FINANCIAL ASPECTS OF INDUSTRIAL I
I LEASING DECISIONS:
IMPLICATIONS FOR MARKETING

| Dissertation for the Degree of Ph. D.
MICHIGAN STATE UNIVERSITY

I PAUL FRANCIS ANDERSON
3‘ - ” 1976

 

 

   
  

   
 
 

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This is to certify that, the
thesis entitled
FINANCIAL ASPECTS OF INDUSTRIAL LEASING
DECISIONS: IMPLICATIONS
FOR MARKETING

presented by

Paul Francis Anderson
has been ac ted towards fulfillment
of t requirements for

Ph. D. degeeinBusiness Administration

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Date

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ABSTRACT
FINANCIAL ASPECTS OF INDUSTRIAL LEASING

DECISIONS: IMPLICATIONS
FOR MARKETING

by

Paul Francis Anderson

Statement of the problem. Despite the growing importance of

 

leasing in the industrial market, little research has been done on the
subject of lease marketing. This is particularly true with regard to
the financial aspects of full-payout leases. The full-payout lease is
essentially a financial device which has the potential to provide the
lessee with a set of economic benefits. The dissertation focuses upon
the nature of these benefits and the analytical techniques employed by
industrial firms in making lease versus purchase decisions. The
research seeks to identify the lease marketing implications of the

decision procedures employed by industrial organizations.

Methodology. A mail survey was conducted to determine the

 

financial analysis methodologies employed by large industrial firms in
making lease versus purchase decisions. A research instrument
consisting of a lease case problem and a questionnaire was sent to the
200 largest industrial firms in the United States listed by Fortune
magazine.

The respondents were asked to analyze the lease-purchase case

using the methodology they would normally employ for similar leasing

I'll m ’ . WW A 04— ,_-’-“. -. ‘-.

Paul Francis Anderson

decisions. The questionnaire provided supplemental information on the

case analysis and the data necessary to develop a respondent profile.

Results and conclusions. Returns were received from 63 companies,

 

a response rate of 31.5 percent. The 57 corporations which chose to
identify themselves represent a combined l974 sales volume in excess of
$215 billion and have a median sales figure in the neighborhood of $2
billion. The major fiding of the survey is that a majority of the
respondent firms apply analytical techniques which are biased in favor of
the purchase alternative. This bias stems from two factors: (I) a
majority of the methodologies do not properly adjust for the differential
risk element in the decision, and (2) many of the decision procedures
require a justification of the investment on the basis of purchase before
consideration is given to leasing. Failure to adjust for risk differences
in the cash flows tends to overstate the "costs” of leasing in both net
present value and internal rate of return models. Furthermore, the
requirement that an acquisition must first be justified on an ownerShip
basis does not allow for the existence of unusually attractive lease
terms which are sufficient to reverée an original negative purchase
decision.

The results indicate that an important opportunity exists for
lease marketers to educate industrial firms to lease-purchase models
which more accurately reflect the economic advantages of leasing. The
major task of the lessor is to communicate the existence and nature of
these models to the relevant "analyst-influencers" within the customer's
organization. This requires a planned and coordinated promotional

program which places heavy emphasis upon personal selling.

 

Paul Francis Anderson

Given the highly technical nature of the information which must be
communicated, it is recommended that lessors adopt the marketing
financial analyst concept. The marketing financial analyst is a sales
representative trained in the areas of financial analysis, accounting,
and taxes. The analyst operates as a member of a sales team and is
responsible for communicating the financial benefits of leasing to
industrial consumers. Support for the analyst is provided by the
lessor's advertising and sales promotion programs. In turn, the firm's
pricing, product quality, and service elements must ensure that the
firm's leases offer real economic advantages to the lessee. The
research suggests that a fully programmed and coordinated marketing
mix which focuses upon the economics of leasing will allow lessors to

better meet the capital equipment needs of American industry.

FINANCIAL ASPECTS OF INDUSTRIAL LEASING
DECISIONS: IMPLICATIONS
FOR MARKETING

By

Paul Francis Anderson

A DISSERTATION

Submitted to
Michigan State University
in partial fulfillment of the requirements

for the degree of

DOCTOR OF PHILOSOPHY

Department of Marketing and Transportation Administration

l976

 

 

To Robin,

The worth of that is that which it contains,

And that is this, and this with thee remains.

 

ACKNOWLEDGMENTS

At the completion of a dissertation one's personal sense of
accomplishment is greatly exceeded by the gratitude that one feels for
those who made the project possible. I consider myself very fortunate
to have had the assistance and encouragement of many fine individuals,
and I would like to acknowledge their contributions to this research.

I would like to thank Dr. William Lazer for his encouragement,
his guidance, and, most of all, for his dedicated personal interest in
the project. Dr. Lazer is the quintessential committee chairman, and I
consider it a privilege to have worked under his direction.

I am also indebted to another member of the committee, Dr. Reed
Moyer. The original dissertation proposal grew out of an assignment in
Dr. Moyer's marketing research course. His assistance in the design of
the survey and the construction of the questionnaire contributed
significantly to the success of the project.

I was particularly fortunate to have Dr. James Greene as a
member of the committee. His expert assistance on the financial aspects
of the dissertation proved to be invaluable.

Finally, I would like to thank Mr. Sidney Rose and Mr. Thomas
Eck of the American Association of Equipment Lessors for allowing me to
attend their annual seminar at the University of Notre Dame. My research
was significantly enhanced by the information I was able to obtain at

those meetings.

TABLE OF CONTENTS

Chapter

I. THE PROBLEM ........................

The Nature of the Problem ................
Purpose and Scope of the Research . ...........
Limitations .......................

II. THE NATURE OF LEASE MARKETING ...............

The Leasing Industry ..................
Manufacturer lessors .................
Captive leasing or credit companies ..........
Independent leasing companies .............

Financial leasing companies .............
Specialized leasing companies ............
Lease brokers ....................
Bank leasing .....................
Direct lease financing ...............
Indirect lease financing ..............

Leases Defined .......... . . . . .......

Types of Leases .....................
Financial leases ...................

Leveraged leases ..................
Sale and leaseback .................
Operating leases ...................

The Potential Benefits of Leasing ............
Potential economic advantages of leasing .......
Questionable economic advantages of leasing ......

Operating advantages of leasing ..........

Advantages of leasing as perceived by lessees . . . . :
A Model of the Lease versus Purchase Decision Process . . .
Summary and Conclusions .................

III. A SURVEY AND SYNTHESIS OF LEASE VERSUS PURCHASE MODELS

Introduction ........... . . . ........
Net Present Value Models ................
The Eiteman and Davisson model . . . . ...... . . .
The conventional methodology .............
The Cohen model ....................
The Weston and Craig and early Weston and Brigham
models .......................
The Basic Interest Rate (BIR) method .........

 

Chapter

Criticisms of the conventional and BIR models .....
The Bower, Herringer, and Williamson model .......
The Bierman and Smidt model ...............
The Weston and Brigham model (1972) . . .........
The Johnson and Lewellen model .............

Criticisms of the Johnson and Lewellen model .
The Schall model ........ . . . .........
Findlay's Net Present Value model ............
Summary and conclusions: NPV methodologies .......

Lease-purchase as a financing decision ........

Lease—purchase as an investment decision .......

Lease-purchase as a financing and investment decision .

Other net present value approaches ..........

Internal Rate of Return Models ........... . . .
The traditional IRR model ................
The Roenfeldt and Osteryoung model ...........
Summary and conclusions: IRR methodologies .......

IV. SURVEY DESIGN AND METHODOLOGY ................

The Research Objective ..................
Hypotheses ....................... .
The Sample ........................
The Research Instrument .............. . . . .
Methods Used to Increase the Response Rate ........

V. SURVEY RESULTS AND CONCLUSIONS ...............

The Respondent Profile . . . ....... . . ......
Results of the Case Analysis ...............
Implications for Lease Marketing .............
The marketing financial analyst .............
The impact of leasing on the marketing mix of
manufacturers .................. .
Recommendations for Future Research ............

APPENDIX A ........................
APPENDIX B .................
BIBLIOGRAPHY ...........................

 

I50

l52
156
I59
l64

l67
I72

I74
I82
I83

LIST OF TABLES

Amortization Schedule for Vancil's Equivalent Loan ......

Depreciation Schedule for the Johnson and Lewellen Example . .

Term Loan Amortization Schedule for the Johnson and Lewellen

Example ..........................

Amortization Schedule for BHW's Equivalent Loan .......

Net Present Value Advantage of Leasing Generated by Four

Lease Analysis Models ...................
Level of Responding Department Within the Company ......

Distribution of Respondents by Industry Classification . . . .

Classification of Respondents According to Fiscal l974 Sales

Volume ...........................

Number of Respondents Reporting Leasing Activity .......

Distribution of Respondents by Dollar Value of l974 Lease

Payments ..........................

Number of Respondents Reporting Use of Formal Financial
Analysis Method for Evaluation of Leasing Decisions

Respondents' View of the Leasing Decision ..........

Classification of Respondents' Lease versus Purchase

Analysis Model .......................

vi

 

7l
75

76
87

l52
153

153
l54

154

l55
l55

l56

 

1.

