Chapter 26: Leasing vs Buying: Financial Analysis

The text explores operating leases as short-term, cancelable contracts where the lessor retains the risks of ownership and obsolescence, utilizing the concept of equivalent annual cost to determine break-even rental rates. Conversely, financial leases (also known as capital or full-payout leases) are examined as long-term, non-cancelable obligations that effectively function as a source of financing, comparable to secured borrowing. A significant portion of the chapter is dedicated to the valuation of financial leases, employing the "lease versus borrow" decision framework. This involves calculating the net present value of the lease by discounting the incremental cash flows—specifically the lease payments and the foregone depreciation tax shields—at the firm's after-tax borrowing rate. The concept of the equivalent loan is introduced to demonstrate how a lease obligation mirrors the debt service of a secured loan, proving that a positive net present value implies the lease offers superior financing terms compared to traditional borrowing. The summary also delves into the economic rationale for leasing, highlighting sensible motivations such as the convenience of short-term use, the transfer of maintenance and administrative costs, and the efficient utilization of tax shields. This is particularly relevant when a lessee in a low tax bracket transfers depreciation benefits to a lessor in a high tax bracket in exchange for lower rental payments. The chapter critically addresses dubious reasons for leasing, such as the misconception that it preserves capital better than borrowing. Furthermore, the text analyzes the impact of tax legislation, such as limits on interest deductibility, which can make leasing more attractive for highly levered firms. Finally, the chapter outlines complex lease structures, including sale and lease-back arrangements and leveraged leases, describing how special-purpose entities, equity participants, and lenders utilize nonrecourse debt to finance big-ticket assets like aircraft.