Analyzing Cash Flows


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.

  1. 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.

  2. 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

    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.


    Figure B-2: Buying vs. leasing— a comparison of cash flows.

  3. 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.




Consultative Selling(c) The Hanan Formula for High-Margin Sales at High Levels
Consultative Selling: The Hanan Formula for High-Margin Sales at High Levels
ISBN: 081447215X
EAN: 2147483647
Year: 2003
Pages: 105
Authors: Mack Hanan

Similar book on Amazon

flylib.com © 2008-2017.
If you may any questions please contact us: flylib@qtcs.net