LIST OF FIGURES

A Model of the Lease versus Purchase Decision Process

 

45

 

CHAPTER I

THE PROBLEM

The Nature of the Problem

 

More than 30 years ago Russell B. McNeill warned readers of the

Harvard Business Review that ”there is danger . . . that adequate

 

attention may not be given to one marketing device, not customarily
considered, which is particularly useful in the distribution of many

kinds of equipment: the lease or rental agreement. . . ."1

Apparently,
his warning did not go unheeded. In the three decades since the
publication of McNeill's article, leasing has become an important tool
in the marketing of industrial equipment.2 Unfortunately, scholarly
work on the subject of lease marketing has not kept pace with the

growth of leasing in industry. This is particularly true with regard

to the types of rental contracts known as financial leases.3 Previous

work in the area has tended to focus on the qualitative rather than the

quantitative aspects of leasing. In general, marketers have failed to

 

1Russell B. McNeill, “The Lease as a Marketing Tool,” Harvard
Business Review 22 (Summer 1944), p. 415

2Peter Vanderwicken, ”The Powerful Logic of the Leasing Boom,”
Fortune 88 (November 1973), p. 136; and Eugene F. Brigham, "The Impact
of Bank Entry on Market Conditions in the Equipment Leasing Industry,"
National Banking Review 2 (September 1964): 11—16.

3A discussion of the various types of leases will be found in
Chapter II.

 

 

 

appreciate the fact that this type of lease is essentially a financial
1

device whose benefits are primarily economic in nature.

This focus on qualitative factors has led marketers to develop
various lists of the "noneconomic" advantages of leasing.2 McNeill,
for example, concludes that the many qualitative aspects of leasing
"make it difficult, if not impossible, to resolve to simple dollar
comparisons the cost of renting versus purchasing machines."3
Similarly, Babione, in the first doctoral dissertation on the subject
of lease marketing, emphasizes the qualitative over the quantitative
factors in the lessee's decision to lease or purchase.4

Eiteman and Davisson were the first writers to consider both
the financial and marketing aspects of leasing.5 They view fixed
assets as "bundles of services" and recognize that the value of an

asset is a function of the services it provides.6 In their opinion,

a lease is simply a means of paying for these services over an extended

 

1Much of the confusion on this point stems from the fact that,
in general, the marketing literature does not differentiate between
financial and operating leases.

2These will be discussed in Chapter II. 3McNeill, p. 425.

4Francis A. Babione, "Marketing Equipment by Leasing" (Ph.D.
dissertation, Ohio State University, I949), pp. 321-23. It should be
noted that Babione also mentions the income tax advantage which was
available to lessees prior to the enactment of the 1954 tax code. He
believes, however, that this benefit is somewhat "overestimated." See,
Babione, p. 321.

5Wilford John Eiteman and Charles N. Davisson, The Lease as a
Financing and Selling Device (Ann Arbor: School of Business
Administration, University of Michigan, 195l).

6Ibid., p. ll. Eiteman and Davisson note that value is not
dependent upon the transfer of legal title.

period of time. Both economic and noneconomic advantages (services)
are stressed by Eiteman and Davisson. Indeed, they were the first to
develop a technique for the financial analysis of lease versus purchase
decisions. While the model is rather crude by contemporary standards,
it represents an important first step toward the quantification of the
economic aspects of leasing.1 Unfortunately, they fail to recognize
the full marketing implications of their analysis technique. The
presentation of the analysis procedure is oriented toward the lessee
and does not consider its significance for lease marketers. In the
final analysis, the Eiteman and Davisson monograph gives little
practical guidance to firms in their attempts to market the economics
of leasing. They also conclude that factors other than financial
considerations must play a major role in the leasing decision.2

Much of the work on lease marketing published since the
appearance of Eiteman and Davisson's monograph has been largely

descriptive or conceptual in nature.3 Few writers have attempted to

 

1This model is discussed in detail in Chapter 111.

2Eiteman and Davisson, p. 83. This is not to gainsay the
importance of certain "noneconomic” benefits of leasing. It will be
shown, however, that many of these noneconomic advantages reduce to
economic considerations.

3See, for example, Wroe Alderson, Marketing Behavior and
Executive Action (Homewood, IL: Richard D. Irwin, I957), pp. 302—3;
Bruce E. MacNab, "The Lease as a Device to Market Equipment" (M.B.A.
thesis, Ohio State University, 1959); Alvin J. Bytwork, "The
Effectiveness of Alternatives to Purchase in the Marketing of
Construction Equipment through Distributors" (Ph.D. dissertation,
Michigan State University, I961); Francis A. Babione, "The Role of
Rentals in Demand Stimulation,“ Michigan Business Review 16 (May 1964):
17-22; R. A. Perkins, "Leasing as a Marketing Tool:1T in Leasing of
Industrial quipment (Washington: Machinery and Allied Products
Institute, 1965), pp. 40-5l; Ferdinand F. Mauser, "A Universe-in-
Motion Approach to Marketing," in Managerial Marketingi, Perspectives
and Viewpoints, 3rd ed., edited by Eugene J. Kelley and William Lazer

 

 

 

develop a body of normative theory in this area. The only significant
exception is Bennett's 1961 paper on the marketing aspects of capital
equipment leasing.1 Bennett deals briefly with such concerns as lease
pricing, product policy, sales force control, and promotion of the
lease program.2 However, the discussion of these issues neglects the
essential economics of the leasing decision. For example, he notes
that the sales force training program "should include, above all else,
a complete understanding of the user's position in deciding whether to

3 This is, in essence, the crux of a successful lease

rent or buy."
marketing program. An understanding of the lessee's decision process
is crucial to the formulation of effective lease marketing strategies.
Unfortunately, Bennett does not follow through on a detailed analysis
of lessee decision procedures and their implications for lessors.
Indeed, few contemporary writers have been able to appreciate
either the importance of leasing as an industrial marketing tool or
the significance of the financial analysis techniques employed by
lessees. Despite the growth of leasing, the field of marketing

continues to be "transfer-of-title" oriented.4 As an example, the

authors of the two best-known models of industrial buyer behavior fail

 

(Homewood, IL: Richard D. Irwin, 1967), pp. 46—56; Gerald G. Cooney,
The Management and Operation of a Bank Affiliated Leasing Company
(Boston: Financial Publishing Company, l97l), pp. 23-31; and
Leonard L. Berry and Kenneth E. Maricle, "Consumption Without Ownership:
Marketing Op ortunity for Today and Tomorrow," MSU Business Topics 21
(Spring 1973): 33-41.

1Peter D. Bennett, Marketing Aspects of Capital Eggipment
Leasing (Austin, TX: Bureau of Business Research, University of
Texas, 1961).

2

 

 

3

Ibid., pp. 50-53. Ibid., p. 53.

4Berry and Maricle, p. 35.

 

 

to even mention leasing in the presentation of their approaches,1 and

the leading textbook in the field of industrial marketing devotes a
total of three paragraphs to the subject.2 General marketing texts
are similarly superficial in their treatment of leases. The majority
of leading textbooks give only passing mention to the subject, and the
more recent editions of the two best—selling works have deleted all
reference to leasing.3 Contemporary writers have variously character-
ized the lease as a "pricing arrangement,“4 an "acquisition service,”5
a method for conserving capital,6 and a device "to retain control over
price."7 Nowhere is there to be found a clear recognition of the
lease as a financial device which provides the industrial consumer with
1Frederick E. Webster, Jr. and Yoram Wind, Or anizational Bu in
Behavior (Englewood Cliffs, NJ: Prentice-Hall, 1972Tf7ifiiifiiifi§thT_g
Sheth, ”A Model of Industrial Buyer Behavior," Journal of Marketing 37
(October 1973): 50-56.

 

 

2See, Richard M. Hill, Ralph S. Alexander, and James S. Cross,
Industrial Marketing, 4th ed. (Homewood, IL: Richard D. Irwin, 1975),
pp. 231-32. This is particularly significant given the estimate that
by 1977 approximately 30 percent of all new capital equipment
acquisitions will be made by lease. See, Vanderwicken, p. 136.

3E. Jerome McCarthy, Basic Marketing, 5th ed. (Homewood, IL:
Richard D. Irwin, 1975), and Philip Kotler, Marketin Mana ement,
2nd ed. (Englewood Cliffs, NJ: Prentice—Hall, 1972).

4Thomas A. Staudt and Donald A. Taylor, A Managerial Introduc-

tion to Marketin , 2nd ed. (Englewood Cliffs, NJ: Prentice-Hall, 1970),
p. 514.

5William Lazer, Marketing Management (New York: John Wiley
and Sons, 1971), p. 239.

 

6George Fisk, Marketing Systems (New York: Harper and Row,
1967), p. 343; and Kotler, lst ed., p. 32.

7McCarthy, 4th ed., pp. 700—701.

 

 

a set of economic benefits.1 Moreover, there is a lack of appreciation

in the marketing literature for the importance of the lessee's analysis

methodology in the lease-purchase decision process.

Purpose and Scope of the Research

 

It is clear that there are a number of significant areas in
which the lease marketing literature is deficient. A genuine need
exists for marketers to become familiar with the economic aspects of
leasing. It is also imperative for firms engaged in leasing to
determine the nature of the lessee's decision process and to identify
the analytical techniques employed by lessees in making the lease
versus purchase decision. Finally, the marketing implications of the
lessee's decision procedure must be detenmined so that lessors may be
able to improve the efficiency with which they are able to satisfy
their customers' capital equipment needs.

With these considerations in mind, this study will focus on the
following research questions:

1. What are the economic and noneconomic benefits of leasing
from the standpoint of the lessee?

2. What is the nature of the lease versus purchase decision
process of industrial organizations?

3. What models exist in the literature for the financial
analysis of lease versus purchase decisions?

4. Which financial analysis methodologies are employed by
large industrial firms to make lease versus purchase decisions?

 

1The economic benefits listed by Stanton and by Staudt and
Taylor are somewhat questionable. See, William J. Stanton, Fundamentals
of Marketing, 4th ed. (New York: McGraw-Hill Book Company, 75 ,
p. 155; and Staudt and Taylor, pp. 514-15. A detailed analysis of the
economic and noneconomic benefits of leasing will be found in Chapter II.

