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Analyzing Lease Vs. Buy Decisions

Summarize different capital budgeting concepts by answering the following questions:

1) What risks and uncertainties should be considered while making a lease vs. buy decision? How do these risks and uncertainties impact capital budgeting?

2) What is the advantage of computing the present value of outflows in making lease vs. buy decisions?

3) In what circumstances is a capital lease a better alternative to an operating lease? Under what circumstances is a capital lease a better alternative than buying an asset?

4) How do qualitative factors like the condition of an asset impact a final lease or buy decision?

Solution Preview

1) Leases are contractual arrangements by which the owner of property (the "lessor") allows another person (the "lessee") to use the property for a stated period of time in exchange for cash payments or other compensation. In business, the two main types of equipment leases you would typically encounter are:

1. True leases - If the lessee acquires no rights to the property other than its use, then the lease is commonly referred to as a "true" (or "straight") lease. Under a true lease, the lessor is treated as the owner of the leased property for both tax and non-tax purposes, and the lessee's rental payments do not establish any equity in the property. A true lease usually gives the lessee the option to prematurely end the lease, subject to conditions that are spelled out in the agreement. Some refer to these types of leases as "operating" leases, as they are often more short term in nature and cancel-able.

2. Financial leases - A lease that is used to effectively finance the purchase of assets is commonly referred to as a "financial" lease. The distinguishing characteristics of financial leases are that (1) the duration of the lease generally coincides with the functional or economic life of the property, (2) the lease may not be canceled, and (3) the lessee is often responsible for maintaining the property. Some refer to these types of leases as "capital" leases.

The organization's expected need for the leased equipment will determine whether it uses a true lease or a financial lease. If there is a need for the equipment for most, if not all, of its useful life, then a financial lease may be more appropriate. In contrast, if the expectation is that the equipment is only needed for a specified period, and that the equipment will be of use to someone else at the end of that period, then perhaps a true lease arrangement is more appropriate.

Capital Investment Planning and Control:

At least five phases of capital expenditure planning and control can be identified:

- Identification (or origination) of investment opportunities.
- Development of forecasts of benefits and costs.
- Evaluation of the net benefits.
- Authorization for progressing and spending capital expenditure.
- Control of capital projects.

In practice, however, companies, although tending to shift to the formal methods of evaluation, give considerable importance to qualitative factors. Some companies also consider intuition, security and social considerations as important qualitative factors. Companies also ...

Solution Summary

In about 1,684 words, this solution discusses leases, different types of leases, capital investment planning and control, the capital budgeting process, the advantage of using the present value method, situations in which capital leases are better, etc. References are included.