Case#34:

LeaseversusBuyAnalysis
WhyBuyItWhenYouCanLeaseIt?

DavidBajak
KatrinaBishop
GaryHsieh

Question1:
WhatarethedifferentkindsofleasesavailableandwhichonewouldbebestsuitedforPaulosrestaurant?Explainwhy?

Therearetwomajortypesofleases:operatingleaseandfinanciallease.

Anoperatingleaseplacestheresponsibilityofmaintenanceandrepairsonthelessor,hasalifespanofnomorethan5years,andisusually
cancellable.

Afinancialleaseplacestheresponsibilityofmaintenanceandrepairsonthelesseeandisusuallynoncancellableandfullyamortized.Tax
orientedlease,saleandleasebacklease,andleverageleaseareallexamplesoffinancialleases.
Asaleandleasebackleaseisaformoftemporaryborrowing,whichallowstheownerofanassettoselltheassettoanothercompany
andleaseitbackforaspecifiedperiod.
UnderataxorientedleasethelessorwillbetreatedbytheIRSastheowneroftheleasedpropertyforfederaltaxpurposesand
permittedtotaketaxbenefits.
Aleveragedleaseallowsthelessortoborrowaportionofthefundsneededtobuytheequipmenttobeleased.

AnoperatingleasewouldbebestsuitedforPaulosrestaurant.Underanoperatinglease,Paulowouldbeabletoreturntheequipmentand
cancelthecontractifneeded.Theequipmentwouldnothavetobelistedasaliabilityorassetonhisbalancesheet.Also,hewouldnothaveto
considermaintenancecost.

Question2:
Calculatethenetadvantagetoleasing(NAL)therestaurantequipment.Itisassumedthattheoldequipmenthasnoresalevaluewhereas
thenewequipmentwouldhaveasalvagevalueof$30,000after5years.Therestaurantstaxrateisestimatedtobe40%.

Inordertoproperlycomparetheleasevs.buydecisionwemustbeabletodistinguishbetweenthesituationsofowningandnotowningthe
assetsattheendofyearfive.Aleasevs.buycomparisonwhereyouaretheownerinonesituationandnottheownerintheotherismuchlike
comparingappleswithoranges.Thecashflowsfromleasingandbuyingforscenariosofowningandnotowningtheassetsarebelow.

Inthesecomparisonscashflowsforleasepaymentswereassumedtobeinarrearsinordertolineupwiththeestimatedsavingsand
maintenancecostsforeachendofyear.Maintenancefeeswereincludedinthebuyingdecisionsincetheyareaccountedforintheleasing
scenarioandweareinterestedincomparingapplestoapples.EstimatedsavingswereincludedintheNPVcalculationsinceitisacashflow
doesaffectourNPVofeachproject.Wecalculateddiscountrateof6%givenourinterestrateandtaxrateandthisvaluewasusedinour
presentvalue(PV)calculationasouraftertaxcostofborrowing.Thisallowsustocompareallaftertaxcashflows(ATCF)toonestandardrate
thatisrelatedtoourborrowingrate.

Ifyouintendonnotbeingtheowneroftheassetstheleasevs.buydecisionisinfavorofbuyingsincethenetadvantagetoleasing(NAL)is
negativenumber.TheNPVofleasingandbuyingwerefoundtobenegativeindicatingtheprojectswillcostmoneyratherthanmakemoneyfor
thecompany.TheNPVofleasingis($53,075.79)however,forbuyingthecostsarenotashighshowinganNPVof($45,771.27).Thesevalues
leadustoanNALof($7,304.27)whichindicatesbuyingisbetterthanleasing.

END
OF
YEAR
0
1
2
3
4
5

(A)
Buying
$
$
$
$
$
$

(B)
AnnualLease
Payment
$
$(25,000.00)
$(25,000.00)
$(25,000.00)
$(25,000.00)
$(25,000.00)

(C)
Estimated
Savings
$4,000.00
$4,000.00
$4,000.00
$4,000.00
$4,000.00

2.NetAdvantagetoLeasing(NOTOWNINGASSET)
NPV(LEASE&DON'TOWN)
LeaseDon'tPurchase
(G)
(D)
(E)
(F)
TaxableIncome
Maintenance
BTCF
Depreciation
(EF)
Cost
(A+B+C+D)
$
$
$
$
$
$ (21,000.00) $
$(21,000.00)
$
$ (21,000.00) $
$(21,000.00)
$
$ (21,000.00) $
$(21,000.00)
$
$ (21,000.00) $
$(21,000.00)
$
$ (21,000.00) $
$(21,000.00)

(H)
IncomeTax
(G*40%)
$
$ 8,400.00
$ 8,400.00
$ 8,400.00
$ 8,400.00
$ 8,400.00

(I)
ATCF
(E+H)
$
$ (12,600.00)
$ (12,600.00)
$ (12,600.00)
$ (12,600.00)
$ (12,600.00)

(J)
AdjustedATCF

PV

$
$ (12,600.00)
$ (12,600.00)
$ (12,600.00)
$ (12,600.00)
$ (12,600.00)

$
$ (11,886.79)
$ (11,213.95)
$ (10,579.20)
$(9,980.38)
$(9,415.45)

NPV

END
OF
YEAR
0
1
2
3
4
5

(A)
Buying
$(100,000.00)
$
$
$
$
$30,000.00

(B)
(C)
AnnualLease Estimated
Payment
Savings

(D)
Maintenance
Cost

$4,000.00
$4,000.00
$4,000.00
$4,000.00
$4,000.00

$(2,000.00)
$(2,000.00)
$(2,000.00)
$(2,000.00)
$(2,000.00)

$
$
$
$
$

NPV(BUY&DON'TOWN)
BuyWithSellingatSalvageValue
(E)
(G)
(F)
BTCF
TaxableIncome
Depreciation
(A+B+C+D)
(EF)
$(100,000.00)
$2,000.00 $ 33,333.33 $(31,333.33)
$2,000.00 $ 44,444.44 $(42,444.44)
$2,000.00 $ 14,814.81 $(12,814.81)
$2,000.00 $ 7,407.41 $(5,407.41)
$32,000.00 $
$32,000.00

(H)
IncomeTax
(G*40%)
$ 12,533.33
$ 16,977.78
$ 5,125.93
$ 2,162.96
$(12,800.00)

