Chapter 7The Leasing Financial Analysis – Getting the Best Equipment Lease Deal

CHAPTER 7

The Leasing Financial Analysis

Overview

One of the most important considerations for your company as a prospective lessee or borrower in deciding whether to enter into an equipment lease or other financing contract is the financial aspect. Accordingly, you must know how to assess the different financing options from a financial viewpoint to make the right economic decision. And, understanding how a lessor makes their financial determinations will give you better negotiation leverage, all of which is explained in the upcoming sections.

The Importance of Cash Flow and Timing for a Prospective Lessee or Borrower

In making a financial assessment of whether to lease or buy equipment with internal or borrowed funds, you must take the varying cash flows, and their timing, into account for each alternative. Stated simply, how much are the cash inflows and outflows, and when do they occur?
The timing of the cash inflows and outflows is critical because of the principle—referred to as the time value of money—that money received earlier is worth more than money received later.

The following example illustrates very simplistically how taking cash flow and its timing into account alters the result of an analysis.

Illustrative example: Cash flow and time value: An equipment user is considering two options: leasing equipment over a seven-
year period with an annual rent of 990 U.S. dollars payable at the beginning of each year and buying the equipment using a seven-year loan with 1,000 U.S. dollars annual payments due at each year’s end. By choosing to lease, the company would pay out 990 U.S. dollars one year earlier than it would have to pay the required 1,000 U.S. dollar loan payment. If the company could earn, say, 6 percent a year after taxes on its available funds, giving up the 990 U.S. dollars in advance would result in a loss of 59.40 U.S. dollars (6% × $990 = $59.40) in the first year. In this case, the advance payment could be said to cost 1,049.40 U.S. dollars ($990 + $59.40 = $1,049.40). Putting other considerations aside, the 1,000 U.S. dollar loan payment would have been less expensive. If the company were able to earn only 1 percent a year after taxes, paying the 990 U.S. dollars would result in only a 9.90 U.S. dollar loss (1% × $990 = $9.90). That is, the effective cost of paying the 990 U.S. dollars would have been 999.90 U.S. dollars, instead of 1,049.40 U.S. dollars. In the latter case, the 1,000 U.S. dollar loan payment could be said to be more expensive.

A Lessee Financial Analysis

Once your company has decided it needs certain equipment, you must determine how to finance its acquisition. The following discussion will address the three possible alternatives for an equipment user:

  • The user leases the equipment (the leasing alternative)
  • The user draws on their general funds to buy the equipment (the purchase alternative)
  • The user takes out a specific loan to buy the equipment (the financing alternative)

This section will compare those three financial alternatives by using a common method for taking cash flows and their timing into account, sometimes referred to as the discounted cash flow—or present value—analysis method. The first step will be to compute the periodic costs and tax savings for each alternative. The next step will be to factor in the timing of those cash flows so that there is a basis for comparison by calculating the present value of each alternative’s cash flows. To compute the present value of a series of future cash flows, an interest rate—referred to as the discount rate—must be selected to discount the flows back to their present worth. The result will be the present value cost of the alternatives. Because getting to these results involves many computations, the following analysis will center around one hypothetical equipment acquisition situation.

Note: The financial analysis computations from which the examples in this chapter were developed were done on SuperTRUMP, a widely used and top lease analysis computer software program, developed and offered by Ivory Consulting Corporation (www.ivorycc.com). The information from the computer analysis results was at times summarized by the author to aid in the explanation of the concepts described in the text material.

A Typical Equipment User’s Financial Alternatives

White Industries wants to acquire a new high-end computer system and can use all available tax benefits. White Industries is considering three financing alternatives—the lease alternative, the purchase alternative, and the financing alternative. Additional facts include (assumed for ease of illustration without regard to whether any applicable tax or other rules will be satisfied are as follows) the following:

General Data

Computer system cost

One million U.S. dollars

Depreciable period

Five years

Residual value

0 U.S. dollars

Investment tax credit

0 percent

Accounting basis:

Accrual

White Industries combined income tax rate
(Federal, state, and local)

35 percent

White Industries tax year

Calendar year

Delivery date

January 1, 2019

Depreciation method

MACRS (half-year, DB/SL 200 percent)


Proposed Financial Lease

Lease term

Seven years

Rental payments

200,000 U.S. dollars, payable in seven annual payments in arrears.

