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Case 34 by Jim Demello

Case 34 by Jim Demello

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Published by Sunita Fichadia
solution to case: Why buy it, When you can lease it?
solution to case: Why buy it, When you can lease it?

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Published by: Sunita Fichadia on Feb 09, 2011
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01/24/2013

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Solution to Case 34
Lease Versus Buy Analysis
Why Buy It When You Can Lease It?
 Questions:1.What are the different kinds of leases available and which one would be bestsuited for Paulo’s restaurant? Explain why.
Leases can be broadly categorized into two types, financial and operating.Financial leases are generally longer-term, fully amortized, and not cancelablewithout a hefty termination penalty. Operating leases are usually shorter-term, partially amortized, and cancelable on short notice. Financial leases are required to be reported on a firm’s balance sheet while operating leases are not. With afinancial (operating) lease, the lessee (lessor) is usually responsible for maintenance, taxes, and insurance.Since the equipment under consideration involves heavy use and wear and tear, and possibly technological developments that could improve operating efficiency, Pauloshould go for an operating lease and let the lessor take care of the maintenance.
2.Calculate the net advantage to leasing (NAL) the restaurant equipment. It isassumed that the old equipment has no resale value whereas the newequipment would have a salvage value of $30,000 after 5 years. Therestaurant’s tax rate is estimated to be 40%.
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3.What typically happens to the leased equipment after the term of the leaseexpires?
After the term of the lease expires the leased equipment is typically leased out again(in case of an operating lease) or sold in the used market. Its fate depends on thetype of equipment, technological developments in the field, as well as the economicand financial conditions of the market.
4.After doing all the calculations, Paulo realizes that he underestimated thecost savings that would result from improved efficiency by $1000 per year.How should this error be handled? Is it relevant? Explain.
As can be seen from the cash flows in #2 above, cost savings are irrelevant in thecase of lease versus purchase decisions since they would benefit both alternativesleaving a net advantage of zero.
5.How should depreciation and taxes be accounted for in the calculations?
Depreciation is a tax write-off available to the owner. It results in a tax savingequal to the annual depreciation charge times the corporate tax rate of the owner.When the equipment is leased, therefore, the lessee loses the depreciation tax shield.Taxes must be adjusted for when calculating the salvage value (if any), the lease payments, and any operating cost savings. The analysis must be done net of taxes.2
Lease Versus BuyYear 0Year 1Year 2Year 3Year 4Year 5LEASEAfter-tax Lease Payment=25000(1-T)($15,000)($15,000)($15,000)($15,000)($15,000)Lost Depreciation tax shield=Dep(T)($13,332)($17,776)($5,928)($2,964)$ -Maintenance cost saving=Maint.Cost(1-T)$1,200$1,200$1,200$1,200$1,200Avoidance of upfront cost$100,000Loss of after-tax salvage value in year 5($18,000)Total Cash flows of leasing versus buying$100,000($27,132)($31,576)($19,728)($16,764)($31,800)Cost of Lease8.70%After-tax cost of borrowing6%DECISION
BORROW AND BUY
 Note: The cost savings and buy option ($40,000) would be irrelevant
 
6.If the equipment were to be leased, would the lease payments be taxdeductible? Explain.
Yes, lease payments are tax deductible just like interest payments on debt.
7.If AAA Leasing Company’s tax rate is 40%, what is the minimum leasepayment that it would be willing to accept? Explain.
The minimum lease payment that AAA Leasing Company would be willing toaccept is $22,110. It can be calculated by first finding the present value of the other relevant cash flows that would be involved during years 0 – 5 using the after-taxdiscount rate of 6% (= $44,118.77). Next, we minus this value from $100,000(=$55881.23), and calculate the 5-year annuity which would equal $55881.23 at adiscount rate of 6% (=$13,266). Finally, we calculate the before-tax value of $13,266 given a tax rate of 40% (i.e. $13,266/(1-Tax rate)=$22,110).
8.What is the maximum lease payment that Paulo should be willing to pay?Explain.
The method to calculate the maximum payment that the lessor should be willing to pay is the same as explained in #5 above. If the lessor and lessee have the same taxrate, the maximum lease payment that the lessee would be willing to pay would beequal to the minimum payment that the lessor would be willing to accept i.e$22,110
9.How much of an impact does the forecast of the salvage value of the newmachine have on the lease versus buy decision?
The after-tax salvage value of the new machine is discounted for 5 years at 6% andtreated as a negative cash flow for the lessee, when analyzing the lease versus buydecision. Thus, to figure out the impact of the salvage value on the lease versus buydecision we can do the following:1.Calculate the present value interest factor at the discount rate (6%)=.7472.Next multiply this factor by 60%, since 60% of the salvage value isdiscounted and treated as a negative cash flow = 0.747*.6 = .44823.Thus the forecast of the salvage value can affect the NPV by about 45%.3

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