Leasing vs. Buying

Business owners have two financial options (Buying or Leasing) when it comes to obtaining an asset for their company. And like anything in finance, these two monetary alternatives each have their advantages and disadvantages.

 

Q1.     What are the pros and cons of leasing a car vs. buying?

Q2.     Suppose Delta Industries is considering purchasing $45 million in new manufacturing equipment. If it purchases the equipment, it will depreciate it on a straight-line basis over five years, after which the equipment will be worthless. It will also be responsible for maintenance expenses of $3 million per year. Alternatively, it can lease the equipment for $10 million per year for the five years, in which case the lessor will provide necessary maintenance. Assume Delta Industries' tax rate is 40% and its borrowing cost is 8%.

           Required:

a)   What is the Net Advantage of Leasing (NAL) associated with leasing the equipment versus financing it with the lease equivalent loan?

b)  What is the break-even lease rate—that is, what lease amount could Gulf Inc. pay each year and be indifferent between leasing and financing a purchase?

Answer:

Nal<0 buy

Nal>0 indifference

Nal>0 lease

Breakeven lease payment

(6 million)/

The lease payment at which a party to a prospective lease is indifferent between entering and not entering into a lease arrangement.

Here the difference is 7665940 over a period of time i.e 1533188 every year

Step-by-step explanation

A. A lease is an agreement whereby the lessor conveys to the lessee in return for a specific payment or series of payments the right to use of an asset for an agreed period of time. Leases are of two types viz., Finance lease and Operating lease. A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Whereas an operating lease is a lease other than a finance lease, i.e., it does not transfer substantially all the risks and rewards incidental to ownership. the following are advantages of leasing a car rather than buying.

Advantages

1. Lower monthly installments:  The lease payments of a car are typically lesser than the monthly payments to buy the car.

2. Tax deductions: The entire lease payment made can be taken as a tax deduction where as on a bought car the deduction is claimed only to the extent of depreciation on wdv method for business purposes.

3. Choice of vehicle: The vehicle can be changed n number of times with an increase or decrease in the lease payment.

4. Maintenance: The maintenance is done by the owner of the vehicle & these costs can be saved.

Disadvantages

1. Expensive in Long run: When you lease, you pay for the use of the vehicle for the first 2 or 3 years of its life - when the car depreciates the most. When your lease is over, you either have to lease another car or purchase one - either way you're going to have monthly payments for a long time, whereas if you purchased a car to begin with, you would essentially drive it payment-free after you've paid off the loans.

2. No changes in structure: There could be no structure changes in the vehicle as it is owned by a third party & would be lot of objections

3. Difficult to obtain lease: It would be difficult to obtain lease as only good credit people are accessed to take the lease.

B.

Decision will be based on after tax cash flows. 

In this case, it will be after tax net cash outflow. In case of lease, the cash outflow is 10 million per annum for 5 years. As lease rental is tax deductible, after tax cash flow will be  10 million (1 - 0.40) or  6 million per annum for 5 years.

In case of buying the asset, cash outflow is annual installment of interest and principal. From annuity table, it may be seen that annuity of 1 is payable for 3.99271 when rate of interest is 8% and period of repayment is 5 years. Therefore, annual installment will be 450,00,000/3.99271 or 112,70,540.5 (principal and interest).

In the first year, interest is payable on the total cost of the asset, i.e., 450,00,000 @ 8% or 36,00,000.