Lease simple interest rate

9.1961 percent

Commencement date

January 1, 2019


Proposed Bank Loan

Loan amount

One million U.S. dollars, repayable in seven equal annual payments of 205,405.50 U.S. dollars in arrears

Loan term

Seven years

Long-term interest rate

10.0 percent

Commencement date

January 1, 2019

The Cost of the Leasing Alternative

The first step is to compute the after-tax cost of the various alternatives. Table 7.1 sets out those costs for the leasing alternative.


Table 7.1

Year ending

Rental payments

Tax savings from rent deductions

After-tax cost

Cumulative after-tax
cost

December 30, 2019

$ 0

$70,000

$(70,000)

$(70,000)

December 30, 2020

200,000

70,000

130,000

60,000

December 30, 2021

200,000

70,000

130,000

190,000

December 30, 2022

200,000

70,000

130,000

320,000

December 30, 2023

200,000

70,000

130,000

450,000

December 30, 2024

200,000

70,000

130,000

580,000

December 30, 2025

200,000

70,000

130,000

710,000

December 30, 2026

200,000

0

200,000

910,000

Total

$1,400,000

$490,000

$910,000

N/A


Table 7.1 is computed as follows:

  • Rental payments are the annual payments the lessee must make. These begin in 2020 because the rent is payable annually in arrears.
  • Tax savings from rent deductions represents the income tax savings White Industries would realize from the rent deductions, computed at White Industries’ assumed combined 35 percent income tax bracket (federal, state, and local).
  • After-tax cost is derived by subtracting the tax savings from the rent deductions from the rental payments.
  • Cumulative after-tax cost represents the transaction’s total after-tax cost as of each year end.

The result is a total after-tax cost of 910,000 U.S. dollars if White Industries leases the computer system.

The Cost of the Purchase Alternative

The next step is to compute the after-tax cost of an outright purchase using internal funds. Annual depreciation expense indicated in Table 7.2 is the amount White Industries would be entitled to deduct under MACRS depreciation as the computer owner over a five-year period. The other columns are computed as in the leasing example (Table 7.1):

Table 7.2

Year
ending

equity

Annual Depreciation tax expense

Tax savings

After-tax cost

Cumulative After-tax cost

December 30, 2019

$1,000,000

$200,000

$ 70,000

$930,000

$930,000

December 30, 2020

0

320,000

112,000

(112,000)

818,000

December 30, 2021

0

192,000

67,200

(67,200)

750,800

December 30, 2022

0

115,200

40,320

(40,320)

710,480

December 30, 2023

0

115,200

40,320

(40,320)

670,160

December 30, 2024

0

57,600

20,160

(20,160)

650,000

Total

$1,000,000

$1,000,000

$350,000

$650,000

n/a

Comparing Cash Flows

Thus, at this point in the analysis, the purchase alternative seems substantially less expensive than the lease alternatives as its total after-tax cost is only 650,000 U.S. dollars compared with 910,000 U.S. dollars for leasing. However, this ignores the leasing cash flow advantage because, as shown in Table 7.3, the total cost of the lease is less until the seventh year.


Table 7.3 Cash flow comparison

Year

Lease
cumulative
after-tax cost

Purchase cumulative
after-tax cost

Lease cash advantage

2019

$(70,000)

$930,000

$1,000,000

2020

60,000

818,000

758,000

2021

190,000

750,000

560,000

2022

320,000

710,000

390,000

2023

450,000

670,000

220,000

2024

580,000

650,000

70,000

2025

710,000

650,000

(60,000)

2026

910,000

650,000

(260,000)


Plainly, leasing does conserve money in the early years, and those available funds could be put to use elsewhere. The resulting earnings on those funds would offset the disparity in total cost between the two alternatives. Thus, it cannot be concluded that leasing is more expensive until the present value of the two alternative’s cash flows is compared.