$ (53,075.79)

(I)
ATCF
(E+H)
$(100,000.00)
$14,533.33
$18,977.78
$7,125.93
$4,162.96
$19,200.00

(J)
AdjustedATCF

PV

$(100,000.00)
$14,533.33
$18,977.78
$7,125.93
$4,162.96
$19,200.00

$(100,000.00)
$13,710.69
$16,890.15
$5,983.07
$3,297.46
$14,347.36

NPV

$ (45,771.27)

NAL

$(7,304.51)

Ifyouwishtobetheowneroftheassetstheleasevs.buydecisionisalsoinfavorofbuyingsincethenetadvantagetoleasing(NAL)isnegative
number.TheNPVofleasingandbuyingwerefoundtobenegativeindicatingtheprojectswillcostmoneyratherthanmakemoneyforthe
company.TheNPVofleasingis($82,966.11)however,forbuyingthecostsarenotashighshowinganNPVof($59,221.92).Thesevalueslead
ustoanNALof($23,744.19)whichindicatesbuyingisbetterthanleasing.

END
OF
YEAR
0
1
2
3
4
5
5

(A)
Buying
$
$
$
$
$
$
$(40,000.00)

(B)
AnnualLease
Payment
$
$(25,000.00)
$(25,000.00)
$(25,000.00)
$(25,000.00)
$(25,000.00)

(C)
Estimated
Savings
$4,000.00
$4,000.00
$4,000.00
$4,000.00
$4,000.00

2.NetAdvantagetoLeasing(OWNINGASSET)
NPV(LEASE&OWN)
LeaseWithPurchase
(D)
(E)
(G)
(F)
Maintenance
BTCF
TaxableIncome
Depreciation
Cost
(A+B+C+D)
(EF)
$
$
$
$
$
$ (21,000.00) $
$(21,000.00)
$
$ (21,000.00) $
$(21,000.00)
$
$ (21,000.00) $
$(21,000.00)
$
$ (21,000.00) $
$(21,000.00)
$
$ (21,000.00) $
$(21,000.00)

(H)
IncomeTax
(G*40%)
$
$ 8,400.00
$ 8,400.00
$ 8,400.00
$ 8,400.00
$ 8,400.00

(I)
ATCF
(E+H)
$
$ (12,600.00)
$ (12,600.00)
$ (12,600.00)
$ (12,600.00)
$ (12,600.00)

(J)
AdjustedATCF

PV

$
$ (12,600.00)
$ (12,600.00)
$ (12,600.00)
$ (12,600.00)
$ (52,600.00)

$
$(11,886.79)
$(11,213.95)
$(10,579.20)
$ (9,980.38)
$(39,305.78)

NPV

$(82,966.11)

NPV(BUY&OWN)
BuyDon'tSell
END
OF
YEAR
0
1
2
3
4
5

(A)
Buying
$(100,000.00)
$
$
$
$
$

(B)
(C)
AnnualLease Estimated
Payment
Savings
$
$
$
$
$

$4,000.00
$4,000.00
$4,000.00
$4,000.00
$4,000.00

(D)
Maintenance
Cost
$
$(2,000.00)
$(2,000.00)
$(2,000.00)
$(2,000.00)
$(2,000.00)

(E)
BTCF
(A+B+C+D)
$(100,000.00)
$2,000.00
$2,000.00
$2,000.00
$2,000.00
$2,000.00

(F)
Depreciation
$33,333.33
$44,444.44
$14,814.81
$ 7,407.41
$

(G)
TaxableIncome
(EF)
$
$(31,333.33)
$(42,444.44)
$(12,814.81)
$(5,407.41)
$2,000.00

(H)
IncomeTax
(G*40%)
$
$ 12,533.33
$ 16,977.78
$ 5,125.93
$ 2,162.96
$ (800.00)

(I)
ATCF
(E+H)
$(100,000.00)
$14,533.33
$18,977.78
$7,125.93
$4,162.96
$1,200.00

(J)
AdjustedATCF

PV

$(100,000.00)
$14,533.33
$18,977.78
$7,125.93
$4,162.96
$1,200.00

$(100,000.00)
$ 13,710.69
$ 16,890.15
$5,983.07
$3,297.46
$ 896.71

NPV

$(59,221.92)

NAL

$(23,744.19)

Thefollowingtablesseparateallthecostsandbenefitsassociatedwithleasingforeachscenario.Costsareshowninred,benefits
areshowningreen,andthesumofallcostsandbenefits(blue)indicatesthenetadvantagetoleasing.

ENDOF
YEAR
0
1
2
3
4
5

(A)
Buying
$
$
$
$
$
$

2.NetAdvantagetoLeasing(NOTOWNINGASSET)
NAL=NPV(COSTS)+NPV(BENEFITS)
CostofLeasing:LeasePayments(Lease:NoPurchase,Buy:SellatSalvageValue)
(B)
(C)
(D)
(F)
(G)
(E)
AnnualLease Maintenance
BTCF
TaxableIncome IncomeTax
Depreciation
Payment
Cost
(A+B+C)
(DE)
(F*40%)
$
$
$
$
$
$(25,000.00) $
$ (25,000.00) $
$(25,000.00) $ 10,000.00
$(25,000.00) $
$ (25,000.00) $
$(25,000.00) $ 10,000.00
$(25,000.00) $
$ (25,000.00) $
$(25,000.00) $ 10,000.00
$(25,000.00) $
$ (25,000.00) $
$(25,000.00) $ 10,000.00
$(25,000.00) $
$ (25,000.00) $
$(25,000.00) $ 10,000.00

(H)
ATCF
(D+G)
$
$(15,000.00)
$(15,000.00)
$(15,000.00)
$(15,000.00)
$(15,000.00)

NPV

ENDOF
YEAR
0
1
2
3
4
5

(A)
Buying
$
$
$
$
$
$

CostofLeasing:LossofTaxShieldCashFlows(Lease:NoPurchase,SellatSalvageValue)
(C)
(D)
(B)
(F)
(G)
(E)
BTCF
AnnualLease Maintenance
TaxableIncome IncomeTax
Depreciation
Payment
Cost
(A+B+C)
(DE)
(F*40%)
$
$
$
$
$
$
$
$
$
$(33,333.33) $ 33,333.33 $(13,333.33)
$
$
$
$(44,444.44) $ 44,444.44 $(17,777.78)
$
$
$
$(14,814.81) $ 14,814.81 $ (5,925.93)
$
$
$
$(7,407.41) $7,407.41 $ (2,962.96)
$
$
$
$
$
$