 

 

5. What are the lease marketing implications of the decision
procedures employed by industrial organizations?

Secondary sources will be employed in an attempt to answer a
majority of the research questions. The empirical portion of the
study focuses on question (4). A survey will be conducted among
Fortune 200 firms to identify the analysis methodologies used by
these corporations in making lease—purchase decisions. The survey
design and methodology are detailed in Chapter IV. The existing
literature on lease versus purchase decision models is reviewed in
Chapter III. This chapter emphasizes the development of the current
body of literature and attempts to compare and contrast the various
analytical techniques. In Chapter II the proposed benefits of leasing
are carefully examined and a descriptive model of the industrial
lease—purchase decision process is offered. The analysis of the
potential benefits of leasing draws on a broad spectrum of sources
from the financial, economic, accounting, and tax literatures. The
objective of this section is to critically review the various
proposed benefits of leasing in an attempt to identify its true
advantages. The model of the lease~purchase decision process builds
upon the foundtions of the Sheth and Webster-Wind models of industrial
buyer behavior.1 Its purpose is to identify the important variables
and interrelationships which impact the decision. In addition, the
model serves as a guide to the formulation of lessor marketing strate—
gies. Finally, in Chapter V the results of the survey are reviewed

and the implications for lease marketing are discussed. The

 

1Sheth, pp. 50—56; and Webster and Wind.

 

 

recommendations for lessors are based upon the survey and upon a

detailed review of the relevant literature.

The study emphasizes the financial aspects of the industrial
leasing process. As such, it is limited to an examination of the
”full-payout” or financial lease.1 The major objective of the
research is to identify the means by which lessors may improve their
ability to market the economics of leasing. In this regard, the
emphasis will be on the leasing of industrial equipment, although much
of the discussion is also applicable to real property leases. The
implications of the study apply to both manufacturer and nonmanufacturer
lessors. It is felt that the marketing activities of both segments of
the industry can benefit from a detailed appraisal of the economics

of leases.

Limitations

The major limitations of the study concern the survey design
and methodology. The survey consists of a nonprobability sample of
large industrial corporations. Thus, generalizations to other
populations are tenuous at best. In addition, the study focuses only
on the financial aspects of the respondents' decision process. No
attempt has been made to identify the qualitative elements which may
impact the respondents' ultimate decision. Finally, it must be
recognized that the survey design is subject to response bias on the

part of the analysts completing the case problem and questionnaire.

 

1Operating leases are discussed briefly in Chapter II. The use
of the term ”lease" throughout the remainder of this dissertation is
understood to refer to financial leases unless specifically qualified.

 

The artificiality of the task and the potential for evaluation

apprehension may lead the analyst to respond in a manner which does

not reflect his actual lease analysis procedure.

 

 

CHAPTER II

THE NATURE OF LEASE MARKETING

The Leasing Industry

The lease represents an ancient method of obtaining the services
of assets. The earliest known references to leases appear in
Hammurabi's Code.1 It is also known that leases were employed during
the Hellenistic and Roman eras as well as during the Middle Ages.2 In
the United States, leasing developed as an outgrowth of conditional
sales contracts in the railroad industry. Kares reports that as early
as 1839 a form of the conditional sales contract was employed when the
Locks and Canals Company retained title to a number of locomotives it
had built for the Baltimore and Susquehanna Railroad until the notes it

accepted had been honored.3

Throughout the remainder of the nineteenth
century, leases and conditional sales contracts were used extensively in
the transportation industry.4 The manufacturers of shoe machinery and
glassware machinery were other early adopters of the lease as a

financing and marketing device.5 It was not until after World War II,

 

1Morris Jastrow, Jr., The Civilization of Babylonia and Assyria
(Philadelphia: J. B. Lippincott Co., 1915), p. 349.

2Peter Kares, ”Some Economic Implications of Equipment Lease
Financing" (Ph.D. dissertation, Purdue University, 1968), p. 13; and
Stanley L. McMichael, Leases: Percentage, Short and Long Term, 4th ed.
(Englewood Cliffs, NJ: Prentice-Hall, 1947), pp. 1-6.

3Kares, p. 14. 4Ibid. SBabione, pp. 73-94.

 

 

 

11

however, that the financial lease became an important method of
acquiring assets of all types. Prior to this time, leasing was largely
confined to specific industries.1

The postwar growth of leasing coincided with the formation of
the independent leasing companies during the early 19505. The first
independent, established in 1952, was the United States Leasing
Corporation.2 United States Leasing, along with firms such as Boothe
Leasing Corporation, Hertz, Lease Plan International, and National
Equipment Rental, experienced rapid growth during this period. At the
same time, manufacturers such as IBM, Remington Rand, Pitney-Bowes, and
the National Cash Register Company were expanding their use of leasing
in the business equipment industry.3 As a result, more firms in
different industries were being exposed to the lease as a means of
acquiring industrial equipment.

While reliable statistics on the volume of industrial leasing
do not exist,4 Brigham estimates that equipment leasing grew at a rate
of 30 percent a year during the decade of the 19505.5 Estimates for
1973 place the original cost value of industrial equipment on lease

between $60 and $75 billion.6 It is estimated that this is growing at

 

1See, McNeill, pp. 416-17; and, Eiteman and Davisson, p. 17.

3

2Bennett, p. 19. Ibid., pp. 11—23.

4The American Association of Equipment Lessors is currently
conducting the first extensive survey of the industry. See, AAEL News
Bulletin, 18 July 1975, p. 3.

5Brigham, ”Impact of Bank Entry.”

6Vanderwicken, p. 136; and, ”Leases: A Hidden Debt,” Business
Week, 12 October 1974, p. 60.

12

an annual rate between 16 and 20 percent.1 Vanderwicken notes that if
the present growth rate in leasing continues, approximately one-fifth
of all new capital equipment acquired in 1977 will be leased.2
There are approximately 1,800 to 1,900 financial institutions
and subsidiaries of industrial firms involved in industrial leasing.3
In addition, there is a growing, but unknown, number of manufacturers
who offer their products for both sale and lease.4 Participants in the
leasing market may be grouped into four, somewhat overlapping,
categories. These include manufacturer lessors, captive leasing or

credit companies, independent leasing companies, and bank lessors.

Each of these will be described in the following sections.5

Manufacturer lessors

The bulk of industrial leasing is done by manufacturing firms
that lease their products.6 Leasing still tends to be prominent in
specific industries. The best-known example is the office and business
equipment industry. Other industries in which leasing is important
include: construction equipment, machine tools, materials handling

equipment, petroleum refining equipment, telephone and telegraph

 

1Ibid. 2Vanderwicken, p. 136.

3John T. Leatham, "No Letup in Leasing,” Conference Board Record

 

11 (March 1974): 62; and, Vanderwicken, p. 136

4Vanderwicken, p. 136.

5The following taxonomy draws heavily upon Vincent John McGugan,
Com etition and Ad ustment in the E ui ment Leasin Industr (Boston:
Federal Reserve Bank of Boston, 1972), and Henry G. Hamel, Leasin in
Industry (New York: National Industrial Conference Board, 1968).

6Leatham, p. 62.

 

 

13

machinery, and transportation equipment.1 Manufacturers have found
that leasing adds a new dimension to their marketing efforts. In many
instances, manufacturer lessors are able to offer unique benefits
through lease transactions which are not available from other types of
lessors. For example, manufacturers may be able to provide the lessee
with repair, maintenance, and management services at a lower effective
cost than other types of leasing institutions. Similarly, the
manufacturer's expertise with regard to the secondary market for the
equipment may allow him to realize a higher residual value at the
termination of the lease. This advantage may, in turn, be passed on
to the lessee via a lower lease rate. Each of these potential advantages

will be elaborated upon in a later section of the chapter.

Captive leasing or credit companies

 

A number of manufacturers have established special leasing
subsidiaries referred to as "captives" or finance companies. The most
important function of the captive is to obtain the outside financing
necessary to support the leasing activities of the parent concern.
Depending upon the nature of the industry and the parent's volume of
leases, the captive may work very closely with the parent company or
may operate much like an independent leasing company.2 The former
arrangement is the most common and simply represents an alternative

organizational structure for the leasing activities of manufacturers.

 

1Bennett, p. 16. 2McGugan, pp. 35-36.

 

Independent leasing companies

Hamel identifies three basic types of independent leasing

companies: (1) the financial leasing company, (2) the specialized
leasing company or service organization, and (3) the lease broker.1
The first is, in essence, a financial intermediary which leases all
types of capital assets. The specialized leasing firm concentrates on
specific types of assets and provides other services in addition to
financing. In contrast, the lease broker provides no financing services
and is primarily concerned with arranging transactions between lessees
and lessors. It should be noted that these categories are not mutually

exclusive. It is not uncommon, for example, to find large independents

acting in all three capacities.

Financial leasing companies. The financial leasing company acts

very much like a financial intennediary. Its primary function is the
provision of funds to facilitate the acquisition of capital assets.
Typically, the lessor purchases the asset at the lessee's direction and
has it delivered without actually handling the equipment. In general,
financial lessors are highly leveraged. The smaller firms will
frequently finance each lease as a separate transaction. In contrast,
the larger companies will usually obtain their financing in large
blocks from banks, insurance companies, pension trusts, and
institutional investors.2 The debt financing is normally secured by a

pledge of the lease payments and by the leased assets themselves.3

 

2

1HameI, pp. 16-20. Ibid., p. 18. 3McGugan, p. 30.

 

15

Specialized leasing companies. Specialized lessors provide

various nonfinancial services in addition to basic lease financing.
These firms tend to concentrate on the leasing of automotive, office,
and industrial equipment.1 The services provided by the specialized
leasing companies include the disposal of used equipment, maintenance
and service of leased equipment, the provision of insurance coverage,
and the payment of taxes and license fees.2 This is in contrast to
financial leasing companies which generally provide no auxiliary
services beyond the financing of the acquisition. Specialized lessors
will also lease equipment for shorter time periods than financial

leasing firms and will offer leases which are cancellable.

