 0.507 18566 7 19575 0.452 8848 Total Present Value of Interest Payments Rs. 302955 made to the banker Note: Even though the interest rates are charged at 15% the amount paid are discounted at the rate of 12% which is the average cost of capital of company to arrive at the present value of cost involved in borrowing and using the equipment.
2.4 Use of Depreciation Funds
Table.4 Year Depreciation Accumulated End Amount Rs. Depreciation Fund Rs. 1 2 3 4 5 6 7 Interest Present Present Earned by the Value factor Value of fund @12% @12% Interest Earned 89286 89286 10714 0.893 9568 89286 178572 21429 0.797 17079 89286 267858 32143 0.712 22886 89286 357144 42857 0.636 27257 89286 446430 53572 0.567 30375 89286 535716 64286 0.507 32593 89286 625000 0 0.452 0 Total Present Value of Interest Earned by the Accumulated Rs.139758 Depreciation funds – which a benefit for the owner (Buying option)
Note: 1. Even though the company is borrowing at 15% interest rate it is assumed that the company can utilize or lend only at 12% which is less than the banker’s lending rate (assumed for illustration purpose). Also the amount earned is discounted at 12% to arrive at the present value which is the cost of capital of the company. 2. There is no interest earned at the last year because the project ends and the accumulated depreciation funds are needed to replace the equipment. 3. The depreciation amount Rs. 89286/- is arrived at by dividing Rs. 625000 by 7 years which is the life in years of the equipment.
2.4.1 The Tax Advantage of Depreciation
The benefit of tax advantage on the depreciation amount is a real one as the depreciation amount is not an out of pocket cost. The advantage is gained because the depreciation is deducted before the tax is paid and the after tax cash flow is affected by the amount of depreciation and the taxation rate.
Table.5 Year Depreciation Tax Advantage on PV Present Value of Tax End Amount Depreciation factor Advantage gained @ 35% = Dep x 0.35 @12% 1 89286 29850 0.893 26656 2 89286 29850 0.797 23790 3 89286 29850 0.712 21253 4 89286 29850 0.636 18985 5 89286 29850 0.567 16925 6 89286 29850 0.507 15134 7 89286 29850 0.452 13492 Total present value of Tax advantage gained on Rs.136235 depreciation funds which is another benefit of ownership (Buying Option) Note: 1. The same present value can be arrived at by multiplying the Present Value of Annuity of Rs.1 which is equal to 4.564 by the tax advantage amount Rs.29850 = Rs.136235.
3.0 Lease or Buy Decision
The hypothetical example shows that almost the same amount is going out of company whether leasing or buying but the present value of the options are different due to depreciation and its usage. The NPV of Leasing = Rs. 684600/The NPV of Buying through borrowing and using = Rs. 651962/Hence the buying option is preferred. The NPV of the decision = Rs.32638/- Answer to example.
4.0 Checking the decision from Earnings view point
Assume that the company could earn Rs.200000/- before paying interest depreciation and taxation. i.e EBIDT = Rs.200000/- Let us work out the profitability of the business in the two cases viz leasing and buying.
4.1 Profits from Leasing; Table.6 Year EBIT Lease Rentals Earning Tax at Earning After End Rs. Paid. Rs. Before Tax 35% Tax 1 200000 150000 50000 17500 32500 2 200000 150000 50000 17500 32500 3 200000 150000 50000 17500 32500 4 200000 150000 50000 17500 32500 5 200000 150000 50000 17500 32500 6 200000 150000 50000 17500 32500 7 200000 150000 50000 17500 32500 Present Value of profits earned at 20% Cost of equity – Assuming 13 % dividend which is one percent higher than the cost of capital = 3.605 x Rs. 32500 = Rs.117163/Note: 1. PV factor at 20% for 7 years = 3.605 2. To declare 13 % dividend you need to earn 20% before tax at the tax rate of 35%.