0
1
2
3
4
5

(H)
ATCF
(D+G)
$
$(13,333.33)
$(17,777.78)
$(5,925.93)
$(2,962.96)
$

CostofLeasing:LossofAsset'sResidualValueifSold(Lease:NoPurchase,SellatSalvageValue)
(G)
(H)
(B)
(C)
(D)
(F)
(E)
ATCF
AnnualLease Maintenance
BTCF
TaxableIncome IncomeTax
Depreciation
(DE)
(F*40%)
(D+G)
Payment
Cost
(A+B+C)
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$(30,000.00) $
$
$ (30,000.00) $
$(30,000.00) $ 12,000.00 $(18,000.00)

NPV

NPV

IRR
NAL
NALisnegative,thereforethereisanetadvantagetobuyinginthiscase.

$
$(12,578.62)
$(15,822.16)
$(4,975.52)
$(2,346.94)
$

PV
$
$
$
$
$
$(13,450.65)

$(13,450.65)

BenefitofLeasing:CashFlowofInitialInvestment(Lease:NoPurchase,SellatSalvageValue)
(B)
(C)
(D)
(F)
(G)
(H)
ENDOF
(A)
(E)
AnnualLease Maintenance
BTCF
TaxableIncome IncomeTax
ATCF
YEAR
Buying
Depreciation
Payment
Cost
(A+B+C)
(DE)
(F*40%)
(D+G)
0
$100,000.00 $
$
$ 100,000.00 $
$
$
$100,000.00
1
$
$
$2,000.00 $2,000.00 $
$2,000.00 $(800.00) $1,200.00
2
$
$
$2,000.00 $2,000.00 $
$2,000.00 $(800.00) $1,200.00
3
$
$
$2,000.00 $2,000.00 $
$2,000.00 $(800.00) $1,200.00
4
$
$
$2,000.00 $2,000.00 $
$2,000.00 $(800.00) $1,200.00
5
$
$
$2,000.00 $2,000.00 $
$2,000.00 $(800.00) $1,200.00

NALTotalCashFlows(Lease:NoPurchase,SellatSalvageValue)
(C)
(D)
(F)
(G)
(E)
Maintenance
BTCF
TaxableIncome IncomeTax
Depreciation
Cost
(A+B+C)
(DE)
(F*40%)
$
$ 100,000.00 $
$
$
$2,000.00 $ (23,000.00) $(33,333.33) $ 10,333.33 $ (4,133.33)
$2,000.00 $ (23,000.00) $(44,444.44) $ 21,444.44 $ (8,577.78)
$2,000.00 $ (23,000.00) $(14,814.81) $ (8,185.19) $3,274.07
$2,000.00 $ (23,000.00) $(7,407.41) $(15,592.59) $6,237.04
$2,000.00 $ (53,000.00) $
$(53,000.00) $ 21,200.00

PV

$(35,723.24)

(A)
Buying

(B)
ENDOF
(A)
AnnualLease
YEAR
Buying
Payment
0
$100,000.00 $
1
$
$(25,000.00)
2
$
$(25,000.00)
3
$
$(25,000.00)
4
$
$(25,000.00)
5
$(30,000.00) $(25,000.00)

$
$(14,150.94)
$(13,349.95)
$(12,594.29)
$(11,881.41)
$(11,208.87)

$(63,185.46)

NPV

ENDOF
YEAR

PV

PV
$100,000.00
$1,132.08
$1,068.00
$1,007.54
$950.51
$896.71

$105,054.84

(H)
ATCF
(D+G)
$100,000.00
$(27,133.33)
$(31,577.78)
$(19,725.93)
$(16,762.96)
$(31,800.00)

PV
$100,000.00
$(25,597.49)
$(28,104.11)
$(16,562.27)
$(13,277.84)
$(23,762.81)

8.703%
$(7,304.51)

ENDOF
YEAR
0
1
2
3
4
5

(A)
Buying
$
$
$
$
$
$

(B)
AnnualLease
Payment
$
$(25,000.00)
$(25,000.00)
$(25,000.00)
$(25,000.00)
$(25,000.00)

2.NetAdvantagetoLeasing(OWNINGASSET)
NAL=NPV(COSTS)+NPV(BENEFITS)
CostofLeasing:LeasePayments(Lease:Purchase,Buy:KeepInsteadofSell)
(D)
(F)
(G)
(C)
(E)
BTCF
TaxableIncome
IncomeTax
MaintenanceCost
Depreciation
(A+B+C)
(DE)
(F*40%)
$
$
$
$
$
$
$ (25,000.00) $
$ (25,000.00) $ 10,000.00
$ (25,000.00) $ 10,000.00
$
$ (25,000.00) $
$
$ (25,000.00) $
$ (25,000.00) $ 10,000.00
$
$ (25,000.00) $
$ (25,000.00) $ 10,000.00
$
$ (25,000.00) $
$ (25,000.00) $ 10,000.00

(H)
ATCF
(D+G)
$
$(15,000.00)
$(15,000.00)
$(15,000.00)
$(15,000.00)
$(15,000.00)

NPV

ENDOF
YEAR
0
1
2
3
4
5

(A)
Buying
$
$
$
$
$
$

CostofLeasing:LossofTaxShieldCashFlows(Lease:Purchase,Buy:KeepInsteadofSell)
(F)
(G)
(D)
(B)
(E)
(C)
TaxableIncome
IncomeTax
BTCF
AnnualLease
Depreciation
MaintenanceCost
(DE)
(F*40%)
(A+B+C)
Payment
$
$
$
$
$
$
$
$(33,333.33) $33,333.33 $(13,333.33)
$
$
$
$(44,444.44) $44,444.44 $(17,777.78)
$
$
$
$(14,814.81) $14,814.81 $(5,925.93)
$
$
$
$(7,407.41) $ 7,407.41 $(2,962.96)
$
$
$
$
$
$

