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Ownership may be effected through outright purchase without indebtedness, through financed purchase, or, for all practical purposes, through a long-term lease. In an outright purchase, the buyer has full rights of ownership. Where the buyer obtains financing (before or after the purchase), his ownership is diminished by the limitations on his control of the asset. For example, in an installment purchase, the buyer’s right to sell may be restricted by the lender’s lien. In a long-term lease, the lessee lacks not only the right to sell but also all of the asset’s residual rights, except for any purchase options available.

Short-term leasing is an alternative to the above forms of ownership. Here, the lessee is freed of almost all the risks of ownership, including obsolescence and maintenance, but the amount of the rental naturally reflects these advantages. In choosing between some form of ownership (as described above) on the one hand and short-term leasing on the other, management is faced with such operational considerations as maintenance, risk of obsolescence, and the degree of control desired. If ownership is selected, a further decision—this one involving essentially financial considerations—is necessary with regard to the form of ownership. It is with this second, basically more complex, decision that this appendix is concerned. The focus will be specifically on the choice between outright purchase and long-term lease as a form of ownership.

Choosing Outright Purchase vs. Long-Term Lease

The decision to buy or lease can be made only after a systematic evaluation of the relevant factors. The evaluation must be carried out in two stages: First, the advantages and disadvantages of purchase or lease must be considered, and second, the cash flows under both alternatives must be compared.

Leasing advantages and disadvantages shows the principal advantages and disadvantages of leasing from both the lessor’s and lessee’s standpoint. This listing is only a guide. For both parties, the relative significance of the advantages and disadvantages depends on many factors. Major determinants are a company’s size, financial position, and tax status. For example, to a heavily leveraged public company, the disadvantage of having to record additional debt may be considerable, even critical; the disadvantage may be insignificant to a privately held concern.

Lessee Advantages

• One hundred percent financing of the cost of the property (the lease is based on the full cost) on terms that may be individually tailored to the lessee.
• Possible avoidance of existing loan indenture restrictions on new debt financing. Free of these restrictions, the lessee may be able to increase his base, as lease obligations are generally not reflected on the balance sheet, although the lease obligation will probably require footnote disclosure in the financial statements. (It should be noted, however, that a number of the more recent loan indentures restrict lease commitments.)
• General allowability of rental deductions for the term of the lease, without problems or disputes about the property’s depreciable life.
• Possibly higher net book income during the earlier years of the basic lease term than under outright ownership. Rental payments in the lease’s earlier years are generally lower than the combined interest expense and depreciation (even on the straight-line method) that a corporate property owner would otherwise have charged in the income statement.
• Potential reduction in state and city franchise and income taxes. The property factor, which is generally one of the three factors in the allocation formula, is reduced.
• Full deductibility of rent payment. This is true notwithstanding the fact that the rent is partially based on the cost of the land.

Lessee Disadvantages

• Loss of residual rights to the property upon the lease’s termination. When the lessee has full residual rights, the transaction cannot be a true lease; instead, it is a form of financing. In a true lease, the lessee may have the right to purchase or renew, but the exercise of these options requires payments to the lessor after the full cost of the property has been amortized.
• Rentals greater than comparable debt service. Since the lessor generally borrows funds with which to buy the asset to be leased, the rent is based on the lessor’s debt service plus a profit factor. This amount may exceed the debt service that the lessee would have had to pay had he purchased the property.
• Loss of operating and financing flexibility. If an asset were owned outright and a new, improved model became available, the owner could sell or exchange the old model for the new one. This may not be possible under a lease. Moreover, if interest rates decreased, the lessee would have to continue paying at the old rate, whereas the owner of the asset could refinance his debt at a lower rate.
• Loss of tax benefits from accelerated depreciation and high interest reductions in early years. These benefits would produce a temporary cash saving if the property were purchased instead of leased.

Lessor Advantages

• Higher rate of return than on investment in straight debt. To compensate for risk and lack of marketability, the lessor can charge the lessee a higher effective rate—particularly after considering the lessor’s tax benefits—than the lessor could obtain by lending the cost of the property at the market rate.
• The lessor has the leased asset as security. Should the lessee have financial trouble, the lessor can reclaim a specific asset instead of having to take his place with the general creditors.
• Retention of the property’s residual value upon the lease’s termination. The asset’s cost is amortized over the basic lease term. If, upon the lease’s expiration, the lessee abandons the property, the lessor can sell it. If the lessee renews or purchases, the proceeds to the lessor represent substantially all profit.

Lessor Disadvantages

• Dependence upon lessee’s ability to maintain payments on a timely basis.
• Vulnerability to unpredictable changes in the tax law that (1) reduce tax benefits and related cash flow or (2) significantly extend depreciable life. The latter measure would lessen the projected return upon which the lessor based his investment.
• Probable negative after-tax cash flow in later years. As the lease progresses, an increasing percentage of the rent goes toward nondeductible amortization of the principal. Both the interest and depreciation deductions (under the accelerated method) decline as the lease progresses.
• Potentially large tax on disposition of asset imposed by the Internal Revenue Code’s depreciation recapture provisions.

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.

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.

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. Buying vs. leasing— a comparison of cash flows is a comparison of cash flows developed under both buying and leasing.

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:

1. A two-year increase in depreciable life reduces the benefit of outright purchase to (x-y) dollars.
2. 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.

Considering Taxes

There are two ways in which a lease can be treated for tax purposes: as a true lease or as a form of financing. If the lease is viewed as a true lease, the lessee is entitled to a deduction, in the appropriate period, for his annual rental expenses. (Normally, the appropriate period is the period in which the liability for rent is incurred, in accordance with the terms of the lease, granted that the timing of the liability is not unreasonable.) If the lease is viewed as a form of financing, the lessee is deemed the property’s equitable owner and is thus permitted to deduct the depreciation and interest expense.

The test the IRS applies to determine whether a lease is a true lease or a form of financing is basically an evaluation of the purchase options. If the lessee can purchase the property for less than the fair market value or for an amount approximately equal to what the debt balance would have been had the asset been bought outright, the transaction is viewed as a financing agreement. If the lessee has a purchase option in an amount substantially exceeding the probable fair market value or the debt balance, the transaction would probably be recognized as a lease.

Protecting the Business Relationship

A final aspect of the lease-buy decision relates to the lessor-lessee relationship. If the lessor encounters financial difficulties, under certain circumstances the prospective lessee can be adversely affected. That is, depending upon the terms of the lease and the lessor’s financing arrangements, a lender might look to the property to satisfy a default by the lessor. Although careful wording of the agreement can afford a measure of protection, it is essential that the lessee look into the prospective lessor’s financial condition, business reputation, and client relationships. If the findings are favorable, negotiations may be carried out with a minimum of delay and expense. If the findings are unfavorable, the prospective lessee might still wish to proceed, relying on the protective clauses in the agreement, or he might abandon the lease (at least with that party) entirely.