4.2.1 Profits from Operations – Buying Option -Table.7
Year EBIDT End 1 2 3 4 5 6 7 200000 200000 200000 200000 200000 200000 200000 Interest Depreci Paid ation Tax EAT PV Present @35 factor Value % @ 20% 93750 89286 16964 5937 11027 0.833 9185 85277 89286 25437 8903 16534 0.694 11475 75532 89286 35182 12314 22868 0.579 13241 64326 89286 46388 16236 30152 0.482 14533 51439 89286 59275 20746 38529 0.402 15489 36619 89286 74095 25933 48162 0.355 17098 19575 89286 91139 31899 59240 0.279 16528 Present value of profits earned from operations discounted Rs.97549 at 20% EBT
4.2.2 Profits earned by the Interests earned on Depreciation funds Table.8 Year Interest Earned Tax @ EAT Pv factor @ Present value End on Depreciation 35% 20% of Earnings Funds 1 10714 3750 6964 0.833 5801 2 21429 7500 13929 0.694 9667 3 32143 11250 20893 0.579 12097 4 42857 15000 27857 0.482 13427 5 53572 18750 34822 0.402 13998 6 64286 22500 41786 0.355 14834 7 0 0 0 0.279 0 Total present value of interest earned or benefits from Rs. 69824 the utilization of depreciation funds Hence the total present value of profits earned from buying operation = Rs.167373/The buying option is more profitable by the present value of Rs.50210/5.0 Evaluation of Alternatives at different Tax rates Table .9 shows the present value of the lease evaluation at different tax rates. Tax at “0” % Tax at “35%” Tax at “50%” PV PV Discounted PV Discounted Discounted at 20% at 26% at 13% Rs. Rs. Rs.
Leasing Option
Present value
221150 328987 1.4876
117163 167373 1.4285
77075 104393 1.3544
Buying Option
Total Present Value The benefit Ratio between Options
Table .10 shows the present value of the Buying Option –Details at different tax rates. Tax at “0” % Tax at “35%” Tax at “50%” PV PV Discounted PV Discounted Discounted at 20% at 26% at 13% Rs. Rs. Rs. Details of Buying PV of Profits from Operations 194233 97549 60373 PV of Interest Earned by Accumulated Depreciation The benefit ratio between Operations and Interest earned 134754 1.4414 69824 1.3970 44020 1.3715
Note: The present values are found by discounting at 13% and 20% and 26% assuming a 13% dividend for the prevailing cost of capital of 12%. The values in table above suggest that buying option is supported only because of the depreciation funds and its utilization. Otherwise Leasing is always the best option. The theoretical literature on corporate leasing also predicts that the economic gains from leasing are negatively related to the lessee’s effective tax rate and positively related to the lessee’s external financing costs. Previous empirical studies have examined the valuation effects of leasing and the relation between a firm’s propensity to lease its assets and its tax rate and external financing costs. (6) The values in the table is in accordance with the theoretical works and evidence already done.
6.0 Conclusion
The leasing option is always costlier than buying. Leasing is costly even in an environment where there is no corporate tax. The buying has two important advantages over leasing. The first one is the use of depreciation funds. The second one is the tax advantage or tax gain arising from deducting depreciation for calculating the corporate tax. The same tax advantage is not real for lease rentals as it is an out-of –pocket cost and it has no impact on the tax calculations. Even though the buying option always lead in number terms over leasing option as the tax rate increases the benefit ratio between the buying option and the leasing option decreases indicating that the lease rentals are preferred in a situation where corporate taxes are higher. Moreover those companies capable of utilizing the depreciation funds effectively only can enjoy the benefits of buying option. Companies having idle/ low investment projects for depreciation funds cannot make out great benefits over buying. They should go for leasing. We need to dig further with the life of the asset and the leasing option. The leasing options may still be preferred because of the defender’s strength (old machines long life higher than the depreciation period) over new equipment’s price and the borrowing rate to replace the same. The discount rate the expected rate of return the cost of capital and the interest earned are all the same for all practical purposes.