0
1
2
3
4
5

CostofLeasing:AddedCosttoOwnAsset(Lease:Purchase,Buy:KeepInsteadofSell)
(F)
(D)
(B)
(G)
(E)
(C)
TaxableIncome
BTCF
AnnualLease
IncomeTax
Depreciation
MaintenanceCost
(DE)
(A+B+C)
Payment
(F*40%)
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$(40,000.00) $
$
$ (40,000.00) $
$
$
(A)
Buying

(H)
ATCF
(D+G)
$
$(13,333.33)
$(17,777.78)
$(5,925.93)
$(2,962.96)
$

0
1
2
3
4
5

BenefitofLeasing:CashFlowofInitialInvestment(Lease:Purchase,Buy:KeepInsteadofSell)
(B)
(D)
(F)
(G)
(C)
(E)
AnnualLease
BTCF
TaxableIncome
IncomeTax
MaintenanceCost
Depreciation
Payment
(A+B+C)
(DE)
(F*40%)
$100,000.00 $
$
$ 100,000.00 $
$
$
$ 2,000.00 $ (800.00)
$
$
$2,000.00 $2,000.00 $
$
$
$2,000.00 $2,000.00 $
$ 2,000.00 $ (800.00)
$
$
$2,000.00 $2,000.00 $
$ 2,000.00 $ (800.00)
$
$
$2,000.00 $2,000.00 $
$ 2,000.00 $ (800.00)
$
$
$2,000.00 $2,000.00 $
$ 2,000.00 $ (800.00)
(A)
Buying

(H)
ATCF
(D+G)
$
$
$
$
$
$(40,000.00)

NALTotalCashFlows(Lease:Purchase,Buy:KeepInsteadofSell)
(D)
(F)
(C)
(E)
BTCF
TaxableIncome
MaintenanceCost
Depreciation
(A+B+C)
(DE)
$
$ 100,000.00 $
$
$2,000.00 $ (23,000.00) $(33,333.33) $10,333.33
$2,000.00 $ (23,000.00) $(44,444.44) $21,444.44
$2,000.00 $ (23,000.00) $(14,814.81) $(8,185.19)
$2,000.00 $ (23,000.00) $(7,407.41) $ (15,592.59)
$2,000.00 $ (63,000.00) $
$ (23,000.00)

(G)
IncomeTax
(F*40%)
$
$(4,133.33)
$(8,577.78)
$ 3,274.07
$ 6,237.04
$ 9,200.00

IRR
NAL
NALisnegative,thereforethereisanetadvantagetobuyinginthiscase.

$
$(12,578.62)
$(15,822.16)
$ (4,975.52)
$ (2,346.94)
$

PV
$
$
$
$
$
$(29,890.33)

$(29,890.33)

(H)
ATCF
(D+G)
$100,000.00
$1,200.00
$1,200.00
$1,200.00
$1,200.00
$1,200.00

NPV

(B)
ENDOF
(A)
AnnualLease
YEAR
Buying
Payment
0
$100,000.00 $
1
$
$(25,000.00)
2
$
$(25,000.00)
3
$
$(25,000.00)
4
$
$(25,000.00)
5
$(40,000.00) $(25,000.00)

PV

$(35,723.24)

NPV

ENDOF
YEAR

$
$(14,150.94)
$(13,349.95)
$(12,594.29)
$(11,881.41)
$(11,208.87)

$(63,185.46)

NPV

ENDOF
YEAR

PV

PV
$100,000.00
$1,132.08
$1,068.00
$1,007.54
$ 950.51
$ 896.71

$105,054.84

(H)
ATCF
(D+G)
$100,000.00
$(27,133.33)
$(31,577.78)
$(19,725.93)
$(16,762.96)
$(53,800.00)

PV
$100,000.00
$(25,597.49)
$(28,104.11)
$(16,562.27)
$(13,277.84)
$(40,202.49)

13.721%
$(23,744.19)

Question3:
Whatdoyouthinktypicallyhappenstoleasedequipmentafterthetermoftheleaseexpires?
Thelesseemaypurchasetheequipmentforthepricestatedintheleasecontractorreturntheequipmentwithnofurtherobligation.The
decisiononwhetherornottokeeptheequipmentwoulddependonthetypeoftheequipment,itscurrentcondition,anditsfairmarketvalue.

Question4:
Afterdoingallthecalculations,Paulorealizesthatheunderestimatedthecostsavingsthatwouldresultfromimprovedefficiencyby$1,000
peryear.Howshouldthiserrorbehandled?Isitrelevant?Explain.
Thisdoesntaffectleaseversusbuydecisionsbecausethesavingsareincurredeitherway.HoweveritdoesaffecttheNPVofeachproject.

END
OF
YEAR
0
1
2
3
4
5

(A)
Buying
$
$
$
$
$
$

(B)
AnnualLease
Payment
$
$(25,000.00)
$(25,000.00)
$(25,000.00)
$(25,000.00)
$(25,000.00)

(C)
Estimated
Savings
$5,000.00
$5,000.00
$5,000.00
$5,000.00
$5,000.00

4.UnderestimateofSavingsCost(NOTOWNINGASSET)
NPV(LEASE&DON'TOWN)
LeaseDon'tPurchase
(D)
(E)
(G)
(F)
Maintenance
BTCF
TaxableIncome
Depreciation
Cost
(A+B+C+D)
(EF)
$
$
$
$
$
$ (20,000.00) $
$ (20,000.00)
$
$ (20,000.00) $
$ (20,000.00)
$
$ (20,000.00) $
$ (20,000.00)
$
$ (20,000.00) $
$ (20,000.00)
$
$ (20,000.00) $
$ (20,000.00)

(H)
IncomeTax
(G*40%)
$
$ 8,000.00
$ 8,000.00
$ 8,000.00
$ 8,000.00
$ 8,000.00

(I)
ATCF
(E+H)
$
$ (12,000.00)
$ (12,000.00)
$ (12,000.00)
$ (12,000.00)
$ (12,000.00)

(J)
AdjustedATCF

PV

$
$ (12,000.00)
$ (12,000.00)
$ (12,000.00)
$ (12,000.00)
$ (12,000.00)

$
$ (11,320.76)
$ (10,679.96)
$ (10,075.43)
$(9,505.12)
$(8,967.10)

NPV

END
OF
YEAR
0
1
2
3
4
5

(A)
Buying
$(100,000.00)
$
$
$
$
$30,000.00

(B)
(C)
AnnualLease Estimated
Payment
Savings

(D)
Maintenance
Cost

$
$
$
$
$

$(2,000.00)
$(2,000.00)
$(2,000.00)
$(2,000.00)
$(2,000.00)

