Lease Evaluation: The Lessee’s Angle

Let's dive deeper into how a lessee (the renter) evaluates the lease vs. buy decision. We'll explore the methods, models, and practical considerations that help a lessee make the most informed choice.

I. Core Concepts Revisited

• Lessee Focus: The lessee is concerned with minimizing costs and maximizing the benefits of using an asset. They want the most financially advantageous way to acquire the use of that asset, not necessarily ownership.
• Comparative Analysis: The lessee's evaluation centers on a thorough comparison of the economic consequences of leasing versus purchasing the same asset. This involves calculating the total cost under each option and then adjusting for the time value of money.
• Time Value of Money: Money today is worth more than the same amount of money in the future due to its potential earning capacity. This is why we use techniques like Net Present Value (NPV) to account for the timing of cash flows.
• Beyond Cost: Financial analysis is just one part. Non-financial factors and the characteristics of the lessor play a vital role in the final decision.

II. Step-by-Step Lease Evaluation Process (for the Lessee)

1. Define Objectives:

   • What are the lessee's primary goals? Are they cost minimization focused, or are there other strategic considerations?
   • Are they looking to keep the equipment in use for the longest time?
   • How is the equipment to be operated?
   • Is it essential to maintain financial ratios above a certain level?

2. Gather Relevant Information:

   • Asset Cost: Obtain the purchase price of the asset (including any applicable taxes or installation costs).
   • Lease Terms: Get detailed lease proposals outlining:
     • Lease payments (amount and frequency)
     • Lease term (duration)
     • Renewal options (if any)
     • Purchase option (if any)
     • Maintenance responsibilities
     • Insurance requirements
     • Any other fees or charges
   • Financial Data: Collect the lessee's financial information, including:
     • Marginal cost of capital (overall cost of financing for the company)
     • Cost of debt (interest rate at which the company can borrow)
     • Tax rate
     • Depreciation method used by the company
   • Salvage Value: Estimate the asset's salvage value (resale value) at the end of the lease term or at the end of its useful life if purchased outright.

3. Financial Analysis: Choosing the Right Model

   Key Idea: These models help calculate the Net Present Value (NPV) or a similar metric to compare the costs and benefits of leasing vs. buying.

   a) Net Present Value (NPV) Approach (General Overview):

   • Calculate the present value of all cash outflows (costs) for the buying option. These include the initial purchase price, maintenance costs, operating costs, and taxes.
   • Calculate the present value of all cash outflows (costs) for the leasing option. These include lease payments, maintenance costs (if the lessee is responsible), and taxes.
   • Also, factor in the present value of any tax benefits (depreciation if buying, or lease payment deductions), and the salvage value if buying.
   • The option with the lower present value of costs is the preferred financial choice.

   b) Equivalent Loan Model (More Specific):

   • Assumes leasing is a substitute for borrowing: The amount you would have borrowed to buy the asset is the basis for comparison.
   • Calculate the effective interest rate on an "equivalent loan" that would match the lease payments.
   • Determine the tax implications of owning (depreciation) vs. leasing (deductible lease payments).
   • Compute the Net Value of Leasing (NVL) - a variant of NPV specific to this model.

   c) Weingartner's Model (Addresses Capital Structure):

   • Incorporates the target capital structure of the company (mix of debt, equity, and lease financing).
   • Calculates present values using the weighted average cost of capital (WACC).

   d) Bower-Herringer-Williamson (BHW) Model (Recognizes Risk): * Separates cash flows into "financing" and "operating" components. * Uses different discount rates for each component to reflect different levels of risk. Lease payments might be discounted at a lower rate than salvage value, which is more uncertain.

   e) Capital Asset Pricing Model (CAPM):

   • Can be used to determine the appropriate discount rate (required rate of return) to use in the NPV calculations, especially for riskier cash flows like the salvage value. The CAPM formula is: Required Rate of Return = Risk-Free Rate + Beta * (Market Rate of Return - Risk-Free Rate) Where Beta reflects the asset's systematic risk relative to the market.

   Simplified Formulas (Illustrative)

   These are simplified examples to illustrate the core idea. Actual formulas can be more complex.