7.0 Bibliography
1. Bower .R.S “ Issues in Leasing” Financial Management Winter 1973 pp 25-34. 2. Miller. M.H. and C.W.Upton “Leasing Buying and the Cost of Capital Services” Journal of Finance 1976 .31. pp 761-86 3. Schall.L. “ Lease –or-Buy and Asset Acquisition Decision” Journal of Finance September 1974 pp 1203-14. 4. Myers, S. C., Dill, D. A., & Bautista, A. J. (1976). “Valuation of financial lease contracts”. Journal of Finance, 31,799–819. 5. Modigliani.F and M.H.Miller “Corporate Income Taxes and the Cost of Capital” American Economic Review June 1963 pp 433-443. 6. John R.Ezzell and Premal P Vora “Leasing Versus Purchasing: Direct Evidence on a Corporation’s Motivations for Leasing and Consequences of Leasing” The Quarterly Review of Economics and Finance 41 (2001) pp 33-47. 7. Brealey, R. A., & Young, C. M. (1980). “Debt, taxes and leasing–a note”. Journal of Finance, 35, 1245–1250. 8. Handa, P. (1991). “An economic analysis of leasebacks”. Review of Quantitative Finance and Accounting, 1, 177–189. 9. Krishnan, V. S., & Moyer, R. C. (1994). Bankruptcy costs and the financial leasing decision”. Financial Management, 23, 31–42. 10. Schallheim, J. S. (1994). Lease or buy? Principles for sound decision making. Boston: Harvard Business School Press. 11. Smith Jr., C. W., & Wakeman, L. M. (1985). Determinants of corporate leasing policy. Journal of Finance, 40,895–908. 12. Sharpe, S. A., & Nguyen, H. H. (1995). Capital market imperfections and the incentive to lease. Journal ofFinancial Economics, 39, 271–294. 13. “Financial Management” I.M.Pandey 7th Revised Edition 1995 Vikas Publishing House (P) Ltd. New Delhi. Pp 942-963 14. “Financial Management” –Text and Problems- 2nd edition. M.Y. Khan P.K. Jain. 1994 3rd Reprint. Tata McGraw Hill Publishing Company Ltd. Newdelhi. Pp 395 -413 15. “Financial Management” –Text and Problems- 4th edition. M.Y. Khan P.K. Jain. 1994 Tata McGraw Hill Publishing Company Ltd. Newdelhi. 16. Aswath Damodaran “Dealing with Operating Leases in Valuation” www.stern.nyu.edu *****
ICWA ‘s Research bulletin Volume XXXII , August- December 2008.
Please send your comments to [email protected]
SIMULATION MODEL FOR LEASE- OR –BUY DECISION
By Prof. S.Padmanaban & Dr. R.Gayatri This article proposes a model for evaluation of leasing and buying based on the costs and benefits associated with each options. The cost associated with leasing is the lease rentals to be paid and the maintenance costs if any. The cost associated with buying through borrowing and using the machine is the value of the asset itself and the interest charges to be paid to the banker or financier. There is an important benefit associated with the buying option. That is the use of the Accumulated Depreciation Funds. The accumulated depreciation funds could earn an interest in par with the cost of capital at which the company is operating. Earlier models suggested the calculation of the present value in the form of before tax and after tax cash flows occurring at the year ends. In this model the author proposes to calculate the benefits in the form of interest earned by the depreciation funds (at the rate equal to the cost of capital or at the rate less than the lender’s rate) that are accumulated for N-1 years where N is the life of the equipment or asset under consideration. In this model the author argues that there is no impact of tax on the lease rentals and the after tax cash outflow is the same as that of before tax cash flow. The reason being the lease rentals are expenses going out of company. i.e out-of-pocket cost has no tax impact. The depreciation is an expense not going out of a company but deducted as expense for corporate tax purposes and retained in the company till the funds are used for replacing the asset. The benefit associated with retaining the depreciation funds are worked out separately in this model. The model is explained through an example problem and attempting to find its solution through the basic present value approach. This model is not contrary to any of the earlier models as it supports the simulation concept. Hence the evaluation of lease versus buying should be a case by case approach. Considering the costs and benefits associated with each situation and the tax brackets under which the companies are operating one has to decide whether to go for leasing or buying. In conclusion the author says that leasing is always costlier than buying. But the buying option is less beneficial as the corporate tax increases. The buying option is suitable for companies having only good investment avenues and for those who can utilize the depreciation funds beyond the average cost of capital. Further research is required on the life of the asset and its survival beyond the depreciated period as chances are more that the depreciation claims are speeded up by companies to enjoy tax advantage. Assets of such kinds may be available in the market for low lease rentals which may beat the buying option of a new equipment entry. *****
SIMULATION MODEL FOR LEASE- OR –BUY DECISION
By Prof. S.Padmanaban & Dr. R.Gayatri
1.0 Introduction
Firms often have a choice between buying assets and leasing them. Leasing is a contract in which an asset is taken for use by paying rentals instead of buying. An obvious advantage of leasing is that one need not invest in the full value of the asset. To enjoy this advantage the lessee is obligated to make periodical lease payments and as agreed upon should bear the maintenance costs and repair costs in keeping the asset under usable condition. Deciding, whether to go for Buying or Leasing depends on the level of Taxation the Depreciation treatment/ tax advantage arising out of depreciation in comparison with the lease rental. Most of the evaluation methods and calculations are based on Present Value approach and this method is widely accepted as we can see in many text books. In this article same present value approach is adopted but the tax treatments and approach to the benefits of depreciation are different from the conventional one. The author explains the reason for such treatment with some logical arguments. It is up to the readers to judge the approach and accept as there are several ways and means to evaluate a lease. The simulation approach argues for the use of depreciation funds at the interest rate equal to the cost of capital- an important benefit enjoyed by the owner of the asset (Buying Option) and also argues that there is no such cash flow called as after tax cash flow when there is no impact of tax on the before tax cash flows such as lease rentals being out-of- pocket costs. The author calls this model as simulation model as it adopts the costs and benefits associated with the options and simulates the situation. The simulation model is explained with a hypothetical example problem and situation in which a company has to decide whether to go for leasing or buying.