$5,000.00
$5,000.00
$5,000.00
$5,000.00
$5,000.00

NPV(BUY&DON'TOWN)
BuyWithSellingatSalvageValue
(E)
(G)
(F)
BTCF
TaxableIncome
Depreciation
(A+B+C+D)
(EF)
$(100,000.00)
$3,000.00 $ 33,333.33 $ (30,333.33)
$3,000.00 $ 44,444.44 $ (41,444.44)
$3,000.00 $ 14,814.81 $ (11,814.81)
$3,000.00 $ 7,407.41 $(4,407.41)
$33,000.00 $
$33,000.00

(H)
IncomeTax
(G*40%)
$ 12,133.33
$ 16,577.78
$ 4,725.93
$ 1,762.96
$(13,200.00)

$ (50,548.37)

(I)
ATCF
(E+H)
$(100,000.00)
$15,133.33
$19,577.78
$7,725.93
$4,762.96
$19,800.00

(J)
AdjustedATCF

PV

$(100,000.00)
$15,133.33
$19,577.78
$7,725.93
$4,762.96
$19,800.00

$(100,000.00)
$14,276.73
$17,424.15
$6,486.84
$3,772.71
$14,795.71

NPV

$ (43,243.86)

NAL

$(7,304.51)

END
OF
YEAR
0
1
2
3
4
5
5

(A)
Buying
$
$
$
$
$
$
$(40,000.00)

(B)
AnnualLease
Payment
$
$(25,000.00)
$(25,000.00)
$(25,000.00)
$(25,000.00)
$(25,000.00)

(C)
Estimated
Savings
$5,000.00
$5,000.00
$5,000.00
$5,000.00
$5,000.00

4.UnderestimateofSavingsCost(OWNINGASSET)
NPV(LEASE&OWN)
LeaseWithPurchase
(G)
(E)
(D)
(F)
TaxableIncome
BTCF
Maintenance
Depreciation
(EF)
(A+B+C+D)
Cost
$
$
$
$
$
$ (20,000.00) $
$(20,000.00)
$
$ (20,000.00) $
$(20,000.00)
$
$ (20,000.00) $
$(20,000.00)
$
$ (20,000.00) $
$(20,000.00)
$
$ (20,000.00) $
$(20,000.00)

(H)
IncomeTax
(G*40%)
$
$ 8,000.00
$ 8,000.00
$ 8,000.00
$ 8,000.00
$ 8,000.00

(I)
ATCF
(E+H)
$
$ (12,000.00)
$ (12,000.00)
$ (12,000.00)
$ (12,000.00)
$ (12,000.00)

(J)
AdjustedATCF

PV

$
$ (12,000.00)
$ (12,000.00)
$ (12,000.00)
$ (12,000.00)
$ (52,000.00)

$
$(11,320.76)
$(10,679.96)
$(10,075.43)
$ (9,505.12)
$(38,857.43)

NPV

$(80,438.69)

NPV(BUY&OWN)
BuyDon'tSell
END
OF
YEAR
0
1
2
3
4
5

(A)
Buying
$(100,000.00)
$
$
$
$
$

(C)
(B)
AnnualLease Estimated
Savings
Payment
$
$
$
$
$

$5,000.00
$5,000.00
$5,000.00
$5,000.00
$5,000.00

(D)
Maintenance
Cost
$
$(2,000.00)
$(2,000.00)
$(2,000.00)
$(2,000.00)
$(2,000.00)

(E)
BTCF
(A+B+C+D)
$(100,000.00)
$3,000.00
$3,000.00
$3,000.00
$3,000.00
$3,000.00

(F)
Depreciation
$ 33,333.33
$ 44,444.44
$ 14,814.81
$ 7,407.41
$

(G)
TaxableIncome
(EF)
$
$(30,333.33)
$(41,444.44)
$(11,814.81)
$ (4,407.41)
$3,000.00

(H)
IncomeTax
(G*40%)
$
$ 12,133.33
$ 16,577.78
$ 4,725.93
$ 1,762.96
$(1,200.00)

(I)
ATCF
(E+H)
$(100,000.00)
$15,133.33
$19,577.78
$7,725.93
$4,762.96
$1,800.00

(J)
AdjustedATCF

PV

$(100,000.00)
$15,133.33
$19,577.78
$7,725.93
$4,762.96
$1,800.00

$(100,000.00)
$ 14,276.73
$ 17,424.15
$6,486.84
$3,772.71
$1,345.06

NPV

$(56,694.50)

NAL

$(23,744.19)

Anestimatedsavingsof$5,000leadsustothesameNALof($7,304.27)forleasingandthesameNALof($23,744.19)forbuying.Thisindicates
thatestimatedsavingsisnotafactorinourleasevs.buydecision.However,asyoucanseefromthecashflowstheestimatedsavingsdoes
haveaneffectonourNPVandtheincreaseinestimatedsavingsdecreasesthecostoftheproject.

Question5:
Howshoulddepreciationandtaxesbeaccountedforinthecalculations?
LeaseOption:
Iftheequipmentisleased,depreciationshouldnotbeincludedbecausethelesseeisnottheactualowneroftheequipment.Thetaxbenefit
foreachleasepaymentiscalculatedbymultiplyingtheleasepaymentbyPaulosrestaurants40%taxrate.Tocalculatethepresentvalueof
eachcashflow,thediscountrateof6%isusedbecauseitistheaftertaxcostofborrowing.Thereasonforusingtheaftertaxcostofborrowing
istoavoidcountingthetaxbenefittwice.

BorrowandPurchaseOption:
Thedepreciationexpense,alongwiththeinterestandmaintenanceexpenses,shouldbeincludedinyourcalculationsbecauseitistax
deductible.DepreciationfortaxpurposesisbasedontheModifiedAcceleratedCostRecoverySystem(MACRS)andiscalculatedforeach
paymentbymultiplyingtheexpensebythetaxrateof40%,whichyieldsthetaxbenefitperpayment.

Question6:
Iftheequipmentweretobeleased,wouldtheleasepaymentsbetaxdeductible?Explain.