To calculate the present value of the leasing and buying cash flows, White Industries must discount both alternatives’ cash flows to their present worth. Choosing a 10 percent annual discount rate and assuming White Industries pays its estimated taxes on April 15, June 15, September 15, and December 15 of each year, the after-tax cash flows for the leasing and purchase alternatives are as follows, as shown in Table 7.4 below:


Table 7.4 Present value comparison

Lease

Purchase

Year

After-tax cost

Present value

After-tax cost

present value

January 01,
2019

0.00

0.00

1,000,000.00

1,000,000.00

April 15, 2019

(17,500.00)

(17,008.64)

(17,500.00)

(17,008.64)

June 15, 2019

(17,500.00)

(16,729.81)

(17,500.00)

(16,729.81)

September 15, 2019

(17,500.00)

(16,321.77)

(17,500.00)

(16,321.77)

December 15, 2019

(17,500.00)

(15,923.67)

(17,500.00)

(15,923.67)

70,000.00

65,983.89

930,000.00

934,016.11

January 01, 2020

200,000.00

181,179.00

0.00

0.00

April 15, 2020

(17,500.00)

(15,408.09)

(28,000.00)

(24,852.95)

June 15, 2020

(17,500.00)

(15,166.50)

(28,000.00)

(24,245.80)

September 15, 2020

(17,500.00)

(14,785.85)

(28,000.00)

(23,657.37)

December 15, 2020

(17,500.00)

(14,425.22)

(28,000.00)

(23,080.38)

130,000.00

121,404.92

112,000.00

95,639.47

January 01,
2021

200,00.00

164,130.23

0.00

0.00

April 15, 2021

(17,500.00)

(13,958.16)

(16,800.00)

(13,399.83)

June 15, 2021

(17,500.00)

(13,729.34)

(16,800.00)

(13,180.16)

September 15, 2021

(17,500.00)

(13,394.47)

(16,800.00)

(12,858.70)

December 15, 2021

(17,500.00)

(13,067.78)

(16,800.00)

(12,545.07)

130,000.00

109,980.48

67,200.00

51,983.76

January 01,
2022

200,000.00

148,685.24

0.00

0.00

April 15,
2022

(17,500.00)

(12,644.67)

(10,080.00)

(7,283.33)

June 15,
2022

(17,500.00)

(12,437.38)

(10,080.00)

(7,163.93)

September 15, 2022

(17,500.00)

(12,134.03)

(10,080.00)

(8,989.20)

December 15, 2022

(17,500.00)

(11,838.08)

(10,080.00)

(8,818.737)

130,000.00

99,631.08

40,320.00

28,255.19

January 01,
2023

200,000.00

134,693.66

0.00

0.00

April 15,
2023

(17,500.00)

(11,454.78)

(10,080.00)

(6,597.95)

June 15,
2023

(17,500.00)

(11,267.00)

(10,080.00)

(6,459.79)

September 15, 2023

(17,500.00)

(10,992.19)

(10,080.00)

(6,331.50)

December 15, 2023

(17,500.00)

(10,724.09)

(10,080.00)

(6,177.08)

130,000.00

90,255.60

40,320.00

25,598.32

January 01,
2024

200,000.00

122,018.71

0.00

0.00

April 15,
2024

(17,500.00)

(10,376.86)

(5,040.00)

(2,988.54)

June 15,
2024

(17,500.00)

(10,206.75)

(5,040.00)

(2,939.54)

September 15, 2024

(17,500.00)

(9,957.80)

(5,040.00)

(2,867.85)

December 15, 2024

(17,500.00)

(9,714.93)

(5,040.00)

(2,797.90)

