Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

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Using the above data, we can perform a

lease-versus-purchase analysis for the car. To

simplify, we ignore sales tax differences and explicit

consideration of the time value of money, and we

assume that under the purchase alternative the car

will be sold at the end of four years (48 months).

Lease cost

Down payment $2,000

Total lease payments

(48 months × $375 per month)

18,000

Opportunity cost of down payment

(0.05 × $2,000 3 4 years)

400

Total cost of lease $20,400

Purchase cost

Down payment $3,000

Lease cost

Total loan payments

(48 months × $525 per month)

25,200

Opportunity cost of down payment

(0.05 ×$3,000 × 4 years)

600

Estimated trade-in value of car at end

of 48 months

–10,750

Total cost of purchase $18,050

Comparing the total lease and total purchase

costs, we see that the purchase cost of $18,050 is

well below the lease cost of $20,400. Therefore,

you should purchase the car; as a result, you will

save about $2,350 ($20,400 lease cost – $18,050

purchase cost) over the four years.

It is worth noting that if the lessee and lessor have the same discount rate and same tax rates, then

leasing strictly for financial reasons is a zero-sum game between lessee and lessor. Cash outflows for

the lessee represent inflows for the lessor, and vice-versa. Only when the two parties have different tax

rates or costs of capital can leasing increase aggregate value purely for financial reasons. Therefore, the

lower cost of leasing or buying results from factors such as the differing tax brackets of the lessor and

the lessee, different tax treatments for leases versus purchases and differing risks and borrowing costs

for the lessor and the lessee. Moreover, when making a lease-versus-purchase decision, the company will

find that inexpensive borrowing opportunities and high required lessor returns increase the attractiveness

of purchasing. Likewise, leasing decisions are affected by many non-financial factors, such as the risk

of obsolescence and the experience and expertise of the lessor. Subjective factors like these must be

included in the decision-making process. Like most financial decisions, the lease-versus-purchase

decision requires a certain degree of judgement and consideration of qualitative factors.

14 - 4e EFFECTS OF LEASING ON FUTURE FINANCING

Because leasing is considered a type of debt financing, it affects a company’s future financing ability.

Lease payments are shown as a tax-deductible expense on the company’s income statement. Anyone

analysing the income statement would probably recognise that assets are being leased, although the

actual details of the amounts and terms of the leases might be unclear.

Leasing and Financial Ratios

Because the consequences of missing a finance lease payment are the same as those for missing an

interest or principal payment on debt, a financial analyst must view the lease as a long-term financial

commitment of the lessee, analogous to debt. Under standard accounting rules, the inclusion of each

financial (capital) lease as an asset and corresponding liability (long-term debt) provides for a balance

sheet that more accurately reflects the company’s financial status. It thereby permits various types