WhethertheleasepaymentswouldbetaxdeductibleornotwoulddependonhowtheInternalRevenueServicecategorizesthe
leasebasedupontheeffectsofleasingtheequipmentonPaulosrestaurantaccountingstatements.

TheIRSconsidersdifferentaspectsoftheleaseindecidingwhetherleasepaymentsaretaxdeductiblesuchasthefollowing:
Istheequipmentsubjecttodepreciation?
Wasaleasecontractsignedwithin90daysaftertheassetwasplacedinservice?
Aretheleasepaymentsontheequipmentspreadoutoverthelifeoftheassetoraretheyacceleratedoveramuchshorter
period?
Canthelesseecontinuetousetheequipmentafterthelifeoftheleaseatpreferentialratesornominalamounts?
Isthelesseegivetheoptiontopurchasetheassetonexpirationdateforanamountatleast10%ormoreoftheoriginalcost
oftheequipment?

ThemainconcernoftheIRSistomakesuretheleasecontractisnotdesignedtoavoidtaxes.Ifleasepaymentsaremadeovera
periodmuchshorterthantheequipmentslife,thelesseeisallowedeithertocontinueleasingtheassetatanominalamount,orthe
lesseeisallowedtobuytheassetatabelowmarketprice,theIRSmayviewtheleaseasaloanandprohibitthelesseefrom
deductingtheleasepaymentsintheyear(s)inwhichtheyaremade.Otherwise,ifGenerallyAcceptedAccountingPrinciples(GAAP)
wereusedinaccountingfortheassetandtheleasemeetsthecriteriaunderFASB,allpaymentsmaybedeductedfromrevenuesas
annualexpenses.

Question7:
IfAAALeasingCompanystaxrateis40%,whatistheminimumleasepaymentthatitwouldbewillingtoaccept?Explain.

(B)
ENDOF
(A)
AnnualLease
YEAR
Buying
Payment
0
$(100,000.00) $
1
$
$20,109.89
2
$
$20,109.89
3
$
$20,109.89
4
$
$20,109.89
5
$30,000.00 $20,109.89

7.MinimumPaymentAAALeasingCompanyiswillingtoaccept
(C)
(D)
(F)
(G)
(E)
Maintenance
BTCF
TaxableIncome
IncomeTax
Depreciation
Cost
(A+B+C)
(DE)
(F*40%)
$
$(100,000.00) $
$
$
$
$20,109.89 $33,333.33 $ (13,223.44) $5,289.38
$
$20,109.89 $44,444.44 $ (24,334.55) $9,733.82
$
$20,109.89 $14,814.81 $ 5,295.08 $ (2,118.03)
$
$20,109.89 $ 7,407.41 $12,702.49 $ (5,080.99)
$
$50,109.89 $
$50,109.89 $(20,043.96)

(H)
ATCF
(D+G)
$(100,000.00)
$25,399.27
$29,843.71
$17,991.86
$15,028.90
$30,065.94

IRR
NPV
MinimumleasepaymentAAALeasingiswillingtoacceptiswhereNPV=0.Thisoccursat$20,109.89

PV
$(100,000.00)
$23,961.58
$26,560.80
$15,106.31
$11,904.30
$22,467.02

6.000%
$

Fortheleasingcompanyspointofviewthecashflowswouldbereversedsincetheleasingcompanyispayingfortheassetupfront
andreceivingannualleasepaymentsfromPaulo.Sincetheassethasasalvagevalueof$30,000attheendofyear5itisincludedin
theleasingcompanyscalculationofminimumleasepayment(despitetheassetbeingfullydepreciatedbytheleasingcompany).
The$40,000optiontobuywasnotusedbecauseitisnotcertainwhetherthelessorwouldpurchasetheassetattheendofthe
lease.Anannualleasepaymentof$20,109.89istheminimumtheleasingcompanywillaccept.Thisisthebreakevenvaluewhich
causestheNPVofleasingtobe0.

Question8:
WhatisthemaximumleasepaymentthatPaulowouldbewillingtopay?Explain.

(B)
ENDOF
(A)
AnnualLease
YEAR
Buying
Payment
0
$100,000.00 $
1
$
$(22,109.89)
2
$
$(22,109.89)
3
$
$(22,109.89)
4
$
$(22,109.89)
5
$(30,000.00) $(22,109.89)

8.MaximumPaymentPauloiswillingtopayAAALeasingCo.
(D)
(F)
(C)
(E)
BTCF
TaxableIncome
MaintenanceCost
Depreciation
(A+B+C)
(DE)
$
$ 100,000.00 $
$ 100,000.00
$2,000.00 $ (20,109.89) $(33,333.33) $13,223.44
$2,000.00 $ (20,109.89) $(44,444.44) $24,334.55
$2,000.00 $ (20,109.89) $(14,814.81) $ (5,295.08)
$2,000.00 $ (20,109.89) $(7,407.41) $ (12,702.49)
$2,000.00 $ (50,109.89) $
$ (50,109.89)

(G)
IncomeTax
(F*40%)
$
$(5,289.38)
$(9,733.82)
$ 2,118.03
$ 5,080.99
$ 20,043.96

(H)
ATCF
(D+G)
$ 100,000.00
$ (25,399.27)
$ (29,843.71)
$ (17,991.86)
$ (15,028.90)
$ (30,065.94)

IRR
NAL
MaximumleasepaymentPauloiswillingtopayAAALeasingiswhereNAL=0.Thisoccursat$22,109.89

PV
$ 100,000.00
$ (23,961.58)
$ (26,560.80)
$ (15,106.31)
$ (11,904.30)
$ (22,467.02)

6.000%
$

ThemaximumleasepaymentthatPauloiswillingtoacceptwillbethepointwherePaulosNALis0.AtthispointPaulowillbe
indifferenttowardsbuyingorleasingandthecashflowsofbuyingandleasingcometothesamePV.Themaximumleasepayment
Pauloiswillingtopayis$22,109.89.

Thefollowingtableseparatesallthecostsandbenefitsassociatedwithleasing.Costsareshowninred,benefitsareshowningreen,
andthesumofallcostsandbenefits(blue)indicatesthenetadvantagetoleasing.