2.0 Example Problem
A company can take on lease an equipment for rental at Rs.150000 per annum for 7 years. The company operates at 12% cost of capital and borrows at 15% from its bankers. The equipment can be bought for Rs.625000/- and has no salvage value. The department of taxation allows Straight Line depreciation and the corporate tax at present is 35%. The bankers are ready to finance the equipment for an equated annual payments for 7 years. Evaluate the options and decide whether to go for leasing or buying.
2.1. Solution
Table 1 Present value of Lease Rentals to be paid Year Before Tax After Tax Discount Rate Present Value of the End Lease Rentals Lease Rentals @ 12% ( PVn i) Lease Rentals to be Paid 1 150000 150000 0.893 133950 2 150000 150000 0.797 119550 3 150000 150000 0.712 106800 4 150000 150000 0.636 95400 5 150000 150000 0.567 85050 6 150000 150000 0.507 76050 7 150000 150000 0.452 67800 684600 Total Present value of all payments The same amount may be arrived at by using: The present value of annuity factor of Rs.1 for 7 years @12% = 4.564 Annuity Payment =Rs. 150000/The present value of all Lease payments = 4.564 x Rs.150000 = Rs.684600/-
2.1.1 Tax Treatment on Lease Rental Payments
An operating or service lease is usually signed for a period much shorter than the actual life of the asset, and the present value of lease payments are generally much lower than the actual price of the asset. A financial or capital lease generally lasts for the life of the asset, with the present value of lease payments covering the price of the asset. In the conventional approach we apply tax treatment to these lease payments and the after tax cash flow will be equal to Rs.150000 x (1-tax rate). That will be Rs.150000 x 0.65 = Rs.97500/every year and the present value of those payments will be Rs.97500 x 4.564 = Rs.444990/- . How can the present value of the lease payments will be less than that of the value of the equipment at point in time zero? If the present value of the lease payments are less than the value or cost of the equipment it is contrary to the view point of the lessor. In finding the present value what discount factor should be applied is an important question. Some authors use the cost of debt and some authors use cost of debt adjusted for the tax rebate. (13; 14; 15). Both are not acceptable to this author from the view point of cost of capital. All projects and their cash flows are to be discounted at a rate equal to the weighted average cost of capital or at the cost of equity from the view point of wealth maximization objective. Hence the author argues that the after tax and before tax cash flow of lease rentals are the same and these payments have no tax advantage or tax gain in reality. The conventional approach was based only on an opportunity cost view point. Hence the author concludes that there is no tax advantage on the lease rental payments. More over the IRS - Internal Revenue Service (for tax purposes) is wary of lease arrangements designed purely to speed up tax deductions. The present value from Table 1 derived at Rs. 684600/- is real and acceptable from the lessor’s view point also. That is any one willing to accept 12% as expected rate of return will be ready to lease the equipment as the rental values yield a PV of Rs.684600/- which is above the cost of equipment Rs. 625000/-. The Financial Accounting Standards Board (FASB) has specified that firms must treat leases as capital leases if the present value of the lease payments exceeds 90% of the initial value of the asset and the life of the lease is at least 75% of the asset’s life. Hence this model suggests that in lease valuation of any kind the present value of lease rentals should be relevant to the life of the asset. While the differences between operating and financial leases are obvious, some lease arrangements do not fit neatly into one or another of these extremes; rather, they share some features of both types of leases. Firm valuation can be impacted by how we deal with operating leases. While the accounting distinction between capital and operating leases may seem reasonable, there seems to be no reason, from a financial standpoint, to maintain that distinction when it comes to estimating operating income, capital and profitability.(16) Hence in this model the lease valuation is also assessed from the view point of profitability.
