Cash Purchase vs Loan vs Lease to obtain a capital asset Pertemuan Matakuliah: A0774/Information Technology Capital Budgeting Tahun: 2009

Lease Definition –A lease is a contractual agreement between two parties--a lessor and a lessee. The agreement gives the lessee the right to use specific property, owned by the lessor, for a specific period of time in return for stipulated, and generally periodic, cash payments (rent).

When is it best to purchase a capital asset by paying cash or by getting a bank loan or by leasing? (1)the type of asset the company needs (2)whether it is new or used (3)the purchase cost (4)the amount of the down payment, if any (5)the length of finance term, and (6)the payment method/procedure/preference. Then, compare the economic and non-economic factors for the three options (a cash purchase, a bank loan, or a lease). The financing decision will affect the credit rating of the company.

Type of Lease fair market value lease purchase price guarantee lease $1/$101 buy-out lease.

fair market value lease This option is best if the leased asset will not be useful by the end of the lease term--for example, because of new technology. This method offers the best match between cost and usage. You should select the lease term that is equal to the period the asset will be used. You have the option to buy the asset at fair market value at the end of the lease term.

fair market value lease According to Financial Accounting Standard Board (FASB) Statement No. 13. At the end of the lease term, you have four options: (1) return the asset to the lessor (owner) (2) re-lease a newer asset/technology (3) extend the lease term and continue to use the same asset (4) purchase the asset for its fair market value as determined by the lessor.

purchase price guarantee lease This option is best if you want to own the asset at the end of the lease term, but need to acquire the asset 'today with no money down and require a low, periodical payment. At the end of the lease, you purchase the asset for a guaranteed purchase price or re-lease the asset under a new lease plan. The guaranteed purchase price is a fixed percent of the asset's original cost. You use the money available today in other areas to increase company productivity.

Fair market value lease vs purchase price guarantee lease This differs from the fair market value lease in which the lessor determines the purchase price at the end of the lease and you have the option not to buy the asset. In addition, under a purchase price guarantee lease, the asset is capitalized and depreciation of the asset should be deducted in calculating taxable income. At the end of the lease term, you have the option to purchase the asset for the guaranteed purchase price, renew the lease agreement, or return the leased asset to the lessor. According to Statement No. 13, this type of lease is considered a capital lease with a guaranteed residual value.

$1/$101 Buy-Out Lease This option is the best if the leased asset will maintain its usefulness during and after the lease term. This type of lease is similar to a loan and is viewed as such by most state tax laws. This type of lease is easier to process than a loan and no down payment is required (unlike most bank loans). In addition, the lease payment is flexible compared to a loan payment.

$1/$101 Buy-Out Lease Under this type of lease, the leased asset should be capitalized in the balance sheet and depreciation should be deducted in calculating your taxable income. According to Statement No. 13, this type of lease is a finance lease with an un-guaranteed residual value.

Case Studies Assume a corporation needs computers costing $100,000. Economic useful life is 5 years with no residual value. A straight-line depreciation method is used. Payment of total loan is at the end of the fourth year with an annual interest payment of 10%. Down payment for the loan is 20% of the loan at the beginning of the first year. The implicit borrowing rate is also 10%. Rent for a leased asset as an operating lease is $35,000. Purchase guarantee price is $10,000, with no down payment, and the annual lease payment is at end of each year. Lease term is four years. Income tax rate is 40% for all years and there are no deferred taxes.

"A" Corporation has to choose among three alternatives--buy cash versus loan to buy versus lease. If A Corporation decides to lease, it needs to choose the type of lease arrangement. Table 1 presents the factors that should be considered in comparing cash purchases versus bank loan versus lease. Table 2 shows the results of comparing cash purchase versus bank loan versus the three types of leases (purchase guarantee lease, $1/$101 lease, and fair value lease).

The numbers in Table 1 are calculated as follows: Bank loan.: The net present value (NPV) of loan payment is ($100,000 - $20,000 down payment) x (the present value of 1 at n = 4 and i = 10%) = $54,641 + PV of interest 8,000 x ordinary annuity with n = 4 and i = 10% = $25,

Purchase guarantee lease. The NPV of total lease payment + fixed purchase price at the end of lease term are as follows: (Annual lease payment x 4 years) + purchase guarantee price. –Annual lease payment = ($100,000 - $6,830 the PV of purchase guarantee price) / the present value of ordinary annuity with n = 4 and i = 10% = $29,392. –Therefore, total lease payment = ($29,392 x 4 years) + purchase guarantee price $10,000 = $127,568.

$1/$101 lease. The NPV of total lease payments $126,188 is calculated as follows: –Lease rental payment end of each year = 100,000 / = 31,547 x 4 years = $126,188. –Fair value: the NPV of total rents is calculated as follows: $35,000 x 4 years = $140,000.

The calculation of the numbers in Table 2 is as follows: Cash purchases Tax benefit is for the depreciation expense deduction that is calculated using the straight-line method. Assume corporate tax rate is 40%, ($100,000 divided by 5 years) x 40% = $8,000.

The calculation of the numbers in Table 2 is as follows: Bank loan Tax benefit is for depreciation and interest = $11,200. It is calculated as follows: Depreciation expense tax benefits = ($100,000 divided by 5) x 40% = $8,000. Interest expense tax benefits = ($100,000 loan - $20,000 down payment) x 10% = 8,000 x 40% = $3,200.

The calculation of the numbers in Table 2 is as follows: Purchase guarantee lease. Tax benefit for depreciation = ($100,000 - $10,000 residual value) divided by 5 years = $18,000 x 40% = $7,200 and is the same for all 5 years. Useful life of the asset is used for depreciation because of the purchase guaranteed option. Interest tax benefits for each year = balance of lease obligation x 10% x 40% tax rate.

Table 3 shows the calculation of interest every period. $1/$101 buy-out lease Depreciation tax benefit = $100,000 divided by 4 years the lease term = $25,000 x 40% = $10,000 for each year. Interest tax benefits for each year = balance of lease obligation x 10% x 40%.

Table 4 shows the calculation for interest each period. Fair value (rent expense) Tax benefits = rent x 40% tax rate = $35,000 x 40% = $14,000. For all cases, after tax cash outflows is calculated by subtracting tax benefits from the cash outflows.

Conclusion The decision to purchase a long-term asset with cash, to borrow to buy an asset, or to lease an asset depends on many factors. –If you are thinking about buying an asset with available cash, you should consider the availability of cash, opportunity cost, other investments available, tax benefits, and obsolescence of the asset. –If you plan to borrow to purchase the asset, you should consider the amount of cash needed, interest rate, term of a loan, and the tax benefits from interest and depreciation.

Conclusion In terms of lease decisions, you should consider: –the lease term –interest rate –change in technology –residual value –purchase option at the end of the lease. For every choice, you should consider the accounting treatment that is used and its impact on the net income, assets, liabilities, and cash flows of the company.

Factors for Comparing Cash Purchase vs Bank Loan vs Three Types of Leases CASH PURCHASE FACTOR PURCHASE BANK LOAN GUARANTEE LEASE Actual 100% of cost Down payment + Net NPV of total lease Investment Present Value (NPV) payment+ fixed pur- of loan payments chase price at the (20,000+54,641 + end of lease term 25,358.88) $ Initial Cash $100,000 $20,000 (20% down Payment at end of Requirement payment required each year $29,392 by most banks. Payments 100% of cost Fixed Fixed up-front Impact on Substantial 20% down payment + No down payment; Cash decrease in annual interest yearly payment + cash in purchase price end