Content provided in partnership with

A comprehensive lease/purchase model

Engineering Economist, The, Summer 1994 by Gutman, Eyal, Yagil, Joseph

To explain leasing activity, mostly undertaken by banks and other financial institutions (as pointed out by Myers, Dill and Bautista [13], among others), the literature offers numerous leasing valuation models which demonstrate the net advantage of leasing (NAL) when certain conditions are satisfied. Major contributions to the leasing literature include the following studies: Johnson and Lewellen [9], Gordon [6], Schall [15], Lewellen, Long and McConnell [10], Miller and Upton [12], Myers, Dill and Bautista [13], Franks and Hodges[4], Brealey and Young [2], McConnell and Schallheim [11], Ang and Peterson [1], Hochman and Rabinowich [8], Steele [19], Schallheim and McConnell [17], Smith and Wakeman [18], Heaton [7], Brick, Fung and Subrahmanyam [3], Franks and Hodges [5], and Schallheim, Johnson, Lease and McConnell [16]. These studies have made major contributions to the leasing literature, and existing leasing models collectively encompass a broad range of the various aspects of leasing. However, none of the studies seems to present a comprehensive model which incorporates all of the following aspects of the leasing problem: tax rate and discount rate asymmetry between the lessor and the lessee, intertemporal changes in tax rates, loan repayment schedule, scrap value, leverage and inflation. The purpose of this study therefore is to incorporate all of these aforementioned factors into a general leasing model and derive a comprehensive formal expression in terms of both the direction and magnitude of the net advantage of leasing (NAL) over buying. Our basic model results in a general expression for the NAL which is a function of the tax rate asymmetry, the depreciation method and the loan repayment schedule. The basic attribute of the model is that the NAL is determined by the position of the two parties -- the lessor and the lessee -- in terms of the parameters inherent in the leasing problem. A desirable property of the model is its ability to incorporate other characteristics of the leasing issue such as salvage value, leverage, inflation, different discount rates, and intertemporal changes in tax rates. For each of these characteristics a formal expression for the NAL is derived. A sensitivity analysis of the sign and size of the NAL for different parameter values is also provided.

Most Popular Articles in Business: Research and Markets : Tesco Plc - SWOT Framework Analysis; Do Us a Flavor - Ben & Jerry's Issues a Call for Euphoric New Flavors; eBay made easy: ready to start an eBay business? These 5 simple steps will ...; Katrina's lawsuit surge: a legal battle to force insurers to pay for flood ...; Wal-Mart's newest distribution center opened last month near the southwest ...; More »

The rest of the paper is organized as follows. Section I presents the basic model and derives formal expressions for the NAL which incorporate the effects of discount rates, salvage value, leverage, and inflation. Section II extends the model to intertemporal changes in tax rates, and the last section contains a brief summary and conclusion.

THE MODEL

The lease valuation model presented below constitutes a basic model subsequently extended to incorporate other parameters of the lease-or-buy decision such as leverage, inflation, positive salvage value, discount rates, and intertemporal changes in tax rates.

THE BASIC MODEL

The most common and important asymmetry, in the lease-or-buy context, is the tax-rate asymmetry between the lessee and the lessor. Therefore, the basic model will assume such an asymmetry and will demonstrate that it is a necessary condition for leasing supremacy to exist. Four assumptions underlie the basic model: (1) the salvage value of the asset is zero; (2) the purchase of the asset is fully debt financed; (3) the capital market is perfect in the sense that both the lessor and the lessee face the same interest rate; and (4) there are no tax lags; that is, both parties do not defer tax consequences. The debt-financing assumption may be redundant at this stage, but since it is relaxed later on in the analysis it is added here explicitly for the sake of clarity. The first three assumptions are relaxed later in the analysis. With these assumptions, we first calculate the terms under which the lessor breaks even; i.e., the minimum lease rate he is willing to accept. To break even the following equality must hold

(Equation 1 omitted)

where L sub t is the periodic lease payment, T sub r , is the tax late of the lessor, I sub t , P sub t and D sub t are the periodic interest, principal and depreciation, respectively, and r sub t = 1/(1 + r sub r ), where r sub r , is the appropriate discount rate for the lessor. It should be noted that on the pre-tax vs. post-tax discount rate Myers, Dill and Bautista [13] demonstrate that the two approaches are perfectly equivalent provided an appropriate tax adjustment is made in the cash-flow. Since our analysis employs a pre-tax discount rate, the cash-flow contains the tax shield of the interest.

The LHS of Eq. (1) is the present value (PV) of the after-tax income to the lessor from the lease; i.e., the after tax lease payments plus the interest and depreciation tax shields. The RHS is the payments he must meet, which is the repayment of the loan used to acquire the asset. Noting that, in perfect capital markets, the PV of the loan must be equal to the value of the asset (V); i.e., (equation omitted), Eq. (1) can be rewritten as:

A comprehensive lease/purchase model

Engineering Economist, The, Summer 1994 by Gutman, Eyal, Yagil, Joseph

Find Research Guides for:

Find Featured Titles for: Technology

Most Popular Articles in Business

Most Popular Publications in Business