Lease brokers. The basic function performed by the lease broker
is to bring together the parties to a lease transaction. Typically,
this will involve a firm in need of capital equipment, the manufacturer
of the equipment, and a financial intennediary or group of intermedi-
aries. In small or medium-size transactions, only a single financial
institution, typically a bank, will be involved. In large transactions,
it may be necessary to form a consortium of banks and insurance
companies to provide the financing.3 The broker, who is also called a
packager, provides facilitating services and is generally compensated

on a fee basis.

 

1Hamel, p. 16.

2McGugan, p. 32. Other services may also be provided, depending
upon the industry and the specifics of the situation.

3Vanderwicken, pp. 132—36.

 

Bank leasing

Banks may participate in the leasing market either as direct

lessors or as the suppliers of funds for direct lessors. Commercial
banks have always been major suppliers of funds to the leasing industry.
In the last 10 years, however, bankers have expanded their traditional
role of indirect participation and have moved heavily into direct
leasing. Banks which operate their own leasing departments or
subsidiaries take title to the leased equipment and deal directly with
the lessee. Indirect participants deal with nonbank leasing
institutions and provide them with financing on a short— and

intermediate-term basis.

Direct lease financing. In 1963 the Comptroller of the Currency
ruled that ”direct lease transactions . . . constitute legal and proper

activities for National Banks.“1

Shortly thereafter, various states
promulgated similar rulings to allow state chartered banks to enter the
direct leasing field.2 The initial reaction among national banks was
cautious. By December of 1964, only 81 national banks were involved in
direct leasing.3 This has since grown to 655 as of October, 1974.4 In
addition, the volume of direct lease financing by national banks rose

by more than $1 billion to $2.37 billion during the 12-month period

 

1U.S., Comptroller of the Currency, Annual Report, 1963 (1963),

p. 476.

2Eugene F. Brigham, "Equipment Lease Financing,“ The Banker's
Magazine 149 (Winter 1966): 65-66.

3 4

Cooney, p. 13. AAEL News Bulletin, 16 June 1975, p. 10.

 

 

ending October 15, 1974.1 By comparison, the amount of direct lease

financing by state banks remains small.2

Direct bank lessors operate in a fashion which is similar to
financial leasing companies. Most banks contract with the customer to
purchase the specified asset and secure delivery to the customer's
place of business without taking physical possession of the equipment.
The majority of bank leases are of the full-payout variety. That is,
the lease payments over the basic term of the lease exceed the purchase
price of the asset, and the lessee assumes all of the ancillary costs
and liabilities associated with the use of the equipment.3 Banks view
the lease as a debt-equivalent and their role as that of providing the
funds necessary to acquire the use of the asset. The apparent reason
for the entry of large numbers of national banks into the leasing
field is their desire to supplement their lending activities and the

need "to offer as complete a financial service as possible.”4

Indirect lease financing. Banks participate in the leasing
market indirectly by providing funds to various types of lessors. Banks
may lend to manufacturer lessors, independents, or captive leasing
companies. Frequently, banks will establish informal working relation-
ships with a number of independent leasing firms or manufacturer
lessors.5 In some cases, banks reserve the right to review the credit
standing of potential lessees. The leased equipment serves as the

collateral for these loans. In addition, the lessor generally assigns

 

1Ibid. 2Cooney, pp. 13—14. 3McGugan, p. 37. 4Hamel, p. 26.

51bid., pp. 22-25.

 

 

 

18

the lease payments to the bank. Such assignment is considered the major

security for the loan.1

Leases Defined
Various definitions of leasing are possible. Much depends upon
one's viewpoint and the purpose of the definition. Moreover, the
various viewpoints and the resultant definitions are somewhat

interrelated. For example, Webster's Third New International Dictionary

 

gives the following definition of a lease: "A contract by which one
conveys lands, tenements or hereditaments for life, for a term of years,
or at will or any less interest than that of the lessor, usually for a

specified rent or compensation."2

From a legal standpoint, the contract
created by a lease transaction is generally considered to be executory
in nature.3 Black defines executory as "that which is yet to be
executed or performed; that which remains to be carried into operation
or effect; incomplete; depending upon a future performance or event.

The opposite of executed."4 In contrast, an executed contract is one

which has already been carried out and is complete in all respects.5 It

 

1Ibid., p. 22.

2
"Lease.”

3Mary M. Wehle, ”Lessee Decision Criteria and Accounting
Implications” (Ph.D. dissertation, Harvard University, 1972), p. II-7.
Wehle notes, however, that ”there is no single opinion as to whether
a lease is an executed or executory contract. Rather the law is a
patchwork of case decisions on which assumptions may be built. Case law
and judicial decisions bear on the issue, but do not provide complete,
unassailable answers."

4

Webster's Third New International Dictionary (1971), s.v.

 

Black, Law Dictionary 680 (rev. 4th ed. 1968).

51bid., p. 676.

 

 

19

is this view of a lease as an executory contract which is the major
justification for the Accounting Principles Board opinion that
"disclosure rather than capitalization is the correct accounting
treatment," for most types of leases.1 Since both sides of an executory
contract are equally unperformed, the board does not consider lease
obligations to be assets or liabilities under present accounting
concepts.2

From the standpoint of the practitioner, however, the more
important view of the lease may be that of the Internal Revenue Service.
Under Section 162( (a)(3) of the Internal Revenue Code, lease obligations
are an allowable deduction as trade or business expenses.3 However,
for lease payments to qualify as a deduction, the lease must meet the
IRS ”true" lease requirements. If it does not, the transaction is
viewed as a conditional sale, and the payor may only deduct the allowable
depreciation on the asset.4 Thus, a potential tax advantage may result
because of the differential timing of lease and depreciation deductions.
The purpose of the IRS requirements is to prevent a firm from realizing
a tax advantage by treating a conditional sale as a lease transaction.
While the IRS warns that ”no general rule, applicable to all cases, can

"5

be laid down, a transaction may be viewed as a sale rather than a

lease if one or more of the following conditions exist:

 

1APB Accounting Principles (New York: Commerce Clearing House,
1973), p. 6524; and Earl A. Sp1ller, jr. , Financial Accounting, rev. ed.
(Homewood, IL: Richard D. Irwin, 1971), p. 374

21bid. 3

4P-H Federal Tax Course 1975, par. 1841 (1975).

2 P-H 1975 Federal Taxes, par. 11,005.

5Rev. Rul. 55-540, 1955 CB 41.

 

20

1. Portions of the periodic payments are made specifically
applicable to an equity to be acquired by the lessee.

2. The lessee will acquire title upon the payment of a
stated amount of "rentals" which under the contract
he is required to make.

3. The total amount which the lessee is required to pay
for a relatively short period of use constitutes an
inordinately large portion of the total sum required
to be paid to secure the transfer of title.

4. The agreed "rental" payments materially exceed the
current fair rental value.

5. The property may be acquired under a purchase option
at a price which is nominal in relation to the value
of the property at the time when the option may be
exercised, as determined at the time of entering into
the original agreement, or which is a relatively small
amount when compared with the total payments which are
required to be made.

6. Some portion of the periodic payments is specifically
designated as interest or is otherwise readily recog-
nizable as the equivalent of interest.1

As a result of these requirements, lessors will generally seek advance

rulings from the IRS on the status of large lease transactions.2

Types of Leases
Leases may be grouped into two broad categories: financial
leases and operating leases. There are, however, a number of varieties
within each category, as well as hybrid types which are not easily

classified. In the following sections, the general characteristics of

 

1Ibid., pp. 41-42. These represent the published criteria. In
practice, the IRS employs various additional guidelines. See, McGugan,
p. 25, and Rev. Proc. 75-21, IBR 1975-18, 15.

chGugan, p. 25.

 

21

the more important types of leases within each category will be

discussed.1

Financial leases

The financial lease is typically a long- or intermediate-term,
noncancellable lease which is fully amortized over its basic term (that
is, the sum of the lease payments will equal or exceed the original
purchase price of the equipment). In a "net” financial lease, the
payments exceed the purchase price over the term of the contract and
”the lessee pays all property taxes, sales taxes, use taxes, fees,
maintenance, insurance, etc., and assumes all liabilities connected
with the use of the property.”2 Under competitive pressures, however,
the lessor may agree to pay a portion of the asset's operating costs.

Financial leases generally include a purchase option which the
lessee may exercise at the termination of the contract. Great care is
taken in writing purchase options in order to meet the IRS ”true" lease
requirements. In most cases, the contract will stipulate the fair
market value of the equipment at the end of the lease as the purchase
price and will specify the method to be used to determine that value.3
Financial leases are most often written by financial leasing companies
and banks. In addition, many manufacturers and captives write leases

which have many of the characteristics of financial leases.4

 

1The following sections owe much to discussions with executives
and members of the American Association of Equipment Lessors.

ZMcGugan, p. 22. 3

Ibid., p. 23.

4Most of these leases are noncancellable, full-payout leases.
However, they frequently differ from the financial leases written by
independents or banks with regard to services provided and the nature
of the purchase or lease renewal options.

 

22

Leveraged leases. Leveraged leases are a special case of
financial leases. In this instance, the lessor borrows a portion of
the asset's cost from a third party. The lessor generally gives the
third party a mortgage on the leased asset and an assignment of the
lease payments as security.1 In large leveraged lease transactions, a
group of banks will typically act as lessors. They may borrow up to
80 percent of the asset's cost from institutional lenders such as
insurance companies.2 In return, the insurance companies will receive
most of the lease payments as interest and reduction of principal on
the debt. The bank—lessors receive the remaining portion of the lease
payments and, as owners of the asset, all of the tax benefits. The tax
benefits include the tax shields from accelerated depreciation and
interest payments on the debt as well as the investment tax credit. In
addition, the banks realize the residual value of the equipment at the
end of the lease.3

The ability of firms with low or heavily sheltered earnings to
pass on the tax benefits of leasing to bank—lessors is one of the most
powerful attractions of the leveraged lease. From the standpoint of the
bank, the major attraction is the ability to earn high returns through

the use of leverage. In fact, the combination of tax benefits and

 

1McGugan, p. 24.