130,000.00

81,762.37

20,160.00

11,593.83

January 01,
2025

200,000.00

110,536.50

0.00

0.00

April 15,
2025

(17,500.00)

(9,400.38)

0.00

0.00

June 15,
2025

(17,500.00)

(9,246.27)

0.00

0.00

September 15, 2025

(17,500.00)

(9,020.75)

0.00

0.00

December 15, 2025

(17,500.00)

(8,800.74)

0.00

0.00

130,000.00

74,068.36

0.00

0.00

January 01,
2026

200,000.00

100,134.79

0.00

0.00

200,000.00

100,134.79

0.00

0.00

Total

910,000

611,253.72

650,000.00

720,947.55


The discounted cash flow analysis clearly reverses the outcome. The leasing alternative’s present worth is 611,253.72 U.S. dollars, while the purchase alternative’s is 720,947.55 U.S. dollars. Based on this analysis, leasing the computer system would be less expensive than buying with internal funds.

The Financing Alternative

The next step is to calculate the financing alternative’s cash flow in the same manner. The computation is the same as the purchase alternative (Table 7.2), with the additional factors being the payment of the 10 percent interest and the tax savings on deducting the interest. The after-tax cost calculations are as follows as shown in Table 7.5 below:


Table 7.5

Year ending

Debt payments

Year-end principal balance outstand
ing

10 percent interest on principal

Tax savings (deprecia
tion and interest)

Net
after-
tax cost

December 30, 2019

$ 0.00

$1,000,000.00

$100,000.000

$105,000.00

$(105,000.00)

December 30, 2020

205,405.50

894,594.50

89,459.45

143,310.81

62,094.69

December 30, 2021

205,405.50

778,645.45

77,846.85

94,452.70

110,952.80

December 30, 2022

205,405.50

651,107.80

65,110.78

63,108.77

142,296.73

December 30, 2023

205,405.50

510,813.08

51,081.31

58,198.46

147,207.04

December 30, 2024

205,405.50

356,488.88

35,648.89

32,637.11

172,768.39

December 30, 2025

205,405.50

186,732.27

18,673.23

6,535.63

198,869.87

December 30, 2026

205,405.50

0.00

0.00

0.00

205,405.02

Total

$1,437,838.50

$0.00

$437,838.50

$503,243.47

$934,595.02


The present worth calculation, again using a 10 percent discount rate, results in the following (again assuming estimated all income tax payments are made on April 15, June 15, September 15, and December 15 of each tax year):


Table 7.6 Present value comparison

Lease

Financing

Year

after-tax cost

present value

after-tax cost

Present value

January 01, 2019

0.00

0.00

0.00

0.00

April 15,
2019

(17,500.00)

(17,008.64)

(26,250.00)

(25,512.96)

June 15,
2019

(17,500.00)

(16,729.81)

(26,250.00)

(25,094.71)

September 15, 2019

(17,500.00)

(16,321.77)

(26,250.00)

(24,482.65)

December 15, 2019

(17,500.00)

(15,923.67)

(26,250.00)

(23,885.51)

70,000.00

65,983.89

105,000.00

98,975.83

January 01, 2020

200,000.00

181,179.00

205,405.50

186,076.43

April 15,
2020

(17,500.00)

(15,408.09)

(35,827.70)

(31,544.94)

June 15,
2020

(17,500.00)

(15,166.50)

(35,827.70)

(31,027.81)

September 15, 2020

(17,500.00)

(14,785.85)

(35,827.70)

(30,271.04)

December 15, 2020

(17,500.00)

(14,425.22)

(35,827.70)

(29,532.72)

130,000.00

121,404.92

62,094.69

63,699.91

January 01, 2021

200,00.00

164,130.23

205,405.50

168,566.26

April 15,
2021

(17,500.00)

(13,958.16)

(23,613.17)

(18,834.08)

June 15,
2021

(17,500.00)

(13,729.34)

(23,613.17)

(18,525.33)