2.1.2. The Buying Option
Buying the same equipment through borrowing and using has the following costs and benefits. Costs: 1. The present value of the equipment itself Rs.625000 2. The Present Value of the interest payments made discounted at the rate of 12% cost of capital of the company Rs.302995 Pv of Total Costs Rs. 927955 Benefits: 3. Present value of Tax advantage on depreciation at 35% of corporate tax discounted at the rate of 12%- cost of capital Rs.136235 4. Present value of the use of accumulated depreciation funds @12% (i.e Interest earned by the depreciation funds discounted) Rs. 139758 Pv of Total Benefits Rs. 275993 The Net Present Value of Buying option The details are given below. Rs. 651962
2.3 The Annual Installment payments to be made
The annual installment payments to be made to the banker financing the equipment will be calculated as follows: The interest rate = 15% The present value of annuity of Rs.1 @15% for 7 years = 4.160 The cost/ value of the equipment = 625000 Therefore the Equated Annual installment To be paid to the banker = Rs.625000/4.160 = Rs.150240/-
2.3.1 The Break up of Interest Payments and Principal Payments made
Table No.2 Year Installment End Amount Rs. Details of the Break up in the Principal Amount installment Outstanding at the Interest Paid Principal Paid end of year . Rs @ 15% for the Rs. O/s 1 150240 625000 93750 56490 568510 2 150240 568510 85277 64963 503547 3 150240 503547 75532 74708 428839 4 150240 428839 64326 85914 342925 5 150240 342925 51439 98801 244124 6 150240 244124 36619 113621 130503 7 150240 130503 19575 *130665 0 * Approximation or round off error of Rs.162/- which is negligible. Principal Amount Outstanding at the Beginning of year. Rs.
2.3.2 The Present Value of Interest Payments made
One of the cost of buying option- Table 3. Year Interest Payments Present Value Present Value of the End Made to the Banker factor @12 % Interest Payments Made 1 93750 0.893 83719 2 85277 0.797 67966 3 75532 0.712 53779 4 64326 0.636 40911 5 51439 0.567 29166 6 36619 0.507 18566 7 19575 0.452 8848 Total Present Value of Interest Payments Rs. 302955 made to the banker Note: Even though the interest rates are charged at 15% the amount paid are discounted at the rate of 12% which is the average cost of capital of company to arrive at the present value of cost involved in borrowing and using the equipment.
2.4 Use of Depreciation Funds
Table.4 Year Depreciation Accumulated End Amount Rs. Depreciation Fund Rs. 1 2 3 4 5 6 7 Interest Present Present Earned by the Value factor Value of fund @12% @12% Interest Earned 89286 89286 10714 0.893 9568 89286 178572 21429 0.797 17079 89286 267858 32143 0.712 22886 89286 357144 42857 0.636 27257 89286 446430 53572 0.567 30375 89286 535716 64286 0.507 32593 89286 625000 0 0.452 0 Total Present Value of Interest Earned by the Accumulated Rs.139758 Depreciation funds – which a benefit for the owner (Buying option)
Note: 1. Even though the company is borrowing at 15% interest rate it is assumed that the company can utilize or lend only at 12% which is less than the banker’s lending rate (assumed for illustration purpose). Also the amount earned is discounted at 12% to arrive at the present value which is the cost of capital of the company. 2. There is no interest earned at the last year because the project ends and the accumulated depreciation funds are needed to replace the equipment. 3. The depreciation amount Rs. 89286/- is arrived at by dividing Rs. 625000 by 7 years which is the life in years of the equipment.
2.4.1 The Tax Advantage of Depreciation
The benefit of tax advantage on the depreciation amount is a real one as the depreciation amount is not an out of pocket cost. The advantage is gained because the depreciation is deducted before the tax is paid and the after tax cash flow is affected by the amount of depreciation and the taxation rate.