ENDOF
YEAR
0
1
2
3
4
5

(A)
Buying
$
$
$
$
$
$

NOTOWNINGASSET
NAL=NPV(COSTS)+NPV(BENEFITS)
CostofLeasing:LeasePayments(Lease:NoPurchase,Buy:SellatSalvageValue)
(B)
(D)
(F)
(G)
(C)
(E)
AnnualLease
BTCF
TaxableIncome IncomeTax
MaintenanceCost
Depreciation
Payment
(A+B+C)
(DE)
(F*40%)
$
$
$
$
$
$
$(22,109.89) $
$ (22,109.89) $
$ (22,109.89) $ 8,843.96
$ (22,109.89) $ 8,843.96
$(22,109.89) $
$ (22,109.89) $
$(22,109.89) $
$ (22,109.89) $
$ (22,109.89) $ 8,843.96
$(22,109.89) $
$ (22,109.89) $
$ (22,109.89) $ 8,843.96
$(22,109.89) $
$ (22,109.89) $
$ (22,109.89) $ 8,843.96

(H)
ATCF
(D+G)
$
$(13,265.94)
$(13,265.94)
$(13,265.94)
$(13,265.94)
$(13,265.94)

NPV

ENDOF
YEAR
0
1
2
3
4
5

(A)
Buying
$
$
$
$
$
$

CostofLeasing:LossofTaxShieldCashFlows(Lease:NoPurchase,SellatSalvageValue)
(B)
(D)
(F)
(G)
(C)
(E)
AnnualLease
BTCF
TaxableIncome IncomeTax
MaintenanceCost
Depreciation
Payment
(A+B+C)
(DE)
(F*40%)
$
$
$
$
$
$
$
$
$
$(33,333.33) $33,333.33 $(13,333.33)
$
$
$
$(44,444.44) $44,444.44 $(17,777.78)
$
$
$
$(14,814.81) $14,814.81 $(5,925.93)
$
$
$
$(7,407.41) $7,407.41 $(2,962.96)
$
$
$
$
$
$

(H)
ATCF
(D+G)
$
$(13,333.33)
$(17,777.78)
$(5,925.93)
$(2,962.96)
$

NPV

0
1
2
3
4
5

BenefitofLeasing:CashFlowofInitialInvestment(Lease:NoPurchase,SellatSalvageValue)
(B)
(D)
(F)
(G)
(C)
(E)
AnnualLease
BTCF
TaxableIncome IncomeTax
MaintenanceCost
Depreciation
Payment
(A+B+C)
(DE)
(F*40%)
$100,000.00 $
$
$ 100,000.00 $
$ 100,000.00 $
$
$
$2,000.00 $2,000.00 $
$2,000.00 $ (800.00)
$
$
$2,000.00 $2,000.00 $
$2,000.00 $ (800.00)
$
$
$2,000.00 $2,000.00 $
$2,000.00 $ (800.00)
$
$
$2,000.00 $2,000.00 $
$2,000.00 $ (800.00)
$
$
$2,000.00 $2,000.00 $
$2,000.00 $ (800.00)

0
1
2
3
4
5

(B)
AnnualLease
Payment
$100,000.00 $
$
$(22,109.89)
$
$(22,109.89)
$
$(22,109.89)
$
$(22,109.89)
$(30,000.00) $(22,109.89)
(A)
Buying

8.MaximumPaymentPauloiswillingtopayAAALeasingCo.
(D)
(F)
(C)
(E)
BTCF
TaxableIncome
MaintenanceCost
Depreciation
(A+B+C)
(DE)
$
$ 100,000.00 $
$ 100,000.00
$2,000.00 $ (20,109.89) $(33,333.33) $13,223.44
$2,000.00 $ (20,109.89) $(44,444.44) $24,334.55
$2,000.00 $ (20,109.89) $(14,814.81) $ (5,295.08)
$2,000.00 $ (20,109.89) $(7,407.41) $ (12,702.49)
$2,000.00 $ (50,109.89) $
$ (50,109.89)

(G)
IncomeTax
(F*40%)
$
$(5,289.38)
$(9,733.82)
$ 2,118.03
$ 5,080.99
$ 20,043.96

$
$(12,578.62)
$(15,822.16)
$(4,975.52)
$(2,346.94)
$

PV
$
$
$
$
$
$(13,450.65)

$(13,450.65)

(H)
ATCF
(D+G)
$100,000.00
$1,200.00
$1,200.00
$1,200.00
$1,200.00
$1,200.00

NPV

ENDOF
YEAR

PV

$(35,723.24)

CostofLeasing:LossofAsset'sResidualValuewhenSold(Lease:NoPurchase,SellatSalvageValue)
(G)
(B)
(H)
(D)
(F)
ENDOF
(A)
(C)
(E)
AnnualLease
ATCF
BTCF
TaxableIncome IncomeTax
YEAR
Buying
MaintenanceCost
Depreciation
(DE)
(F*40%)
Payment
(D+G)
(A+B+C)
0
$
$
$
$
$
$
$
$
1
$
$
$
$
$
$
$
$
2
$
$
$
$
$
$
$
$
3
$
$
$
$
$
$
$
$
$
$
$
$
$
$
4
$
$
5
$(30,000.00) $
$
$ (30,000.00) $
$ (30,000.00) $ 12,000.00 $(18,000.00)

(A)
Buying

$
$(12,515.03)
$(11,806.63)
$(11,138.34)
$(10,507.86)
$(9,913.08)

$(55,880.95)

NPV

ENDOF
YEAR

PV

PV
$100,000.00
$1,132.08
$1,068.00
$1,007.54
$ 950.51
$ 896.71

$105,054.84

(H)
ATCF
(D+G)
$100,000.00
$(25,399.27)
$(29,843.71)
$(17,991.86)
$(15,028.90)
$(30,065.94)

IRR
NAL
MaximumleasepaymentPauloiswillingtopayAAALeasingiswhereNAL=0.Thisoccursat$22,109.89

PV
$100,000.00
$(23,961.58)
$(26,560.80)
$(15,106.31)
$(11,904.30)
$(22,467.02)