September 15, 2021

(17,500.00)

(13,394.47)

(23,613.17)

(18,073.49)

December 15, 2021

(17,500.00)

(13,067.78)

(23,613.17)

(17,632.67)

130,000.00

109,980.48

110,952.80

95,500.68

January 01, 2022

200,000.00

148,685.24

205,405.50

152,703.83

April 15,
2022

(17,500.00)

(12,644.67)

(15,777.19)

(11,399.85)

June 15,
2022

(17,500.00)

(12,437.38)

(15,777.19)

(11,212.97)

September 15, 2022

(17,500.00)

(12,134.03)

(15,777.19)

(10,939.48)

December 15, 2022

(17,500.00)

(11,838.08)

(15,777.19)

(10,672.66)

130,000.00

99,631.08

142,296.73

108,478.87

January 01, 2023

200,000.00

134,693.66

205,405.50

138,334.09

April 15,
2023

(17,500.00)

(11,454.78)

(14,549.61)

(9,523.58)

June 15,
2023

(17,500.00)

(11,267.00)

(14,549.61)

(9,367.45)

September 15, 2023

(17,500.00)

(10,992.19)

(14,549.61)

(9,138.98)

December 15, 2023

(17,500.00)

(10,724.09)

(14,549.61)

(8,916.08)

130,000.00

90,255.60

147,207.04

101,388.00

January 01, 2024

200,000.00

122,018.71

205,405.00

125,316.57

April 15,
2024

(17,500.00)

(10,376.86)

(8,159.28)

(4,838.15)

June 15,
2024

(17,500.00)

(10,206.75)

(8,159.28)

(4,758.84)

September 15, 2024

(17,500.00)

(9,957.80)

(8,159.28)

(4,642.77)

December 15, 2024

(17,500.00)

(9,714.93)

(8,159.28)

(4,529.53)

130,000.00

81,762.37

172,768.39

106,547.27

January 01, 2025

200,000.00

110,536.50

205,405.50

113,524.03

April 15, 2025

(17,500.00)

(9,400.38)

(1,633.91)

(877.68)

June 15, 2025

(17,500.00)

(9,246.27)

(1,633.91)

(863.29)

September 15, 2025

(17,500.00)

(9,020.75)

(1,633.91)

(842.23)

December 15, 2025

(17,500.00)

(8,800.74)

(1,633.91)

(821.69)

130,000.00

74,068.36

198,869.87

110,119.14

January 01, 2026

200,000.00

100,134.79

205,405.50

102,841.18

200,000.00

100,134.79

205,405.50

102,841.18

Total

910,000

611,253.72

934,595.02

589,599.23


Comparing Cash Flows

As Table 7.6 shows, the financial alternative results in a present value cost of (598,599.23 U.S. dollars), the least expensive of the three alternatives. This result is not intended to mean that financing with borrowed funds is always the best alternative because the specific result was based on the assumed facts. Rather, it is intended to show how dramatically the present value cash flow analysis alters the result. The financing alternative, with the highest cumulative cost, results in the lowest present worth cost, and the purchase alternative, with the lowest cumulative cost, results in the highest present worth cost.

Understanding the Lessor’s Lease
Investment Analysis

A lessor, in making their financial analysis, needs to determine what their economic return will be on the leased equipment. The concepts of cash flow and present value also play an important part in the lessor’s analysis.

This section will analyze one type of lease, the non-leveraged lease, where the lessor uses their own funds entirely to buy the equipment.

Non-Leveraged Lease

As explained earlier, in a non-leveraged lease, the lessor supplies all the money necessary to buy the equipment from their own funds. Whether this type of investment will make economic sense depends on how profitable the transaction will be to the lessor. Thus, determining the profit—commonly referred to as the rate of return (usually computed on an after-tax basis)—is a threshold issue in any financial lease investment evaluation.

