Core Concepts Related to Lease vs. Purchase and Tactical Financial Decisions

Core Concepts Related to Lease vs. Purchase and Tactical Financial Decisions

The two parties to a lease transaction are the lessor, the owner of the asset, and the lessee, who is the asset user.

The four types of leases are financial, operating, combination, and synthetic (Brigham & Ehrhardt, 2019). A financial lease covers the entire life expected life of an asset, is fully amortized, is not cancellable, and does not provide maintenance service. An operating lease provides for both maintenance and financing. Additionally, operating leases bear a cancellation clause and cover a shorter period than the expected life of an asset. A combination lease combines the characteristics of operating and financial leases. For instance, a combination lease can have a cancellation clause and fail to cover an asset’s entire life. Finally, a synthetic lease exists when a firm creates a special purpose entity to borrow, purchase an asset, and lease it back to the company.

For tax purposes, leases are classified as guideline leases. A guideline lease meets requirements set out by the IRS, and when the guidelines are met, the lessee is allowed to deduct lease payments, while the lessor is allowed to deduct the asset’s depreciation for tax purposes.

Leasing is shown directly in the balance sheet when it is classified as a capital lease. However, if classified as an operating lease, it will not be shown in the balance sheet but in the footnotes.

Leasing affects a firm’s capital structure because it is an alternative to debt financing, thereby increasing an organization’s financial leverage.

Depreciation Schedule

Year	MACRS Rate	Depreciation Expense ($)	End-of-Year Rate Book Value ($)
1	0.3333	333,300	666,700
2	0.4445	444,500	222,200
3	0.1481	148,100	74,100
4	0.0741	74,100	0
	1.000	1,000,000

 Cost Owning Timeline

	0	1	2	3	4
AT Loan Payment		-60,000	-60,000	-60,000	-1,060,000
Dep. Tax Savings		1133,320	177,800	59,240	29,640
Maintenance AT	-12,000	-12,000	-12,000	-12,000
Res. Value (AT)					120,000
Net Cash Flow	-12,000	61,320	105,800	-12,760

The ending book value is $0; thus, taxes are paid on the full $200,000 residual value. Maintenance expense is tax deductible, and its value will be $12,000, arrived at as an after-tax of (1-t) of $20,000. Regarding depreciation, they produce tax savings since they are tax-deductible expenses.

A discount rate of 6% is used, which gives a present value of -$591,793. The discount rate is obtained as an after-tax debt cost. The firm’s tax cost is 10%, and since the firm is in the 40% tax bracket, the discount rate will be (1-0.4)10% = 6%.

Lease payments will be Lewis’s only cash flow, considering the equipment is leased. Thus;

	0	1	2	3	4
Lease Payment	-156,000	-156,000	-156,000	-156,000

 

The -$156,000 lease payment is arrived at by considering the after-tax cost of each lease payment of $260,000. ($260,000)(1-t) = $156,000

The present value of leasing at a discount rate of 6% will be -$572,990.

The net advantage to leasing (NAL) will be $18,571, given the difference between the present value of owning and the present value of leasing.

The increased risk will be accounted for in the given case by increasing the rate applied in discounting the cash flow residue value. Notably, this results in a lesser residual cash flow present value. As a result, the cost of ownership becomes higher, making a leasing option desirable because of an increased risk associated with the residual value, increasing the owning cost.

The lessor should contrast the returns available on the lease with returns gained from other available investment options, and the lessor should consider writing the lease as an investment. The options to be contrasted should bear relatively similar risks.

Reference

Brigham, E. F., & Ehrhardt, M. C. (2019). Financial Management: Theory & Practice. Cengage Learning.

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The purpose of this assignment is to explain core concepts related to lease vs. purchase and tactical financial decisions.

Read the Chapter 19, Mini Case in Financial Management: Theory and Practice. Using complete sentences and academic vocabulary, please answer questions A through f.

APA format is not required, but solid academic writing is expected.

This assignment uses a rubric. Please review the rubric prior to beginning the assignment to become familiar with the expectations for successful completion.