Table.5 Year Depreciation Tax Advantage on PV Present Value of Tax End Amount Depreciation factor Advantage gained @ 35% = Dep x 0.35 @12% 1 89286 29850 0.893 26656 2 89286 29850 0.797 23790 3 89286 29850 0.712 21253 4 89286 29850 0.636 18985 5 89286 29850 0.567 16925 6 89286 29850 0.507 15134 7 89286 29850 0.452 13492 Total present value of Tax advantage gained on Rs.136235 depreciation funds which is another benefit of ownership (Buying Option) Note: 1. The same present value can be arrived at by multiplying the Present Value of Annuity of Rs.1 which is equal to 4.564 by the tax advantage amount Rs.29850 = Rs.136235.
3.0 Lease or Buy Decision
The hypothetical example shows that almost the same amount is going out of company whether leasing or buying but the present value of the options are different due to depreciation and its usage. The NPV of Leasing = Rs. 684600/The NPV of Buying through borrowing and using = Rs. 651962/Hence the buying option is preferred. The NPV of the decision = Rs.32638/- Answer to example.
4.0 Checking the decision from Earnings view point
Assume that the company could earn Rs.200000/- before paying interest depreciation and taxation. i.e EBIDT = Rs.200000/- Let us work out the profitability of the business in the two cases viz leasing and buying.
4.1 Profits from Leasing; Table.6 Year EBIT Lease Rentals Earning Tax at Earning After End Rs. Paid. Rs. Before Tax 35% Tax 1 200000 150000 50000 17500 32500 2 200000 150000 50000 17500 32500 3 200000 150000 50000 17500 32500 4 200000 150000 50000 17500 32500 5 200000 150000 50000 17500 32500 6 200000 150000 50000 17500 32500 7 200000 150000 50000 17500 32500 Present Value of profits earned at 20% Cost of equity – Assuming 13 % dividend which is one percent higher than the cost of capital = 3.605 x Rs. 32500 = Rs.117163/Note: 1. PV factor at 20% for 7 years = 3.605 2. To declare 13 % dividend you need to earn 20% before tax at the tax rate of 35%.
4.2.1 Profits from Operations – Buying Option -Table.7
Year EBIDT End 1 2 3 4 5 6 7 200000 200000 200000 200000 200000 200000 200000 Interest Depreci Paid ation Tax EAT PV Present @35 factor Value % @ 20% 93750 89286 16964 5937 11027 0.833 9185 85277 89286 25437 8903 16534 0.694 11475 75532 89286 35182 12314 22868 0.579 13241 64326 89286 46388 16236 30152 0.482 14533 51439 89286 59275 20746 38529 0.402 15489 36619 89286 74095 25933 48162 0.355 17098 19575 89286 91139 31899 59240 0.279 16528 Present value of profits earned from operations discounted Rs.97549 at 20% EBT
4.2.2 Profits earned by the Interests earned on Depreciation funds Table.8 Year Interest Earned Tax @ EAT Pv factor @ Present value End on Depreciation 35% 20% of Earnings Funds 1 10714 3750 6964 0.833 5801 2 21429 7500 13929 0.694 9667 3 32143 11250 20893 0.579 12097 4 42857 15000 27857 0.482 13427 5 53572 18750 34822 0.402 13998 6 64286 22500 41786 0.355 14834 7 0 0 0 0.279 0 Total present value of interest earned or benefits from Rs. 69824 the utilization of depreciation funds Hence the total present value of profits earned from buying operation = Rs.167373/The buying option is more profitable by the present value of Rs.50210/5.0 Evaluation of Alternatives at different Tax rates Table .9 shows the present value of the lease evaluation at different tax rates. Tax at “0” % Tax at “35%” Tax at “50%” PV PV Discounted PV Discounted Discounted at 20% at 26% at 13% Rs. Rs. Rs.