2The IRS requires a lessor to maintain a 20 percent equity in
the equipment in leveraged lease transactions. See, Rev. Proc. 75-21,
IBR 1975—18, 15.

3Vanderwicken, pp. 132-36.

 

23

leverage will frequently allow the lessor to charge an implicit interest
rate which is below the lessee's cost of debt financing.1
Leveraged lease transactions are frequently arranged by a lease
broker. The major function of the broker is to put together the
consortium of financial institutions and assist in the negotiations of
the lease terms. In very large transactions, more than one broker may
be involved. For example, a financial leasing company may arrange the

participation of the banks and an investment banker may arrange for

the insurance company participation.2

Sale and leaseback. The sale and leaseback arrangement is
another special case of the financial lease. In this type of
transaction a firm sells an asset to a financial institution and
immediately leases it back under a financial lease.3 The effect is the
same as if the lessor had purchased the asset from a third party and
leased it to the firm.

A company may benefit from a sale and leaseback if, for some
reason, its tax status changes and it is not able to employ the
depreciation-generated tax shields associated with the asset. Firms
may also use the sale and leaseback as a means of obtaining funds. It

is possible that the sale and leaseback of a capital asset may result

 

1Ibid., p. 192. Vanderwicken reports that it is even possible
for the lessee to obtain the asset at a negative interest cost, i.e.,
the total lease payments over the term of the lease are less than the
purchase price of the equipment.

21bid., pp. 132-36.

3J. Fred Weston and Eugene F. Brigham, Managerial Finance, 5th ed.
(Hinsdale, IL: Dryden Press, 1975), p. 476.

 

24

in a lower net cost of financing than the issuance of a debt instrument.
This might result from the preferred security position of a lessor

vis-a-vis a debt holder.1

Operating leases

Operating leases are generally short-term, cancellable contracts
under which the lessor assumes most or all of the responsibilities of
ownership. Operating leases are not fully amortized over their basic
terms. This type of lease provides the lessee with flexibility in that
equipment may be leased which is needed only for short periods of time.
However, the rates may be relatively high in order to compensate the
lessor for assuming the operating costs and the risks of obsolescence.
Operating leases are most frequently written by manufacturers and
specialized leasing companies and are prominent in the areas of

automotive, office, and industrial equipment.2

The Potential Benefits of Leasing

 

From a marketing standpoint, a lease may be viewed as a package
of economic and noneconomic benefits. A lease is not merely an
alternative means of paying for an asset's services. It has the
potential of offering benefits which go far beyond the provision of use
value. Chief among these benefits are the potential economic advantages

of leasing. (The ability to pay for an asset's services over an

 

1Timothy J. Nantell, "Lessor's Pricing Decision, An Indifference
Theorem, and the Evaluation of Lease yp, Buy Algorithms” (unpublished
paper, University of Michigan, 1975), p. 14.

2Weston and Brigham, 5th ed., pp. 476—77; and McGugan, pp. 27-28.

 

25

extended period of time is not a unique advantage of leasing, since the
same result may be achieved via debt financing of a purchase.) In the
following section, seven "true” economic advantages of leasing will be
discussed. In the next section, a number of economic "advantages” of
a more dubious nature will be examined. Finally, some of the alleged
noneconomic benefits of leasing will be covered and empirical evidence
on the advantages which firms seek to obtain from leases will be
presented.

gpgppfi1al econom1c advantages of

Nantell has identified seven potential economic advantages of

 

leasing.1 The first recognizes the fact that the lessor may be able to
obtain the asset at a lower effective cost than the lessee and may be
willing to pass on all or a portion of the savings in a lower lease
rate. This may be the result of quantity discounts or it could result
from a tax benefit which the lessor can take advantage of but the
lessee is unable to utilize.2

An excellent example of the latter advantage is the investment
tax credit. Firms with low or heavily sheltered earnings may be unable
to use the full amount of the applicable investment credit if they
purchase an asset.3 On the other hand, a lessor may be able to utilize
the full amount of the credit and pass on a portion of the savings to

the lessee via a lower rental rate. Banks are in a particularly

 

1 2

Nantell, ”Lessor's Pricing,” pp. 12-15. Ibid., p. 12.

3For the regulations relating to the use of the investment tax

credit, see, P—H Federal Tax Course 1975, par. 2050 (1975).

 

26

favorable position to write tax-oriented leases since, in general, they
do not face restrictions on the use of the investment tax credit.1
Similarly, independent lessors which are subsidiaries of larger
corporations are able to use the credit to reduce the tax obligations
of their parent firms. In addition to the investment credit “pass-
through,” lessees with large loss carry-forwards may be able to benefit
by allowing the lessor to take the accelerated depreciation and interest
tax shields associated with the capital outlay.2 Vanderwicken provides
an example of a firm with a 10—year multimillion dollar loss carry-
fonward which was able to lease a plant at a considerable savings via
a tax-oriented leveraged lease.3

A second economic advantage of leasing may result if the lessor
incurs a portion of the asset's operating costs. It is possible that
the operating costs to the lessor may be less than those which would
have to be incurred by the lessee. For example, the lessor may be able
to attain economies of scale in the provision of repair, maintenance,
and management services for a particular type of equipment or a specific
group of lessees.4

A third possible advantage may result if the lessor is able to

depreciate the asset over a shorter time period than the lessee. The

 

1McGugan, p. 40. Most large banks have sufficiently high earnings
and sufficiently low capital expenditure programs to employ the full
amount of the credit on the leases they write.

2An interest tax shield would be available to the extent that the
acquisition is wholly or partially financed with debt.

3Vanderwicken, pp. 132-36.
4McGugan, p. 32; and Weston and Brigham, 5th ed., p. 482.

 

27

larger depreciation expenditures of the lessor will result in greater
tax savings which may be passed on in a lower rental cost. This might
result if the lessor uses the lease term as the estimated useful life
of the asset while the lessee employs the Class Life Asset Depreciation

1 To the extent that the lease term is less than the Asset

Range option.
Depreciation Range (ADR), an economic benefit may result. It is
unlikely, however, that a significant advantage could be generated
from the use of differential depreciation lives. In most instances,
the useful economic life and the ADR life will be very close, and any
attempt by the lessor to write the asset off over a period which is
substantially less than its useful economic life could be disallowed
by the IRs.2

Another tax-related advantage to leasing may occur if the tax
rate of the lessor is less than that of the lessee. To the extent that
these savings are passed on to the lessee, a fourth advantage of leasing
has been identified.

Thus far, the advantages of leasing which have been discussed
have resulted from cash flow savings available to the lessor but not to
the lessee. Another set of benefits may result from differential

expectations as between the lessor and lessee. For example, in

determining his lease rate, the lessor may anticipate a higher salvage

 

1Under the Class Life ADR system, firms are allowed to choose a
range of depreciation lives for each type of asset owned by the firm.
The Asset Depreciation Ranges are determined by the IRS. Once a firm
has elected to use the Class Life ADR system for a particular type of
equipment, all assets falling within the Guideline class must be
depreciated under the ADR system during the year of the election. See,
P-H Federal Tax Course 1975, par. 2032-2034 (1975).

2Ibid., par. 2002 and 2032.

 

28

value than the lessee. In particular, manufacturer lessors and their
captives may be uniquely situated to take advantage of their specialized
knowledge of the leased equipment. In addition to their superior
ability to forecast the secondary market for the equipment, they may
be able to realize economies of scale in the reconditioning and sale
of the asset once it comes off lease.1 Indeed, these firms may actually
be able to stretch the useful economic life of a piece of equipment
through a combination of expert maintenance and marketing.2

A related advantage can occur if the lessor perceives less risk
in the operating expense and salvage value cash flows than the lessee.
This may lead the lessor to discount these flows at a lower rate in
determining the lease charge. Thus, the economic advantage is passed
on in a lower rental rate. Again, manufacturer lessors and captives,
as well as specialized leasing companies, would be in the best position
to capitalize on this potential benefit. Indeed, financial institutions,
which do not have specialized knowledge of the equipment and do not have
the capability of realizing economies in its reconditioning and
disposal, may actually perceive greater risk in these cash flows.3 As
a result, banks and financial leasing companies would tend to be at a
competitive disadvantage with regard to this potential benefit of

leasing.

 

1Weston and Brigham, 5th ed., p. 483; and McGugan, pp. 32-33.

2A case in point is the Clark Equipment Company. See, Weston
and Brigham, 5th ed. ,p. 3.

3Many banks, for example, assume a zero salvage value in
pricing their leases as a matter of policy.

 

29

A final economic advantage may exist if the lessor demands a
lower rate of return than would be required by a lender. This might
be the result of a competitive strategy on the part of a lessor. For
example, the lessor may be attempting to carve out a share of a new
market by underpricing the existing competitors. It may also result
because ”the lessor views his security position as superior to that of
a lender since he retains title to the asset.“1 Furthermore, if the
lessee defaults on a personal property lease, the lessor is entitled
to ”damages"-—defined as the present value of the difference between
the unpaid lease rentals and the lease payments the lessor can obtain
upon re—leasing the asset.2

Questionable economic advantages
of leasing

Through the years, various writers have constructed long lists

 

of the economic benefits of leasing.3 Unfortunately, some of these
proposed benefits do not hold up under close scrutiny. It is the
intention of this section to examine several of the more persistent of

the alleged advantages.4

 

1Nantell, “Lessor's Pricing,” p. 14. 2McGugan, p. 23.

