Lease or Buy. Your company wants to purchase a new network file server
for its wide-area computer network.  The server costs $75,000.  It
will be completely obsolete in three years.  Your options are to
borrow the money at 10 percent or to lease the machine.  If you lease,
the payments will be $27,000 per year, payable at the end of each of
the next three years.  If you buy the server, you can depreciate it
straight-line to zero over three years.  The tax is 34 percent. 
Should you lease or buy?

Blacklace --

This is a pretty straightforward capital costing issue, though I want
to point out some problems with its simplicity at the end.  Our job is
to find out if the firm's present value of cash flows is high with
lease vs. purchase.

You're probably familiar with PV calculations but here's a brief synopsis:
Expectations Investing
"How Do We Calculate Present Value?" (Sept. 10, 2001)
http://www.expectationsinvesting.com/tutorial1.shtml

If we buy -- today -- we're borrowing the money, so there's no cash
out until year end.  Luckily that matches the assumptions for the
lease.  But at the end of 3 years you'll have a whopping $82,500 to
pay back because of interest + the original capital.

Cash flows in the following spreadsheet are red if the money is going
out and black if the money is coming back in.  Red is bad -- and
larger red numbers are worse:
http://www.mooneyevents.com/server.xls

So, you can see that buying the network server is the worse option.

Now let's talk about some problems with these assumptions in the real world:
?	corporate costs of capital rarely match the rate at which the
company borrows, whether from the bank or in the bond market.  The
costs of capital are virtually always HIGHER due to firm and business
risk.
?	we've put tax assumptions at year-end.  Companies pay taxes
quarterly.  And too, the interest has been put at year-end here too --
and normally it would be paid monthly or quarterly (in the U.S. bonds
are paid quarterly; in Europe and Japan twice a year).
?	If you ever find a lease that ISN'T pre-paid, please let me know!!
?	current U.S. depreciation laws allow accelerated depreciation, which
would dramatically reduce the cost of buying.
?	An end value of the server of as little as $15,000 makes the
purchase decision the preferred choice.  A good finance guy would go
back to IT and say: "Can't we sell this thing (or use it) as a lowly
print server after 3 years?"

If any part of this answer is unclear, please request a clarification
before rating this answer.

Best regards,


Omnivorous-GA

Buy.

Leasing is a scam and most folks who've tried it say 'Never again'.

Hmmm
Leasing : total outlay is $27,000 x 3 = $71,000

Borrowing and repaying over 3 years in the same pattern as the lease:
  $25,000 + 7,500 + 25,000 + 5,000 + 25,000 + 2,500 = $90,000

Quite a hefty difference. $19,000
I can't quite see how depreciation and the tax rate comes into matters
as the lease payments will be made from pre-tax income, as will the
interest payments.
Hmm ... one would land up with a tax credit of just over $25,000

Of course the tax credit is only really useful if one wants to retain
'profits' within the company - or one gives a toss about the
shareholders.

Hi Blacklace,

Lease.

Why buy a depreciating asset? The written down value to zero over 3
years tells you something. You then have 2 options. Sell the unit to
recoup the interest cost if you can find a buyer, or keep running the
machine until it can no longer keep up with demand. That's the plus
side, because you effectively have no costs after the end of the third
year. Worth a punt perhaps, but you did say that it will be obsolete.

But .. your lease payments are only $81,000 over 3 years. Just $6,000
above the cash purchase price. Your costs are reduced compared to
borrowed money and you will have the option of taking up another lease
at the end of the term. That's when you upgrade your server to the
latest model.

Also, I presume that your borrowing costs will have to be met monthly.
If your lease payments are due annually as you say in arrears, all the
better. This gives you better cashflow usage, and your annual payments
are paid with "old money".

Would you agree that computers depreciate faster than cars? Why do
companies lease cars?

Buy land, bricks and appreciating or multiplying assets .. lease the rest.

Unless you believe your company will not exist beyond 2007 .. LEASE.

I can't comment on your tax implications. Thank you for the interesting topic.

Phil

Frde,

Your figures are incorrect. Perhaps you could extrapolate on the tax implications.

Phil

Silver777

You are quite correct
I screwed up materially twice - 27k x 3 = 81k

The second screw up was more interesting, I assumed loan repayment
over three years, rather than borrowing $75k for three years.
Obviously I was wrong, but anybody who bought a three year medium term
note ... would not be offering conventional finance.

However this does remind me of a real life situation back in 1977 when
I worked as an intern in a large UK company - in the finance
department. Since my Father was a director and the Chairman reckoned I
was Ok, they had to find 'make work' for me.

The simple solution was re-evaluating past projects, which had been
calculated on a spreadsheet - which at that time was an A2 bit of
paper.
Fortunately I discovered a teletype terminal and some APL manuals.

The crux of the matter is that some bright spark had decided that
interest costs were 12% and taxation 15% - hence all projects had to
DCF at 27%+ to meet financing requirements.

I could smell something wrong, but it was months later when I was back
in academia that I realized that taxation was a one off annual charge,
and that the internal rate of return should have been 12%.

Personally I have always thought that it is madness that one should
pay corporation tax on any funds retained within the company. A
growing company needs new machinery and increased stock, so taxing
them on increasing 'assets' is a bit like strangling an infant.
Anyway it is a bit daft trying, companies can always move offshore.