Case #34: Lease versus Buy Analysis Why Buy It When You Can Lease It?
David Bajak Katrina Bishop Gary Hsieh
Question 1:
What are the different kinds of leases available and which one would be best suited for Paulo’s restaurant? Explain why? There are two major types of leases: operating lease and financial lease. An operating lease places the responsibility of maintenance and repairs on the lessor, has a life span of no more than 5 years, and is usually cancellable. A financial lease places the responsibility of maintenance and repairs on the lessee and is usually noncancellable and fully amortized. Tax‐ oriented lease, sale‐and‐leaseback lease, and leverage lease are all examples of financial leases. •
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buy decision is also in favor of buying since the net advantage to leasing (NAL) is negative number. The NPV of leasing and buying were found to be negative indicating the projects will cost money rather than make money for the company. The NPV of leasing is ($82,966.11) however, for buying the costs are not as high showing an NPV of ($59,221.92). These values lead us to an NAL of ($23,744.19) which indicates buying is better than leasing.
2. Net Advantage to Leasing (OWNING ASSET) NPV (LEASE & OWN) Lease ‐ With Purchase (D) (E) (G) (F)
The lease agreement comes out to be the better option when the lease term is long at about 60 months than a purchase agreement for the same length of time. This is because in the lease agreement, the company is able to break even at about 51 months as compared to the purchase agreement which needs the company to make the payments till the end of the term in order to breakeven. In addition to this,
Using the tables (shown below and in Exhibit 1) to calculate cash flow before financing and net proceeds from sale, a DCF method was used to arrive at a NPV of $216,789 and IRR of 13.3% for a 5-year holding period at assumed vacancy of 5% (Exhibit 1). As mentioned earlier, this IRR exceeds the 12.5% initially set out, and therefore seems like a feasible project. Using a higher vacancy rate of 7%, however, lowers the IRR to a point that is no longer feasible. If holding all else same, a vacancy of 7% on the building yields a NPV of $122,420 and an IRR of 11.47% (please see table below and Exhibit 2). This IRR does not meet the minimum required and therefore the assumption of vacancy rates staying at 5% is paramount to our analysis. This aspect of the analysis is considerably risky as an assumed vacancy rate does not necessarily yield a guaranteed rate. If vacancy happens to rise, then the valuation of the property is far different than what was originally envisioned.
* m. From point 2, we’ve seen than securing the lease would allow the expected value to increase by 3.1725 million. This is therefore the maximum value we’re ready to pay based solely on the main expected value. Nevertheless, if the risk appetite is lower, we could calculate a value that ensures none of the options to have negative return (see tree in appendix 5). This value is equal to 1.3 million.
By using the 7.2% after tax rate and assuming the equipment will be sold at the beginning of the 5th year for its book value, if Agro-Chem bought the equipment the company would achieve a project NPV of ($1,043,500.23). In contrast, if Agro-Chem decided to lease the equipment with the same assumptions they would obtain a project NPV of ($1,030,205). Given these assumptions and based off our calculated NPV we recommend that Agro-Chem lease the equipment rather than buy because of the $13,295.23 savings. This $13,295.23 savings is the NAL.
d. Is it more beneficial to continue leasing the business space or to buy the building?
Table 7 in the detailed analysis above shows the summary of the Discounted Cash Flow analysis performed for each of the four potential properties considered for investment. From the chart below, we observe that of the four properties, TFB has the maximum increase in reversion value at the end of the holding period, i.e. 10years. On a primarily income generation potential basis, Alison Green, with a Net Present value of the future rents at $734.29 looks attractive among the four options. Looking at the Investment ranks of the four properties with Simple returns and Discounted returns variables, Alison
Commercial’s NPV is $.1516 million (see Table 3). This was determined by using the present values of the four year lease agreement between Prudent and Commercial. We concluded that Commercial’s discount rate will be 10% because of their opportunity cost. Commercial needs to have a residual value on the DAS of 6.8 million or greater, which will give them a positive net present value. Therefore, if their net present value shows negative, they would not want to lease to us. Assuming Commercial receives the same 5 year MACRS rate on the equipment purchase, then the system should be worth 7.01 million (book value) at the end of year 4 (see Table 4). This allows Commercial to have a positive NPV of $.1516 million (see Table 4). Therefore, they would be willing to lease the DAS to us.
6. When considering a real estate investment opportunity, which of the following issues need to be addressed?
The determination of whether an arrangement is or contains a lease is based on the substance of the arrangement and requires an assessment of whether the fulfilment of the arrangement is dependent on the use of a specific asset or assets and whether the arrangement
Changes to the rent roll and vacancy rate as well as the addition of debt cost in the mode yield an npv of $553k. When the initial investment of $400k is taken into consideration this yields a total npv of $153k. This is a positive NPV and therefore the investment is not a losing proposition. However this should be compared to other investments.
Option 2 (Proceed with Mid-Rise Apartment Complex, Selling in Year 10): While replacing the current structure with a more appealing mid-rise apartment complex would increase the market value of the property, it would also require financing and additional investments. Thus far, Sexton has run into several problems, beginning with the planning commission, and now higher cost estimates, financing and timing issues. Even if Sexton were to obtain financing and somehow meet the January 2005 target date, his original estimates of rental income and cash flow analysis are still not guaranteed. Exhibit 2 provides a net present value range between 103,000 and $214,000 for proceeding with the mid-rise apartment complex and selling in year 10 based on a range of cap rates.
The risk of own or rent comparison is identified as of minor impact and required no further action in this phase of the project. Moderate and major risks required more detailed analysis. The investment risks are identified as providing the greatest potential risks
In today’s world, customers often face a dilemma about whether to buy or lease. Lease is an agreement in which one party gains a long term rental agreement, and the other party receives a form of secured long term debt. On the other hand, buying involves transfer of ownership from seller to buyer. Buying or leasing decision depends mostly on customer’s preference. There are many factors to consider before taking a buying or leasing decision.
AMG Inc, a Fortune 500 financial services company, is implementing 7,542 new PCs in the time frame of twelve months in multiple locations covering eight states. This is a $7.5 million technology financing decision which needs to be investigated. The current decision that Adam Stolz, controller for the CFO, faces is whether AMG should lease or buy the new PCs. Also, he is under pressure from the CEO to keep the transaction off of the balance sheet, in which case the equipment/software would have to be defined as an operating lease, according to the standards defined in FAS 13. The lease options consist of a 24-month lease or a 36-month lease, and AMG could also choose to purchase the computers for the same
What are the key takeaways to remember when determining future lease versus buy decisions of this magnitude?