3See, for example, McNeill, pp. 422-25; Mark Levy, ”The Trend of
Corporations to Sell Their Real Estate to Institutional Investors," The
Mortgage Banker 8 (November 1947): 11—16, and (December 1947): 2—7; 353
Frank K. Griesinger, ”Pros and Cons of Leasing Equipment,” Harvard
Business Review 33 (March-April 1955), reprinted in Leasing Series
(Boston: Harvard Business Review, n.d.), pp. 49-63.

4A somewhat more detailed listing of the proposed benefits of
leasing will be found in Andrew T. Nelson, "The Impact of Leases on
Financial Analysis” (Ph.D. dissertation, Michigan State University,
1962), pp. 14-38.

 

 

30

One of the best known and most widely debated arguments for
leasing is that it provides the firm with ”off balance sheet financing.”
Under Accounting Principles Board Opinions 5 and 31, most leases do not
have to be capitalized as liabilities on the lessee's balance sheet.1
Firms need only disclose the presence of leases via footnotes to the
audited financial statements.2 The omission of lease commitments from
the balance sheet has a favorable, and deceptive, effect on various
financial ratios.3 The alleged advantages of this financial ratio
improvement are twofold. First, if creditors do not fully appreciate
the implications of a firm's lease commitments, they may perceive less
risk in granting loans to the company. As a result, the lessee's
ability to raise additional debt capital may be enhanced, and the firm
may be able to obtain the funds at a lower rate.4 Second, if equity
investors do not perceive the same amount of risk with lease commitments
as they do with an equivalent amount of debt financing, they may require
a lower return on equity for a lessee firm. The result is a lower

implicit cost of lease financing.5

 

1APB Principles, pp. 6521—26 and 6817—21.

2The Financial Accounting Standards Board has recently issued
the long—awaited draft of its proposed requirements for lease accounting.
Based on the proposed criteria for capitalization, it appears that the
changes will be minimal. See, ”Accounting for Leases,” Executive News
Briefs 3 (September 1975): 1—2.

3Nelson, pp. 135—41.

4James C. Van Horne, Financial Management and Policy, 3rd ed.
(Englewood Cliffs, NJ: Prentice-Hall, 1974), p. 582.

5

 

Ibid.

31

It is unlikely, however, that debt and equity investors are
seriously misled by the accounting treatment of leases.1 There is a
good deal of sophistication in the financial community with regard to
leasing, and it is improbable that many financial analysts are fooled
by the off balance sheet nature of leases.2 Indeed, the leasing
industry itself cautions that financial institutions take a firm's
lease obligations into account in determining its credit worthiness.3
What is more, the empirical evidence on market efficiency generally
supports the position that changes in accounting procedures do not
affect the decisions of investors. In other words, investors are able
to "see through the numbers" and assess the intrinsic value of

. . 4
securities.

 

1One of the earliest arguments to this effect was made by
Donald R. Gant, "Illusion in Lease Financing," Harvard Business Review

 

37 (March-April 1959), reprinted in Leasing Series (Boston: Harvard
Business Review, n.d.), pp. 1-22.
2A 1959 survey by Vancil and Anthony found that financial

institutions were well aware of the implications of leases but that
few used formal analytical techniques to transform lease commitments
to debt equivalents. See, Richard F. Vancil and Robert N. Anthony,
”The Financial Community Looks at Leasing," Harvard Business Review
37 (November-December 1959), reprinted in Leasing Series (Boston:
Harvard Business Review, n.d.), pp. 31-48.

 

 

 

3Leonard Rochwarger, "The Flexible World of Leasing,” Fortune
89 (November 1974), pp. 56-59 (advertisement). It should be noted,
however, that many lessors still include off balance sheet financing
as an advantage in their promotional brochures.

4An excellent review of the empirical evidence on market
efficiency will be found in James H. Lorie and Mary T. Hamilton, Ip§_
Stock Market (Homewood, IL: Richard D. Irwin, 1973), pp. 70-97; and
Baruch Lev, Financial Statement Analy§js (Englewood Cliffs, NJ:
Prentice-Hall, 1974), pp. 212-23. The major studies on the effect of
accounting changes on security prices are reviewed in Lev, pp. 235-44.

 

 

32

One of the oldest arguments in favor of leasing is that it

provides the firm with 100 percent financing.1

This is frequently
referred to as the "conservation of working capital" advantage. It is
reasoned that since a lease does not require a down payment or initial
equity investment, the firm is able to "conserve” cash or working
capital. The underlying assumption is that funds invested in high-
turnover working capital "earn" more than if they are invested in
low-turnover fixed assets.

Unfortunately, there are serious flaws in this line of reasoning.
It is doubtful that a lease allows a firm to conserve cash vis-a-vis
debt financing. In line with the previous discussion, it is reasonable
to conclude that investors consider lease and debt financing to be
equivalent. As such, a firm "would use up less of its capacity to
raise nonequity funds with debt than it would with leasing."2 It
could, therefore, issue an alternative debt instrument to make up the
difference. Thus, both debt and lease financing "conserve" similar
amounts of working capital.

On the other hand, it is clear that a lease requires a lower
initial outlay than a cash purchase.3 Nevertheless, any benefit which
accrues to the lessee is the result of deferring the lease payments and

not from investing the funds in high-turnover working capital. As

Johnson points out, it is meaningless to talk about current assets

 

1See, for example, McNeill, p. 422; and Eiteman and Davisson,
pp. 73-75.

2Van Horne, 3rd ed., p. 579.

3Here it is assumed that the asset is purchased with cash which
would otherwise be retained in the business.

33

"earning“ more than fixed assets.1 A firm requires a given mixture of
both fixed and current assets to operate at its chosen capacity level.
The relevant question is not how much cash is "released" with alternative
financing methods, but, rather, which method raises shareholder wealth
by the greatest amount.2 This may be determined by discounting the
alternative cash flows at the appropriate risk adjusted rates.3 To the
extent that there is an advantage to deferring lease payments, it will
be reflected by the discounting mechanism.

It is sometimes argued that leasing offers an advantage in that
the tax shield generated by the lease payments exceeds the tax shields
from depreciation and interest which would be available if the asset
were purchased with debt capital. However, the argument does not
consider the possibility that the higher fixed commitments associated
with the lease may cause shareholders to perceive greater risk in the
firm. Assuming that the firm has an optimal capital structure,4 the
higher lease charges may cause investors to raise the firm's equity
capitalization rate. In some instances, the higher capitalization rate
may be sufficient to nullify the tax benefits of the lease.

Another proposed benefit of leasing is the argument that a lease

allows a firm to amortize the cost of any land which is included in the

 

1Robert W. Johnson, Financial Management, 3rd ed. (Boston: Allyn
and Bacon, 1966), pp. 533-34.

 

2Lawrence D. Schall, ”The Lease-or—Buy and Asset Acquisition
Decisions," Journal of Finance 29 (September 1974): 1203.

 

3This subject will be take up in great detail in Chapter III.

4Modigliani and Miller notwithstanding, in a world of taxes and
bankruptcy costs it appears reasonable to assume that an optimal capital
structure exists. See, Van Horne, 3rd. ed., pp. 237-43.

34

rental payments.1 If the firm were to purchase the land, it would not
be able to depreciate it for tax purposes. However, since lease
payments are tax deductible, the lessee is able to write off the
original cost of the land. Counteracting this advantage is the fact
that the residual value of the pr0perty at the end of the lease term
reverts to the lessor. Given the general trend in real estate prices,
it is possible that the sale price of the land will offset the lessee's
tax advantage.2

One final argument for leasing will be considered. It is said
that firms with poor credit ratings are able to obtain assets through
leases when they are unable to acquire debt capital. However, if
investors view lease and debt commitments as equivalent, the lessee may
be paying a high implicit cost because of an increase in the firm's
equity-capitalization rate. In addition, the firm will most certainly
face a high lease rate in order to compensate the lessor for bearing
the risk of default. These higher costs may be sufficient to reduce
the return on the leased asset below the required return for its

risk class.

Operating advantages of leasing

 

As in the case of the potential economic advantages of leases,
long lists of the noneconomic or operating advantages of leasing have
been compiled. In this section, some of the more frequently cited

operating advantages will be examined.

 

1Ibid., p. 580.

This assumes, of course, that we are comparing discounted
values.

35

Various potential advantages are included under the rubric of
flexibility and convenience. It is argued that leasing provides the
firm with flexibility because it allows for piecemeal financing of
relatively small asset acquisitions. It is pointed out that debt
financing of such acquisitions can be costly and difficult to arrange.1
Leases, on the other hand, may be arranged more quickly and with less
documentation.

A closely related advantage is that leasing may allow a division
or subsidiary manager to acquire equipment without approval of the
corporate capital budgeting committee. Depending upon the firm, the
manager may be able to avoid the time-consuming process of preparing
and presenting a formal acquisition proposal. It is argued that the
greater flexibility this affords the executive constitutes a prime
motivation for leasing.

A third advantage which relates to flexibility is that lease
payment schedules may be structured to coincide with the revenues
generated by the asset, or they may be timed to match seasonal
fluctuations in a given industry. Thus, the firm is able to synchronize
its lease payments with its cash cycle-~an option which is rarely
available with debt financing.

The convenience aspect of leasing may take many forms. It is
argued, for example, that leasing simplifies bookkeeping for tax
purposes because it eliminates the need to prepare time—consuming
depreciation schedules and subsidiary fixed asset schedules.2 In

addition, the fixed payment nature of lease rentals allows more accurate

 

2

1Van Horne, 3rd ed., p. 578. Nelson, p. 16.

36

forecasting of cash needs. Finally, it is frequently pointed out that
leasing allows the firm to avoid the "problems" associated with
ownership. Executives often note that leasing ”keeps the company out of
the real estate business." Implicit in this statement is the assumption
that the firm's human and material resources may be more profitably
allocated to its primary line of business and that it is better to allow
the lessor to deal with the nuances associated with ownership.