   • NPV (Buying): -Purchase Price + PV(Operating Costs) + PV(Maintenance Costs) - PV(Depreciation Tax Shield) + PV(Salvage Value)
   • NPV (Leasing): -PV(Lease Payments) + PV(Operating Costs) + PV(Maintenance Costs) - PV(Lease Payment Tax Shield)

   Important Points About the Models:

   • Debt Displacement: Most models assume leasing displaces debt. If you lease, you don't need to borrow as much.
   • Risk Adjustment: The discount rate(s) used should reflect the riskiness of the cash flows. A higher discount rate is used for more uncertain cash flows (e.g., salvage value).

4. Non-Financial Considerations:

   • Asset Life: If the asset's useful life is shorter than the typical lease term, leasing might be preferred.
   • Technological Change: If the asset is likely to become obsolete quickly, leasing transfers that risk to the lessor.
   • Flexibility: Leasing provides flexibility to upgrade or change equipment more easily.
   • Restrictive Covenants: Leasing avoids certain restrictive covenants (agreements) that come with debt financing.
   • Control: What controls does the Lessor have over the use of the equipment.

5. Evaluate the Lessor's Financial Standing:

   • Can the lessors give lease based on your requirements?
   • How many leases have they provided up until now?
   • Financial health of Lessor is a concern or not?
   • What services do they provide?
   • Flexibility of the payment terms.
   • Credit rating for Lessor.

6. Decision and Negotiation:

   • Based on the financial and non-financial analysis, the lessee makes a decision to lease or buy.
   • If leasing is the preferred option, the lessee can use the break-even rental (the maximum they're willing to pay) as a negotiating tool with the lessor.

III. Detailed Models

1. Weingartner's Model

   It is a Model that is deemed to the assumption that the target capital structure which consist a mix of debt, lease finance, as well as equity and identify the incorrect statement to this lease valuation model.

2. Equivalent loan Model:

   The effective rate of interest implied by the completed transaction is calculated.

3. Bower-Herringer-Williamson (BHW) Model:

   The discount rate is determined by the pre-tax marginal cost of debt in FA and post-tax marginal cost of capital is in OA.

4. Bower Model:

   Under the formula PV (Lease Rentals discounted at pre-tax cost of debt).

   PV(Tax shield on lease rentals discounted at unspecified rates ) .

IV. Key Takeaways

• NPV is the Foundation: The NPV method forms the basis of lease evaluation, either explicitly or implicitly.
• Tax Matters: Tax implications (depreciation, lease payment deductions) are critical.
• Risk is Key: Choosing appropriate discount rates to reflect the riskiness of cash flows is crucial.
• It's Not Just About Numbers: Non-financial factors and the lessor's quality should weigh heavily in the decision.

In essence, the lessee must thoroughly crunch the numbers, consider the qualitative aspects, and carefully select a lessor to make a well-rounded and advantageous lease decision.

Question:

GreenTech Innovations needs new solar panel installation equipment. They are considering two options: leasing or buying a specialized machine.

• Option 1: Lease. A 5-year lease with annual lease payments of $25,000, payable at the end of each year. GreenTech has the option to purchase the machine at the end of the lease for $10,000.

• Option 2: Purchase. Purchase the machine for $80,000. GreenTech will depreciate the machine straight-line to a salvage value of $0 over 5 years.

Additional Information:

• GreenTech's marginal tax rate is 25%.
• The risk-free rate (yield on a government bond) is 3%.
• The market risk premium (expected return on the market minus the risk-free rate) is 7%.
• GreenTech's beta (a measure of its systematic risk relative to the market) is 1.2.
• Annual maintenance costs are expected to be $3,000, payable at the end of each year, regardless of whether the machine is leased or purchased.

Tasks:

1. Calculate GreenTech's cost of capital using the CAPM.
2. Perform a present value analysis to determine whether GreenTech should lease or buy the equipment.
3. Include the tax shield from depreciation (for the purchase option) and the tax deductibility of lease payments and maintenance expenses in your analysis.
4. Provide a recommendation based on your analysis. Show all calculations clearly.