6.000%
$

Question9:
Howmuchofanimpactdoestheforecastofthesalvagevalueofthenewmachinehaveontheleaseversusbuydecision?
9.ImpactofSalvageValueonDecision(NOTOWNINGASSET)
NAL=NPV(COSTS)+NPV(BENEFITS)
CostofLeasing:LossofAsset'sResidualValueifSold(Lease:NoPurchase,SellatSalvageValue)
(H)
(C)
(D)
(F)
(G)
(B)
ENDOF
(A)
(E)
ATCF
AnnualLease Maintenance
BTCF
TaxableIncome IncomeTax
Depreciation
YEAR
Buying
(F*40%)
(D+G)
Payment
Cost
(A+B+C)
(DE)
0
$
$
$
$
$
$
$
$
1
$
$
$
$
$
$
$
$
2
$
$
$
$
$
$
$
$
3
$
$
$
$
$
$
$
$
4
$
$
$
$
$
$
$
$
5
$(13,708.20) $
$
$ (13,708.20) $
$(13,708.20) $5,483.28 $(8,224.92)

NPV

ENDOF
YEAR
0
1
2
3
4
5

(B)
AnnualLease
Payment
$100,000.00 $
$
$(25,000.00)
$
$(25,000.00)
$
$(25,000.00)
$
$(25,000.00)
$(13,708.20) $(25,000.00)
(A)
Buying

NALTotalCashFlows(Lease:NoPurchase,SellatSalvageValue)
(C)
(D)
(F)
(G)
(E)
Maintenance
BTCF
TaxableIncome IncomeTax
Depreciation
(F*40%)
Cost
(A+B+C)
(DE)
$
$ 100,000.00 $
$
$
$2,000.00 $ (23,000.00) $(33,333.33) $10,333.33 $ (4,133.33)
$2,000.00 $ (23,000.00) $(44,444.44) $21,444.44 $ (8,577.78)
$2,000.00 $ (23,000.00) $(14,814.81) $(8,185.19) $3,274.07
$2,000.00 $ (23,000.00) $(7,407.41) $(15,592.59) $6,237.04
$2,000.00 $ (36,708.20) $
$(36,708.20) $ 14,683.28

PV
$
$
$
$
$
$(6,146.14)

$(6,146.14)

(H)
ATCF
(D+G)
$ 100,000.00
$ (27,133.33)
$ (31,577.78)
$ (19,725.93)
$ (16,762.96)
$ (22,024.92)

PV
$ 100,000.00
$ (25,597.49)
$ (28,104.11)
$ (16,562.27)
$ (13,277.84)
$ (16,458.30)

IRR
6.000%
NAL
$
MaximumsalvagevaluewhichmakesleasingfavorableiswhereNAL=0.Thisoccursat$13,708.20

Amaximumsalvagevalueof$13,708.20wouldswingtheleasevs.buydecisiontowardsthelease.Thelowerthesalvagevaluefrom
thispointthemoreappealingleasingwouldlook.Thisisduetothefactthatsalvagevalueisacostofleasingandalowersalvage
valuewouldreducethisleasingcost,makingleasingmoreattractive.

Question10:
IfPauloleasestheequipment,whatimpactwouldithaveonthefirmsdebtcapacity?

IfPauloleasestheequipmentunderanoperatinglease,theFinancialAccountingStandardsBoard(FASB)decidedthatitdoesnot
havetobeincludedonthebalancesheet.Offbalancesheetfinancingwillgenerallyhavenoeffectonhisdebtcapacity.

However,ifitisacapitalorfinanciallease,thepresentvalueoftheleasemustbereportedasbothanassetandaliabilityonthe
companysbalancesheet.FASBrecognizesafinancialleaseasbeingsimilartoborrowingfundsinordertopurchasetheasset.The
equipmentwouldgoontheassetsideofthebalancesheetandtheleaseappearsontheliabilityside.Acapitalorfinanciallease
mayincreasePaulosfinancialleverage.

Currently,Paulo'scompanyisanallequityfirm.TheonlywayPaulo'scompanycangetclosertotheiroptimalamountofdebtisif
theystarttakingindebt.Soiftheygotaloanfromabank,theywouldgetclosertotheiroptimalamountofdebt.However,ifthey
leasedinstead,theirdebtcapacityremainsthesamebecausetheyarenotincurringanydebt.

Question11:
Doesthesizeofthebusinessplayanyroleinleaseversusbuydecisionsofthistype?

Smallbusinessesareverytiedtocashflow.Therefore,leasingversusbuyinghasasignificantimpactifthecompanyisasmall
company.Forexample,ifPauloboughttheequipmentfor100,000andtheequipmentturnedouttobehorribleornotfunctionthe
wayPaulohadanticipated,hemaynothavethecapabilitytofindanother100,000topurchaseanewsetofequipment.However,a
largerbusinesswhocouldaffordtopurchasetheequipmentwouldbeabletotakeonthatriskandalsowouldhavethebenefitof
writingoffthedepreciationquickerthantheannualleasepayment.

Question12:
Doesthetypeofassetunderconsiderationhavemucheffectontheleaseversusbuydecision?

Thetypeofassethasaverysignificantimpactonthedecisionbetweenleasingandbuying.Forexampleiftheassetwasalaptop
andyouneedtoobtainnewlaptopsevery3years,itmaybebesttosimplygeta3yearleasethantobuythelaptop.However,in
ourscenario,restaurantequipmentisanassetthathasahighpotentialofbeingusedlongerthanitsdepreciatinglifeandtherefore,
tendstoleantowardsbuyingtheassetthanleasing.

Question13:
Arethereanyotherfactorsthatneedtobeconsideredinaleaseversusborrowandbuydecisionofthetype?Explain.

Apartfromsizeofbusiness,andtypeofasset,youalsohavetoconsiderthetimeframe.Inthisscenario,ourNALwasbasedoffofa
5years.However,whatifyouconsideredaleasethatwas3years?Ormaybelongerthan5years,like10?(eventhoughgenerally
leasesaren'tlongerthan5years).Theremaybecaseswheredependingonthetiming,thattheNALwhereitmayoriginallyhave
favoredleasingcouldchangeandfavorbuyingorviceversa.

Question14:
Allthingsconsidered,shouldPauloleaseorborrowandbuytheequipment?Explain.

Pauloshouldbuytheequipment.OurcalculationforNALclearlyshowsthatbuyingisbetterthanleasing.Inadditiontothe
calculationforNAL,currentlyPaulo'srestaurantisanallequityfirmandobtainingaloananddevelopingdebtwillputhimastep
closertohisoptimaldebtcapacity.Evenifthesalvagevaluewashalf,buyingwouldstillbemoreattractiveandevenifthelease
paymentswere4,000lessayear,buyingwouldstillbemoreattractive.