It is difficult to generalize with regard to the validity of the
various arguments for greater flexibility and convenience in leasing.

To be sure, some companies, under specific conditions, may find leasing
advantageous for any one of the reasons listed above. It is likely
that the cost-benefit trade-offs will be different for every firm.

With regard to most of the advantages which were cited, the
relevant concept is that of function shifting. By leasing a piece of
capital equipment, a firm has effectively shifted various functions to
the lessor (bookkeeping, disposal of used equipment, etc.). The lessee
will only benefit in these situations if, (1) the lessor is able to
perform the functions at a lower cost than the lessee, and (2) the
lessor is then willing to pass the savings on in a lower lease rate.
Thus, we return to a variant of Nantell's second economic advantage of
leasing. To the extent that the lessor faces lower Operating and/or
administrative costs than the lessee, a true economic advantage to
leasing may result. As a practical matter, however, it would be very
difficult for a firm to quantify the potential convenience and

flexibility benefits that it might derive from leasing.

37

Another highly touted advantage of leasing is its lack of
restrictions. Unlike term loan agreements or bond indentures, lease
contracts generally do not contain protective-covenant restrictions.
Furthermore, it is sometimes possible to exclude lease payments from
the firm's debt commitments in calculating various financial ratios
under existing covenants. Once again, the extent to which the lack of
restrictions benefits a firm will depend on the price it must pay. If
a lessor views its basic security position to be superior to that of a
creditor, it may not require a higher return to compensate it for the
lack of restrictions on the lessee. On the other hand, if the
prospective lessee is viewed as a marginal credit risk, a higher rate
may have to be charged.

Similar reasoning applies to two other alleged operating
advantages of leasing. It is argued that a lease is advantageous
because the risk of obsolescence is avoided and because the lessor
will provide the firm with better and more reliable service in order
to maintain the resale value of the asset. In actuality, the risk of
obsolescence is passed on to the lessee in any financial lease. Since
the original cost of the asset is fully amortized over the basic lease
term, all of the risk is borne by the lessee. In an operating lease, on
the other hand, the lessor sets his rates to cover the risk of early
obsolescence. Thus, the risk is once again passed on.

With regard to the quality of service under a lease contract,
much will depend on the lessor's own cost-benefit trade-off. If the
lessor is a manufacturer or specialized leasing company, it may be

profitable to maintain the resale value of the asset by insuring that

38

the equipment is properly repaired and maintained. A financial leasing
company, on the other band, would probably find it too expensive to
follow this approach. Thus, it is difficult to generalize with regard
to this potential advantage.

In summary, it may be seen that many of the so-called noneconomic
or operating advantages of leasing reduce to economic considerations.
To the extent that the lessor realizes economies of scale in the
performance of various functions, the lessee may benefit by shifting
these functions to the lessor. A benefit may accrue if the "price”
the lessor charges for performing these functions is below the lessee's
cost. These trade-off relationships are likely to be situation-specific

and may be difficult to quantify in actual practice.

Advantages of leasing as perceived
by lessees

In the preceding sections, many of the proposed benefits of

 

leasing were discussed. Seven "true" potential economic advantages
were identified and a number of other economic and "noneconomic"
advantages were critically reviewed. In this section, the benefits
which firms perceive in lease transactions will be considered.

The data are derived from a 1972 study by Wehle and are based
on interviews with top executives of 24 companies and mail questionnaires
received from 30 firms.1 The companies included in the interview data
are of varying sizes and represent such industries as airlines,
petroleum, retail trade, manufacturing, and service. The questionnaire

respondents are all national and multinational corporations. The

 

'NehIe, pp. V-l to v-32.

39

research objective was to identify the specific benefits which firms
seek when entering lease transactions.

Wehle's major conclusion is that a firm's motivation for leasing
is a function of many factors, including "the industry, the form and
conditions of the lease, the firm's competitive position and the asset

leased."1

She also found that the most important consideration in the
decision varies for different assets and at different times for the same
firm. Thus, the leasing decision appears to be a dynamic process in
which the "evaluative criteria" are very much situation specific.
Nevertheless, the responses to the questionnaire allow some
generalizations with regard to the more significant advantages as
perceived by the lessees. Wehle asked the respondents to consider four
categories of potential benefits: (1) operating, (2) funds flow,
(3) financial ratio, and (4) tax. The data indicate that operating
considerations are the most salient for the firms surveyed.2 Within
this category, the following advantages were considered to be

significant reasons for entering into financial leases:3

1. Leasing avoids the problems of disposing of second-hand
equipment.

2. Leasing can be tailored to the lessee's needs more easily
than ordinary purchasing.

3. Leasing will ensure the proper installation and functioning
of equipment.

4. Property is leased because the purchase price is set at a
higher level to encourage leasing.

 

1 2

Ibid., p. VI-54. Ibid.

3Only data relating to financial leases will be presented in
this section. For the results relating to operating leases, see,
ibid.. DP. VI-43 to VI-46.

4O
5. Property is leased because it is not available for
purchase.1
The funds flow considerations which were considered to be
important include:
1. Leasing provides 100 percent financing.
2. Leasing frees working capital for other uses.

3. Leasing is cheaper on a net basis than a similar amount
of debt.

4. Debt covenants restrict further borrowing but do not
prohibit leasing.

5. Leasing enables corporations to obtain the use of more
assets than it would have if it relied on purchasing
alone.
6. Leasing leaves normal lines of credit undisturbed.
7. Leasing avoids the restrictions found in loan agreements.2
The interview and questionnaire data indicate that financial
ratio considerations are less significant in the leasing decision than
is generally believed. Wehle concludes that many firms believe
sophisticated investors are not fooled by the off balance sheet
accounting treatment of leases. However, some firms suggest that this
may be an advantage in dealing with "smaller stockholders and less

sophisticated statement users."3

As a result, the following two
financial ratio considerations were viewed as significant by the
respondent firms:

1. Leasing does not appear as a liability on the lessee's
balance sheet.

2. Leases are not included in debt-equity ratios.4

 

1Ibid., p. v1-45. 21bid., p. v1—43. 31bid., p. VI-56.

41bid., p. v1-44.

41

Similarly, the study indicated that tax advantages were not a
major factor in the leasing decision. Only three tax—related benefits
were considered to be important:

1. The tax deductibility of leasing costs results in more
immediate cash flow.

2. Leasing provides 100 percent deductibility of costs.

3. Property taxes are not levied on leased property in many
states in which the company operates.

On the basis of the interview and questionnaire data, Wehle
concludes that firms enter lease transactions primarily for operating
and funds flow considerations. The research indicates that financial
ratio and tax factors play a role in the decision, but that they are
only determinant "in very limited circumstances."2

It is interesting to compare Wehle's empirically-determined list
of perceived benefits with the potential benefits discussed in the
preceding sections. It can be seen that there is a discrepancy between
the benefits which lessees perceive and those which may actually be
realized from lease transactions. It appears that some firms may be
leasing in the hope of attaining illusory advantages. Such questionable
"advantages" as 100 percent financing and off balance sheet financing
are obvious examples.

This raises important ethical questions for the lease marketer.
Because of the confusion over the "true" benefits of leasing, the lessor
may be in a position to take advantage of the lessee. A review of lessor
promotional brochures reveals that many of the discredited "advantages"

of leasing are employed in the marketing of leases. It is unclear,

 

'Ibid.. p. VI-46. 21bid., p. v1-57.

 

42

however, whether these are truly determining factors in the leasing
decision. Wehle's research identified many factors which are
"significant" in the lessee's decision process, but she concludes that
three considerations are predominant: (l) the "inability to purchase
the asset at a reasonable price, (2) a desire to maintain operating
flexibility, and (3) the firm's definition of its own sphere of
operation."1 Given the general nature of these factors, it is
impossible to determine the extent to which firms are misled by lessor
marketing activities. Further research in this area is clearly needed.
Another factor which comes to light from Wehle's research is that
many companies may not be aware of the true potential economic
advantages of leases. While a number of firms indicated that they
believe leasing to be less expensive than a similar amount of debt, the
reasons for this belief were not investigated. For example, it was
previously noted that a significant economic advantage may result from
the investment tax credit "pass-through." Yet, Wehle determined that
tax considerations are not a major factor in the respondents' decision
process. This could, of course, be a function of the questionnaire
and interview design or the specific sample which was chosen for
investigation. On the other hand, it may be the result of a lack of
knowledge on the part of the respondents. It is quite possible that
industry is unaware of the sources of the potential economic advantages
of leasing. If this is the case, lessors have the opportunity to raise

awareness levels through a proper adaptation of their communications mix

 

'Ibid., pp. VI-54 to v1-55.

43

strategies. Again, further research is required to determine current

awareness levels among present and prospective lessees.

A Model of the Lease versus Purchase
Decision Process

 

 

It is possible to define lease marketing as the performance of
those functions necessary to execute a transaction between lessee and
lessor. However, this definition fails to capture the essential element
of effective lease marketing: the provision of economic benefits to the
lessee. It must be recognized that when a firm purchases an industrial
product, it obtains one set of benefits and when it leases the same
product, it obtains a different benefit set. As a result, lease
marketing may be properly viewed as a product augmentation strategy.1
Product augmentation recognizes that customers do not purchase physical
products, they purchase the "expectation of benefits."2 Augmentation
seeks to provide these benefits in the form of additional services such
as financing, packaging, customer advice, training, warehousing,
delivery, or any other service which provides the consumer with utility.
Leasing, therefore, may be viewed as one additional benefit which may be
used to gain a competitive advantage in the market place.

Whether the lessor is the manufacturer of the product or one of
the various types of leasing organizations, the concept of leasing as an
augmentation strategy is applicable. The augmentation approach focuses

upon the problem-solving nature of the customer's acquisition decision.3

 

1Theodore Levitt, Marketing for Business Growth (New York:
McGraw—Hill, 1974), p. 14.

