Harvard Summer SchoolFinancial Modeling (SSAM S-409, 31834) – Summer 2006

Instructor: Miranda Lam, Ph.D. CFALease versus Buy

DescriptionLease versus buy is a common financing decision faced by financial managers. There are three major types of leases: sales-and-leaseback arrangements, operating leases and capital leases. The lease examined in this exercise is an operating lease. This type of lease arrangement usually provides both financing and maintenance but is not fully amortized. In other words, the payments required under the lease contract are not sufficient to recover the full cost of the equipment and the contract is written for a period considerably shorter than the expected economic/mechanical life of the equipment. A final feature of operating leases is that they frequently contain a cancellation clause, which gives the lessee the right to cancel the lease before the expiration of the basic agreement usually with a penalty.

Modeling GoalIn this example, we will apply financial functions, the Data Table command and the Goal Seek command in Excel.

InstructionsYour company needs to replace a machine and your responsibility is to decide which is the better financial option: leasing or buying the machine with a loan. The machine has a useful life of 8 years but the lease contract is only 4 years. For tax purposes, the machine falls into the 3-year class life under MACRS. If you purchase the machine, you will finance the entire purchase price with an amortized loan over 4 years. Since the cash flows of the two options differ each year, the easiest way to compare the two is to summarize the cash flows into present values.

(Excel Tip: Start with the workbook you created for MACRS. Save it under a new name.)

Assumptions (Part A)Lease term 4 YearsMachine Cost $90,000 TodayMarginal tax rate 40%Interest on Debt 15%Inflation Rate 5%Estimated resale value at the end of the lease $35,000 (in year 4)Revenue $80,000 In year 1Operating Expenses $40,000 In year 1Maintenance Cost $9,000 In year 1Lease Payment $25,000 Per year

Model StructureCash flows if the machine is purchased with a loan:

For years 1 through 3 Revenue, operating costs, and maintenance costs grow with inflation and occur at the end of

each year Depreciation expense: use your user-defined function ACRS3 EBIT = revenue – all costs - depreciation Interest expense: use EXCEL’s IPMT function EBT = EBIT – interest expense

Taxes = EBT * Marginal tax rate Net Profit = EBT – Taxes Operating Cash Flow (OCF) = EBIT – Taxes + Depreciation Principal payment: use EXCEL’s PPMT function Total Net Cash Flows = OCF - Interest expense – Principal payment

For year 4 Net proceed from machine sale at the end of the project = resale value – tax on capital

gain/loss Tax on capital gain/loss = (Resale value – book value) * marginal tax rate Book value: use your user-defined function.

Total Net Cash Flows = OCF – interest expense – Principal payment + Net proceed from machine sale

Cash flows if the machine is leased: Revenue and operating costs grow with inflation and occur at the end of each year. Lease payments are fixed through out the contract. Regular lease payments are due at the end

of each year plus a one-year non-refundable deposit due when the contract is signed at year 0. EBT = revenue – all costs Taxes = EBT * Marginal tax rate Operating Cash Flow (OCF) = Net Profit = EBT – Taxes

Decision Variables: For simplicity, we will use one discount rate for all cash flows. Since the alternative to

leasing is borrowing, the discount rate (opportunity cost) is the after-tax interest rate. NPV of Buy NPV of Lease “Bottom-line Variable”:

Net Advantage to Leasing (NAL) = NPV of Leasing - NPV of Buy

To obtain more information before we decide on the financing strategy, we will perform sensitivity analysis on two input parameters: lease payments and the estimated resale value at the end of the lease. Use the DATA TABLE command in Excel to perform sensitivity analysis on the Net Advantage to leasing. Vary lease payments from $20,000 to $30,000, in increments of $1,000, and resale values from $0 to $40,000, in increments of $5,000. Challenge: Present your analysis in “words” rather than numbers. Display the word “Lease” if leasing is the better option and display the word “Buy” if buying is the better option.) Break-even or indifference analysis is another important analytical tool in finance. Since we are choosing between two options, it is useful to know what lease payment makes you indifferent between buying and leasing. Use the GOAL SEEK or the SOLVER command to find the break-even lease payment.