Okay, let's solve the GreenTech Innovations lease vs. buy question step-by-step.

1. Calculate GreenTech's Cost of Capital (Discount Rate) using CAPM:

• CAPM Formula: Cost of Equity = Risk-Free Rate + Beta * Market Risk Premium

• Risk-Free Rate = 3% = 0.03

• Beta = 1.2

• Market Risk Premium = 7% = 0.07

• Cost of Equity = 0.03 + 1.2 * 0.07 = 0.03 + 0.084 = 0.114 = 11.4%

Therefore, GreenTech's cost of capital, which we will use as the discount rate, is 11.4%.

2. Option 1: Lease Analysis

• Year 0: No cash flow
• Year 1-5: Lease Payment = $25,000
• Year 1-5: Maintenance Costs = $3,000
• Year 5: Purchase Option = $10,000

Calculate after-tax cash flow per year

• $25,000 + $3,000 = $28,000

• $28,000 * (1 - .25) = $21,000

• Purchase Option = $10,000

• $10,000 * (1 - .25) = $7,500

• Year 1-5 After-Tax Outflow = $21,000

• Year 5 After-Tax Outflow for Purchase Option = $7,500

Calculate PV of the Lease option

• Annuity Due PV = PMT * [1-(1+r)^-n] /r
• $21,000 * [1-(1 + .114)^-5] / .114
• $21,000 * [1-(1.114)^-5] / .114
• $21,000 * [1-.5815] / .114
• $21,000 * 3.6719
• $77,110
• PV of the purchase option
• FV / (1+r)^n
• 7,500 / (1+.114)^5
• 7,500 / 1.7197
• $4,361
• Total PV Lease Option: $77,110 + $4,361 = $81,471

3. Option 2: Purchase Analysis

• Year 0: Purchase Price = $80,000
• Year 1-5: Maintenance Costs = $3,000
• Year 1-5: Depreciation Tax Shield

Calculate After-Tax Depreciation:

• Annual Depreciation = $80,000 / 5 = $16,000
• Tax Shield = Depreciation * Tax Rate = $16,000 * 0.25 = $4,000 per year.

Calculate After-Tax Maintenance Costs:

• After-Tax Maintenance Cost = Maintenance Cost * (1 - Tax Rate) = $3,000 * (1 - 0.25) = $3,000 * 0.75 = $2,250 per year.

Calculate Total Annual After-Tax Cost (Years 1-5):

• After-Tax Maintenance Cost - Tax Shield = $2,250 - $4,000 = -$1,750

Calculate Present Value of Purchase:

• Year 0: $80,000

• Year 1-5: -$1,750 (This is a net inflow because the tax shield is larger than the after-tax maintenance cost)

• PV of Inflow = $1,750 * [1-(1.114)^-5] / .114

• PV of Inflow = $1,750 * 3.6719

• PV of Inflow = $6,426

• Total PV: $80,000 - $6,426 = $73,574

4. Comparison and Recommendation:

• Present Value of Leasing: $81,471
• Present Value of Purchasing: $73,574

Based on the present value analysis, GreenTech Innovations should purchase the equipment. The present value cost of purchasing ($73,574) is less than the present value cost of leasing ($81,471).

Conclusion:

Purchasing the equipment appears to be the more financially sound decision for GreenTech Innovations, given the assumptions and calculations presented. The depreciation tax shield significantly lowers the effective cost of ownership.

Important Considerations:

• Accuracy of Estimates: The accuracy of the discount rate, market risk premium, beta, residual value, and future maintenance cost estimates will greatly impact the result.
• Other Qualitative Factors: Consider any flexibility benefits of leasing, potential for technological obsolescence, and the specific terms of the lease agreement regarding maintenance responsibilities.
• Sensitivity Analysis: It's prudent to perform a sensitivity analysis, changing the discount rate, tax rate, and lease terms slightly, to see how robust the decision is. If a small change significantly alters the outcome, more careful investigation is warranted.
• Capital Constraints: If GreenTech has capital constraints, leasing may be preferrable despite having a lower present value.