Traditionally, an after-tax lessor’s rate of return has been defined as the interest rate—sometimes referred to as the discount rate—that will discount a lease’s after-tax cash flows back to a value equal to its initial cash outlay. Or, looking at it another way, it is the rate that, when applied to the original cash investment, will produce the future cash flow amounts generated by the lease.

To explain the investor rate of return analysis approach, we will work through a hypothetical non-leveraged lease example, assuming the following facts:

Equipment Data

Cost

One million U.S. dollars

Depreciable life

Five years

Residual value

0 U.S. dollars

Delivery date

January 1, 2019

Lease commencement date

January 1, 2019

Description

Computer system


Lease Investment Data

Lease term

Seven years

Rental payments

Seven annual payments in arrears, each equal to 200,000 U.S. dollars

ITC

0 percent

Lessor combined income tax rate

(federal, state, and local)

35 percent

Depreciation method

MACRS (half-year, DB/SL 200)


Based on those facts, and the assumption that the lessor is an accrual basis taxpayer, Table 7.7 sets out the lessor’s cash flow and federal income reports.

Table 7.7

Year ending

Rent income

Annual depreciation

Taxable income

Total taxes paid

Equity

Pre-tax cash flow

After-tax cash flow

Dec. 30, 2019

0.00

200,000.00

0.00

0.00

1,000,000.00

(1,000,000.00)

(1,000,000.00)

Dec. 30, 2020

200,000.00

320,000.00

(120,000.00)

(42,000.00)

0.00

200,000.00

242,000.00

Dec. 30, 2021

200,000.00

192,000.00

8,000.00

2,800.00

0.00

200,000.00

197,200.00

Dec. 30, 2022

200,000.00

115,200.00

84,800.00

29,680.00

0.00

200,000.00

170,320.00

Dec. 30, 2023

200,000.00

115,200.00

84,800.00

29,680.00

0.00

200,000.00

170,320.00

Dec. 30, 2024

200,000.00

57,600.00

142,400.00

49,840.00

0.00

200,000.00

150,160.00

Dec. 30, 2025

200,000.00

0.00

200,000.00

70,000.00

0.00

200,000.00

130,000.00

Dec. 30, 2026

200,000.00

0.00

0.00

0.00

0.00

200,000.00

200,000.00

Total

$1,400,000.00

$1,000,000.00

$400,000.00

$140,000.00

$1,000,000.00

$400,000.00

$260,000.00


The columns in Table 7.7 are computed as follows:

  • Annual depreciation represents the amount of the annual MACRS deduction available to the lessor on the computer as a five-year recovery property and applying the half-year convention (all discussed in Chapter 4).
  • Taxable income is the result of subtracting the annual depreciation deduction from the rent income. The lessor is an accrual basis taxpayer, so the rent income is accrued for the year ending December 30, 2019, for income tax purposes, resulting in no taxable income for this year ($200,000 rent income – $200,000 depreciation expense = 0), and there would be no tax accrued rent income for the year ending December 30, 2026.
  • Total taxes paid represents the dollar savings or cost on the income or loss in the Taxable income column based on a 35 percent combined income tax rate (federal, state, and local). Where the figure is negative, the lessor reduces their overall tax liability by that amount.
  • After-tax cash flow results from adjusting Pre-tax cash flow by the amount of the taxes paid or saved. Thus, where the Total taxes paid figure is negative, this amount is added to Pre-tax cash flow; where the Total taxes paid figure is positive, this amount is subtracted from Pre-tax cash flow.

Once the after-tax cash flows have been calculated, the after-tax rate of return—often referred to as the after-tax yield—can be found by finding the interest rate that will discount the after-tax cash flows back to the cost of the computer, one million U.S. dollars. Here, the lessor will receive an after-tax yield equal to 9.1961 percent.

Summary

The key to a proper lessee lease verses purchase analysis, or a lessors’ investment return analysis, is determining the various cash inflows and outflows on a present value basis. Because of the complexity of making these determinations, and the risk of human computation error, it is always advisable to use one of the many computer programs available today for these purposes.