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This final installment of a three-part series offers a comparison of leasing and financing and explains how to evaluate both options. (Links to parts one and two of our series can be found at the end of this article.) By Daniel P. Duffy The common denominator for determining the effectiveness of either a loan or lease proposal is its effect on the operator’s after-tax income. The goal of any firm is to maximize its after-tax income. The preferred option, then, is the one that limits the amount of after-tax cash outflows. Often a true apples-to-apples comparison requires equating these outflows to current dollars. Lease Payments and After-Tax Cash Flows Unlike loan payments, lease payments are considered tax-deductible expenditures on the operator’s income statement. Therefore, the key fact to remember is that a lease payment can be deducted from the operator’s before-tax income in the period in which the equipment is utilized. This tax deduction makes leasing competitive with obtaining financing to purchase a piece of equipment. The lease payments received by the lessor are treated as taxable income. The after-tax cash outflow of a lease payment is relatively easy to calculate. The outflow is equal to the lease payment less the tax savings that occurs when treating the lease payment as a tax-deductible expense. Therefore, the outflow is equal to the lease payment multiplied by 1 — tax rate (as a percentage of ordinary income). Thus, for a company paying a 30% tax rate, the after-tax cash outflow for a lease payment would be equal to 70% of the lease payment. Borrowing and After-Tax Cash Flows The calculation of the cash outflows associated with loan payments is more complicated and requires two steps. The first step is to determine the annual interest component of each loan payment. This calculation is done using standard loan payment formulas that differentiate between each period’s principal and interest payments. The second step requires calculating the annual depreciation and the resultant total cash outflow. The depreciation and interest payments on the loan are considered an expense and may be deducted as operating expenses from the firm’s annual income statement. Similar to lease payments, these expenses result in a tax savings that is subtracted from the loan payment to determine the year’s cash outflow. Lease or Purchase? The basic factor in evaluating the decision to lease or purchase equipment is the present value (PV) of the projected stream of cash outflows associated with each option. Inevitably, cash outflows associated with leasing or financing will occur at different times and for different durations of time. Therefore, a PV analysis is the only way to obtain an apples-to-apples comparison. The appropriate discount rate for this analysis should be current after-tax cost of debt. Most factors affecting the decision are known or can be projected with reasonable accuracy; therefore, this is a decision involving very low risk. For example, assume that a lessee making a lease or purchase decision has a current after-tax cost of debt equal to 6%. The purchase price of the equipment is $24,000. The annual lease payments are sent to the lessor to guarantee him or her a 14% return on investment. The equipment is expected to have no salvage value (a simplifying assumption). All maintenance, insurance, and other costs are borne by the lessee. If the lessor took on the costs of maintenance, insurance, and so on, the lessor would include the present value of these payments in his lease payment calculations. In this instance, since the lessee would bear these costs whether leasing or buying, the costs don’t factor into the decision to lease or purchase. As for purchase considerations, loan terms are five years at 9%. Five-year straight-line depreciation is applied to the equipment. Tax rates are at 40% on ordinary income. The cash outflows associated with leasing are the lease payments themselves plus the tax benefits associated with the lease payments. The tax benefits result from being able to expense the leasing payments for tax purposes. The lease payment (X) is determined by the following formula: $24,000 = (1.000)X + (2.914)X, where 2.914 is the present interest factor for an annuity discounted at 14% per year. The resultant annual lease payment in this case is $6,132. The resultant cash outflow results from deducting the tax benefits from the lease payments as shown in the following table.