Leasing Option
Present value
221150 328987 1.4876
117163 167373 1.4285
77075 104393 1.3544
Buying Option
Total Present Value The benefit Ratio between Options
Table .10 shows the present value of the Buying Option –Details at different tax rates. Tax at “0” % Tax at “35%” Tax at “50%” PV PV Discounted PV Discounted Discounted at 20% at 26% at 13% Rs. Rs. Rs. Details of Buying PV of Profits from Operations 194233 97549 60373 PV of Interest Earned by Accumulated Depreciation The benefit ratio between Operations and Interest earned 134754 1.4414 69824 1.3970 44020 1.3715
Note: The present values are found by discounting at 13% and 20% and 26% assuming a 13% dividend for the prevailing cost of capital of 12%. The values in table above suggest that buying option is supported only because of the depreciation funds and its utilization. Otherwise Leasing is always the best option. The theoretical literature on corporate leasing also predicts that the economic gains from leasing are negatively related to the lessee’s effective tax rate and positively related to the lessee’s external financing costs. Previous empirical studies have examined the valuation effects of leasing and the relation between a firm’s propensity to lease its assets and its tax rate and external financing costs. (6) The values in the table is in accordance with the theoretical works and evidence already done.
6.0 Conclusion
The leasing option is always costlier than buying. Leasing is costly even in an environment where there is no corporate tax. The buying has two important advantages over leasing. The first one is the use of depreciation funds. The second one is the tax advantage or tax gain arising from deducting depreciation for calculating the corporate tax. The same tax advantage is not real for lease rentals as it is an out-of –pocket cost and it has no impact on the tax calculations. Even though the buying option always lead in number terms over leasing option as the tax rate increases the benefit ratio between the buying option and the leasing option decreases indicating that the lease rentals are preferred in a situation where corporate taxes are higher. Moreover those companies capable of utilizing the depreciation funds effectively only can enjoy the benefits of buying option. Companies having idle/ low investment projects for depreciation funds cannot make out great benefits over buying. They should go for leasing. We need to dig further with the life of the asset and the leasing option. The leasing options may still be preferred because of the defender’s strength (old machines long life higher than the depreciation period) over new equipment’s price and the borrowing rate to replace the same. The discount rate the expected rate of return the cost of capital and the interest earned are all the same for all practical purposes.
7.0 Bibliography
1. Bower .R.S “ Issues in Leasing” Financial Management Winter 1973 pp 25-34. 2. Miller. M.H. and C.W.Upton “Leasing Buying and the Cost of Capital Services” Journal of Finance 1976 .31. pp 761-86 3. Schall.L. “ Lease –or-Buy and Asset Acquisition Decision” Journal of Finance September 1974 pp 1203-14. 4. Myers, S. C., Dill, D. A., & Bautista, A. J. (1976). “Valuation of financial lease contracts”. Journal of Finance, 31,799–819. 5. Modigliani.F and M.H.Miller “Corporate Income Taxes and the Cost of Capital” American Economic Review June 1963 pp 433-443. 6. John R.Ezzell and Premal P Vora “Leasing Versus Purchasing: Direct Evidence on a Corporation’s Motivations for Leasing and Consequences of Leasing” The Quarterly Review of Economics and Finance 41 (2001) pp 33-47. 7. Brealey, R. A., & Young, C. M. (1980). “Debt, taxes and leasing–a note”. Journal of Finance, 35, 1245–1250. 8. Handa, P. (1991). “An economic analysis of leasebacks”. Review of Quantitative Finance and Accounting, 1, 177–189. 9. Krishnan, V. S., & Moyer, R. C. (1994). Bankruptcy costs and the financial leasing decision”. Financial Management, 23, 31–42. 10. Schallheim, J. S. (1994). Lease or buy? Principles for sound decision making. Boston: Harvard Business School Press. 11. Smith Jr., C. W., & Wakeman, L. M. (1985). Determinants of corporate leasing policy. Journal of Finance, 40,895–908. 12. Sharpe, S. A., & Nguyen, H. H. (1995). Capital market imperfections and the incentive to lease. Journal ofFinancial Economics, 39, 271–294. 13. “Financial Management” I.M.Pandey 7th Revised Edition 1995 Vikas Publishing House (P) Ltd. New Delhi. Pp 942-963 14. “Financial Management” –Text and Problems- 2nd edition. M.Y. Khan P.K. Jain. 1994 3rd Reprint. Tata McGraw Hill Publishing Company Ltd. Newdelhi. Pp 395 -413 15. “Financial Management” –Text and Problems- 4th edition. M.Y. Khan P.K. Jain. 1994 Tata McGraw Hill Publishing Company Ltd. Newdelhi. 16. Aswath Damodaran “Dealing with Operating Leases in Valuation” www.stern.nyu.edu *****
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