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A cash-flow analysis enables the potential lessee to contrast his cash position under both buying and leasing. This is essentially a capital budgeting procedure, and the method of developing and comparing cash flows should conform to the company's capital budgeting policies and practices. There are several comparison criteria in current use, among which the three most common are rate of return, discounted cash flow, and net cash position.
Outright purchase. The cash outflows in an outright purchase are the initial purchase price or, assuming the asset is purchased with borrowed funds, as is almost always the case, the subsequent principal and interest on the loan. There will also be operating expenses, such as maintenance and insurance, but these
items are excluded from the comparison because they will be the same under both purchase and leasing, assuming a net lease. The charge for depreciation is a noncash item. Cash inflows are the amount of the loan, the tax benefit from the yearly interest and depreciation, and the salvage value, if any.
Leasing. The lessee's cash flows are easier to define than the buyer's. The lessee pays a yearly rental, which is fully deductible. The lessee will thus have level annual outflows offset by the related tax benefit over the lease period. Salvage or residual value does not enter the picture because the lessee generally has no right of ownership in the asset. Figure B-2 is a comparison of cash flows developed under both buying and leasing.
Buy | Lease | |||||||||||
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Period | Debt Service [a] | Principal Repayment | Interest Payment | Depreciation [b] | Interest Plus Depreciation | Tax Benefit at 50 Percent | Aftertax Cash Cost | Cumulative Aftertax Cash Cost | Rental [c] | Tax Benefit at 50 Percent | Aftertax Cash Cost | Cumulative Aftertax Cash Cost |
1 | $ 11,507 | $ 3,614 | $ 7,893 | $ 12,500 | $ 20,393 | $10,197 | $ 1,310 | $ 1,310 | $ 10,990 | $ 5,495 | $ 5,495 | $ 5,495 |
2 | 11,507 | 3,912 | 7,595 | 11,667 | 19,262 | 9,631 | 1,876 | 3,186 | 10,990 | 5,495 | 5,495 | 10,990 |
3 | 11,507 | 4,234 | 7,273 | 10,833 | 18,106 | 9,053 | 2,454 | 5,640 | 10,990 | 5,495 | 5,595 | 16,485 |
4 | 11,507 | 4,583 | 6,924 | 10,000 | 16,924 | 8,462 | 3,045 | 8,685 | 10,990 | 5,495 | 5,495 | 21,980 |
5 | 11,507 | 4,961 | 6,546 | 9,167 | 15,713 | 7,856 | 3,651 | 12,336 | 10,990 | 5,495 | 5,495 | 27,475 |
6 | 11,507 | 5,370 | 6,137 | 8,333 | 14,470 | 7,235 | 4,272 | 16,608 | 10,990 | 5,495 | 5,495 | 32,970 |
7 | 11,507 | 5,813 | 5,694 | 7,500 | 13,194 | 6,597 | 4,910 | 21,518 | 10,990 | 5,495 | 5,495 | 38,465 |
8 | 11,507 | 6,292 | 5,215 | 6,667 | 11,882 | 5,941 | 5,566 | 27,084 | 10,990 | 5,495 | 5,494 | 43,960 |
9 | 11,507 | 6,810 | 4,697 | 5,833 | 10,530 | 5,265 | 5,242 | 33,326 | 10,990 | 5,495 | 5,495 | 49,455 |
10 | 11,507 | 7,372 | 4,135 | 5,000 | 9,135 | 4,567 | 6,940 | 40,266 | 10,990 | 5,495 | 5,495 | 54,950 |
11 | 11,507 | 7,979 | 3,528 | 4,167 | 7,695 | 3,848 | 7,659 | 47,925 | 10,990 | 5,495 | 5,495 | 60,445 |
12 | 11,507 | 8,637 | 2,870 | 3,333 | 6,203 | 3,101 | 8,406 | 56,331 | 10,990 | 5,495 | 5,495 | 65,940 |
13 | 11,507 | 9,349 | 2,158 | 2,500 | 4,658 | 2,329 | 9,178 | 65,509 | 10,990 | 5,495 | 5,495 | 71,435 |
14 | 11,507 | 10,120 | 1,387 | 1,667 | 3,054 | 1,527 | 9,980 | 75,489 | 10,990 | 5,495 | 5,495 | 76,930 |
15 | 11,507 | 10,954 | 553 | 833 | 1,386 | 693 | 10,814 | 86,303 | 10,990 | 5,495 | 5,495 | 82,425 |
$172,605 | $100,000 | $72,605 | $100,000 | $172,605 | $86,302 [d] | $86,303 | $164,850 | $82,425 | $82,425 [e] | |||
Comment on notes (d) and (e). When comparing the cumulative aftertax cash costs, buying is the more expensive alternative by about $4,000. However, present valuing the annual outflows results in buying's being the most economical alternative by approximately $6,000. | ||||||||||||
[a]$100,000 of debt borrowed at 8%. The debt service, payable quarterly in arrears, will be sufficient to amortize the loan fully over 15 years,
[b]Asset cost of $100,000 will be depreciated over 15 years using the sum-of-the-years method. It was assumed that the asset had no salvage value,
[c]Rental on a 15-year lease will be payable quarterly in arrears. The rental was based on an interest factor of 7 1/4 %. It was assumed that the lessee's credit would require 8% interest. Since the lessor retains the depreciation benefits of the asset, he can charge a rent based on 7 1/4 % even though he has financed the acquisition at 8%.
[d]Present worth of $86,302 cost of buying, at 8%, is $41, 198.
[e]Present worth of $82,425 cost of leasing, at 8%, is $47,034. |
Comparing the cash flows. Once the annual cash flows from outright purchase and leasing have been developed, the next step is to contrast the flows by an accepted method (such as discounted cash flow) to determine which alternative gives the greater cash benefit or yield. In so doing, some consideration must be given to the effects of changes in the assumptions adopted. Examples could include a lengthening by the IRS of the depreciation period or a change in interest rates. In this manner, a series of contingencies could be introduced into the analysis, as follows: Assume a ten-year life and a borrowing at 10 percent. If outright purchase is better by x dollars, then:
A two-year increase in depreciable life reduces the benefit of outright purchase to (x-y) dollars.
An upward change in interest rate reduces the benefit of outright purchase to (x - z) dollars.
Probabilities could be assigned to the contingencies; for example, that the depreciable life could be extended by two years, 30 percent; or that interest rates could rise by one half a percentage point, 10 percent. Once the contingencies have been quantified, an overall probability of achieving the expected saving can then be calculated.
It must be stressed that the rate of return—the product of the cash-flow analysis—is not the exclusive or even, in some cases, the main determinant in deciding whether to buy or lease. Such factors as impact on financial statements, desire for operational flexibility, and loan restrictions, as well as other accounting, tax, economic, and financial considerations, may be collectively at least as important. These aspects are essentially nonquantitative, but they can be evaluated with a satisfactory degree of accuracy by weighing the advantages and disadvantages.
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