Note that lease payments are typically upfront costs, paid before each period of the term of the lease. Hence, the yearly differences between when payments are made and when tax advantages accrue to the lessee. For purchase decisions, the estimated annual cash outflows are more complicated to calculate. Loan payments in this instance are $6,170 per year. The loan payments are not expensed, however. Instead, the annual depreciation of the equipment and interest charges on the loan are expensed and result in a tax shield. Depreciation expense is $4,800 per year. The resultant tax savings are deducted from the loan payments to determine actual cash outflow, as summarized in the following table:
The following table summarizes and compares the two potential streams of cash outflow using a present-value analysis–present-value interest factor, or PVIF–based on 6% for the corresponding year:
The incremental savings achieved by borrowing instead of leasing is $1,536. Therefore, borrowing instead of leasing saves the operator $1,536 in today’s dollars. In this example, borrowing is the preferred alternative. Unfortunately, the analysis is seldom this simple. Rarely, if ever, does a lease term coincide exactly with a loan period in regard to when they begin, when they end, and their duration. A mixed stream of cash flows involving equipment, replacement equipment, and varying costs and term durations might be required for an accurate analysis. Tax rates and the after-tax cost of debt on which the entire analysis depends may be changed during the course of the loan or the lease agreements. Thus, other types of depreciation might be more applicable instead of simple straight-line depreciation. Given the potential unknowns, the lease-or-purchase decision remains more art than science. Equipment Replacement Decisions Before you make the decision to buy or lease, you have to make a decision that might be even more difficult: when to let go of old equipment and vehicles. This decision is made more complicated by the unequal operating lifetimes of the equipment in your fleet. Two approaches are common: In the first approach, a comparison is made between the estimated resale values of new equipment (purchased now) at the time the old equipment’s operating life has expired. For example, an existing piece of equipment has a projected remaining operational lifetime (based on operators’ experience and manufacturer’s information) of three years, at which time it will have a projected salvage value of $10,000. Let’s assume that a new piece of equipment purchased to replace the existing equipment has a projected operating lifetime of seven years. Three years from now, the newly purchased equipment will have a salvage value of $12,000. Therefore, it makes financial sense to purchase the new equipment. The second approach makes a comparison over a longer time span, allowing for a common termination date for both pieces of equipment. This approach includes a prediction of the replacement cost of the older machine at the later date. What matters here is the greatest value that the operator can expect from each piece of equipment at the end of the longer operating lifetime. Typically the main problem with both approaches is the lack of a realistic common termination date. Whether the comparison is made over the remaining life of the old equipment or the projected life of the new equipment, some estimate of salvage value is required. Matching up the lifetimes of the equipment can become very complicated. For example, new equipment "A" is projected to last 10 years. Existing equipment "B" has a projected life of six years, after which it has to be replaced by equipment "C." Equipment C will be four years old at the end of the 10-year lifetime of A. Therefore, a proper analysis requires a comparison of the 10-year value of A with the four-year value of equipment C. A daisy chain of comparisons can result unless realistic assumptions regarding residual values are made for a common termination date. There’s the rub. As anyone who has sold a personal automobile can attest, the official projected "Blue Book" value doesn’t count for much in the real world. However, an official accounting projection of the equipment’s salvage value is all that can be expected. Whether a used piece of equipment is sold for more or less than book value depends on forces beyond the control of the seller (e.g., economic activity, demand, technical improvements made to similar equipment in the interim). Summary and Conclusions Whether the business is a lemonade stand or a major construction contractor with a large fleet of iron, its reason for existing is either wealth maximization or profit maximization. Wealth maximization is defined as the strategy of maximizing the value of the owners’ investment in the firm (usually measured by its stock price if it’s a publicly held company) over the long term. This strategy does not permit the sacrifice of long-term returns for current earnings and therefore is not always consistent with the second strategy. Profit maximization is defined as a short-term approach that does not consider risk or the timing of cash flows. Both are legitimate approaches, with wealth maximization considered the traditional approach and profit maximization preferred by most investors currently. Although it might be a bit of an oversimplification, financing equipment purchases, and the advantages of ownership (depreciation, salvage value, and so on) that come with it, lends itself to a wealth-maximization strategy. Leasing, with its short-term focus and minimum upfront costs, is more applicable to a profit-maximization strategy. Even though the preferred strategy will influence the lease or purchase decision, the two goals are not mutually exclusive; profit maximization can be a part of a wealth-maximization strategy. In the final analysis, a mixed approach involving both leasing and purchasing might be the optimum strategy. That way you get the best of both worlds. Guest author Daniel P. Duffy, P.E., is an environmental engineer for Rumpke Waste Inc. in Cincinnati, OH To
read Part 1 of this series click
here
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