Outright Purchase vs. Long Term Lease

The decision to buy or lease can be made only after a systematic evaluation of the relevant factors. The evaluation must be carried out in two stages: First, the advantages and disadvantages of purchase or lease must be considered, and second, the cash flows under both alternatives must be compared.

The section below shows the principal advantages and disadvantages of leasing from both the lessor's and lessee's standpoint. This listing is only a guide. For both parties, the relative significance of the advantages and disadvantages depends on many factors. Major determinants are a company's size, financial position, and tax status. For example, to a heavily leveraged public company, the disadvantage of having to record additional debt may be considerable, even critical; the disadvantage may be insignificant to a privately held concern.

Lessee Advantages

• One hundred percent financing of the cost of the property (the lease is based on the full cost) on terms that may be individually tailored to the lessee.

• Possible avoidance of existing loan indenture restrictions on new debt financing. Free of these restrictions, the lessee may be able to increase his base, as lease obligations are generally not reflected on the balance sheet, although the lease obligation will probably require footnote disclosure in the financial statements. (It should be noted, however, that a number of the more recent loan indentures restrict lease commitments.)

• General allowability of rental deductions for the term of the lease, without problems or disputes about the property's depreciable life.

• Possibly higher net book income during the earlier years of the basic lease term than under outright ownership. Rental payments in the lease's earlier years are generally lower than the combined interest expense and depreciation (even on the straight-line method) that a corporate property owner would otherwise have charged in the income statement.

• Potential reduction in state and city franchise and income taxes. The property factor, which is generally one of the three factors in the allocation formula, is reduced.

• Full deductibility of rent payment. This is true notwithstanding the fact that the rent is partially based on the cost of the land.

Lessee Disadvantages

• Loss of residual rights to the property upon the lease's termination. When the lessee has full residual rights, the transaction cannot be a true lease; instead, it is a form of financing. In a true lease, the lessee may have the right to purchase or renew, but the exercise of these options requires payments to the lessor after the full cost of the property has been amortized.

• Rentals greater than comparable debt service. Since the lessor generally borrows funds with which to buy the asset to be leased, the rent is based on the lessor's debt service plus a profit factor. This amount may exceed the debt service that the lessee would have had to pay had he purchased the property.

• Loss of operating and financing flexibility. If an asset were owned outright and a new, improved model became available, the owner could sell or exchange the old model for the new one. This may not be possible under a lease. Moreover, if interest rates decreased, the lessee would have to continue paying at the old rate, whereas the owner of the asset could refinance his debt at a lower rate.

• Loss of tax benefits from accelerated depreciation and high interest reductions in early years. These benefits would produce a temporary cash saving if the property were purchased instead of leased.

Lessor Advantages

• Higher rate of return than on investment in straight debt. To compensate for risk and lack of marketability, the lessor can charge the lessee a higher effective rate—particularly after considering the lessor's tax benefits—than the lessor could obtain by lending the cost of the property at the market rate.

• The lessor has the leased asset as security. Should the lessee have financial trouble, the lessor can reclaim a specific asset instead of having to take his place with the general creditors.

• Retention of the property's residual value upon the lease's termination. The asset's cost is amortized over the basic lease term. If, upon the lease's expiration, the lessee abandons the property, the lessor can sell it. If the lessee renews or purchases, the proceeds to the lessor represent substantially all profit.

Lessor Disadvantages

• Dependence upon lessee's ability to maintain payments on a timely basis.

• Vulnerability to unpredictable changes in the tax law that (1) reduce tax benefits and related cash flow or (2) significantly extend depreciable life. The latter measure would lessen the projected return upon which the lessor based his investment.

• Probable negative after-tax cash flow in later years. As the lease progresses, an increasing percentage of the rent goes toward nondeductible amortization of the principal. Both the interest and depreciation deductions (under the accelerated method) decline as the lease progresses.

• Potentially large tax on disposition of asset imposed by the Internal Revenue Code's depreciation recapture provisions