2

 

Ibid., p. 8. 3Lazer, p. 239.

44

It attempts to identify the benefits which the consumer may obtain
from leasing and seeks to communicate these benefits to the relevant
members of the customer's organization.

Effective communication of the potential benefits of leasing
requires an understanding of the lessee's decision process. In this
regard, a descriptive model of the lease versus purchase decision
procedure has been developed. The purpose of the model is to identify
the relevant variables in the decision process, to explicate the
relationships among the variables and to focus attention on the unique
role of lease versus purchase analysis models in the decision. It is
also hoped that the model will serve to generate hypotheses for future
research in this area. The model draws heavily upon the Sheth and
Webster-Wind models of industrial buyer behavior.1

A graphic summary of the model is shown as Figure l. The model
may be viewed as a special case of the industrial purchasing process in
which the acquisition decision involves a choice between lease and
purchase. While the model is applicable to the situation in which the
acquisition and lease-purchase decisions are made jointly, the following
discussion will focus on the more common situation in which the decision
to lease or purchase is made after it has been determined that the firm
will acquire the asset. This will simplify the discussion and make it
easier to concentrate on those factors which are unique to the lease-
purchase decision.

As Sheth points out, industrial purchasing decisions may be made

by individuals operating autonomously or collectively.2 Thus, the

 

1See, Sheth; and Webster and Wind. 2Sheth, p. 54.

45

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46

lease-purchase decision process [(A) in Figure 1] may be either an
individual decision (Al) or a buying-center decision (A2). Various
factors interact to determine if a given lease—purchase decision will be
made by a group or by a single person. These may be divided into
acquisition-specific factors (Bl) and company-specific factors (82).1

Acquisition-specific factors include such elements as the amount
of perceived risk associated with the decision and the type and size of
the acquisition. If the cost of an incorrect decision is high and a good
deal of uncertainty surrounds its outcomes, the decision is likely to be
made within the buying center. Similarly, if the decision involves a
major capital expenditure or if it is a first-time acquisition, the
decision is also likely to be made by a group. Indeed, many large firms
have institutionalized the buying center for large capital expenditures
in the form of the capital budgeting committee. A third variable which
will have an impact on whether the decision is made by an individual or
by a group of individuals is the amount of time pressure involved. It
is reasonable to assume that the greater the time pressure associate with
the lease-purchase decision, the greater the likelihood it will be
delegated to a single individual.

Company-specific factors include the firm's orientation, its
size, and its degree of centralization. As Sheth points out, if the
firm has a dominant orientation toward an area such as production or
technology, it is likely that the decision will be made by personnel in
those areas.2 If the firm should have a strong financial orientation,

it is probable that the acquisition decision will be made by those

 

'Ibid. 21bid.

47

persons most closely associated with the use and control of the asset,
while the lease-purchase determination will be made by the financial
group. It is also likely that the decision will be made by a group in
the larger, more centralized organization.

In those organizations in which the lease-purchase decision is
made by a group, the relevant unit of analysis is the buying center.
Webster and Wind define the buying center as those perons ”who
interact for the specific purpose of accomplishing the buying task."1
Depsite the obvious transfer-of-title orientation of this term, it is
used in Figure l to represent those individuals who interact for the
purpose of making the lease—purchase decision. Within the buying
center there exists the potential for individuals to act in the
familiar roles of deciders, influencers, buyers, users, and gatekeepers.2
Frequently, the same individual will assume multiple roles during the
decision process. Depending upon the organization, the buying center
may be an informal group or it may be formally sanctioned and highly
structured, as in the case of a capital budgeting committee.

Of particular interest in the decision process is the person who
operates in the role of the analyst-influencer. The analyst-influencer
is the individual who has the responsibility for performing the
financial analysis of the lease versus purchase decision. In most firms,
this individual will be a member of the financial organization and will
have a formal title which may range from controller to financial analyst.
It is the analyst—influencer who applies the firm's buying technology

(the lease-purchase analysis methods) to the decision problem and

 

'webster and Wind, p. 35. 21bid., pp. 78-80.

48

recommends a course of action.1 The analyst's impact on the group
decision will be a function of many factors, including his expertise
(as perceived by the other group members), his status and power within
the organization, and his track record.

The analyst's recommendation to the buying center will be
determined, in large part, by the particular lease—purchase analysis
model he employs. Each analyst has a wide variety of methodologies
from which to choose. It will be demonstrated in Chapter III that
different methodologies will generate different accept-reject decisions
for the same set of data. As a result, the analytical model employed by
the firm can have a major impact on the lease-purchase decision process.
This is particularly true in situations in which the final lease-
purchase determination is delegated to the analyst-influencer as an
autonomous decision. A situation such as this might result in firms
which make the acquisition decision within the buying center but refer
the financing decision (lease versus borrow and buy) to the controller.
In this instance, the analyst-influencer is also acting in the role of
the decider.

Of course, the firm's buying technology (C3) and the analyst-
influencer's recommendations are not the only factors which determine
the outcome of the lease-purchase process. The lease-or-buy decision
must be viewed within the context of the entire range of perceived

benefits resulting from the acquisition. For example, if the analytical

 

1Buying technology may be defined as the problem-solving

procedures employed by the firm. With regard to lease-purchase
decisions, this involves the lease versus purchase analysis models used
by the analyst-influencer.

49

model indicates that the purchase is slightly more attractive than the
lease, the firm may nevertheless choose to lease the equipment if it
believes that the "advantages" of off balance sheet accounting
treatment outweigh the financial disadvantages of the transaction. It
is, therefore, of critical importance to identify the variables which
affect the lease-purchase benefit set.

Many factors interact to determine the perceived benefit set of
the persons involved in the decision process. Individual factors (C4)
including background, education, task orientation, and previous
experience with lease-purchase decisions (feedback) are an important
influence on the perceived benefit set. For instance, an individual
may have a negative attitude toward financial leases because of a belief
that leases are always more expensive than a comparable amount of debt
financing. This belief may be a function of the individual's
educational experiences, since, in the past, the potential economic
benefits of leasing have not been clearly articulated by writers in the
fields of accounting and finance. As a result, an important opportunity
exists for lease marketers to educate relevant members of the
organization to the potential benefits of leasing.

The educational process, of course, depends upon the promotional
program of the lessor. As Figure 1 suggests, certain external
information sources (0) are under the control of the lease marketer.
These sources include advertising, sales promotion, and personal
selling. It is important to recognize that the various elements of the
promotional mix must overcome the perceptual filtering process (01)

before they can have an impact on the perceived benefit set of the

50

prospects.1 In addition, the members of the organization are exposed
to various noncommercial information sources. These alternative
communications stimuli may serve to complement the lessor's promotional
efforts or they may compete with the objectives of the promotional
program. As such, communications mix strategies must be carefully
planned and coordinated in order for them to have their intended effect
on those persons involved in the decision process.

In addition to communicating the relevant benefits of leasing,
the lessor's promotional campaign may be able to suggest alternative
buying technologies for the analysis of lease—purchase decisions. A
properly trained sales force may be able to educate the relevant
analyst-influencer to advanced models which more accurately reflect the
financial advantages of leasing. A carefully designed and integrated
promotional program may be able to stimulate external search behavior
(02) on the part of the analyst. If this results in contact with the
lessor's sales force, the opportunity may exist to analyze the firm's
decision model and to suggest appropriate changes. Depending upon the
specifics of the situation, such contact may lead to a favorable
recommendation with regard to leasing.

Other factors which influence the benefit set include
environmental (Cl) and organizational (C2) variables. Significant
environmental factors include tight money conditions, inflationary
expectations, changes in tax laws and accounting regulations,

competitive conditions in the capital markets, and seasonal fluctuations

 

1James F. Engel, Hugh G. Wales, and Martin R. Warshaw,

Promotional Strategy, 3rd ed. (Homewood, IL: Richard D. Irwin, 1975),
pp. 57-71.

51

in the firm's sales. These factors may operate individually or in
combination to affect the relative merits of leasing versus owning for
a particular firm. As an example, it was previously noted that one of
the most salient advantages of leasing is the ability of firms with low
or sheltered earnings to take advantage of the investment tax credit.
However, changes in the relevant tax laws or the tax status of the firm
could significantly affect this potential advantage. Similarly, tight
money conditions or inflationary expectations could affect a firm's
perceptions of its future credit availability. Such a situation might
encourage a firm to view leasing as a means of "preserving" its

credit lines.

Organizational factors which impact the perceived benefit set
include the capital expenditure authority of middle-level management,
internal accounting and control procedures, and the availability and
quality of in-house maintenance service. Any one of these factors may
act to make leasing appear more or less attractive. For example, a
division or subsidiary manager may be able to circumvent a corporate
capital budgeting committee by leasing rather than purchasing if a
particular acquisition exceeds his expenditure authority. Similarly,
the status of internal maintenance may cause a manager to lease in
order to secure reliable repair service.

Whatever the final composition of the perceived benefit sets of
the individuals involved, the final decision process (A) will resolve
itself in terms of conflict resolution in the case of buying center
decisions and individual deliberation in the case of autonomous

decisions. Sheth notes that conflict among buying center members is

52

the natural consequence of joint decision making. It arises from
differential motivations and expectations among the parties to the
decision process.1 In particular, differential perceptions concerning
the potential benefits of leasing may lead to conflicts among individuals
from different functional areas. These disagreements will arise partly
out of different educational backgrounds and partly as a result of
"company policy of reward for specialized skills and viewpoints."2

Conflict among buying center members is not necessarily bad.
The important question is how the conflict is resolved. If resolution
results from a rational process of problem solving, information seeking
and persuasion, the resultant decision is likely to be congruent with
organizational goals. On the other hand, if resort is made to
bargaining and politicking, the result is likely to be dysfunctional
from the standpoint of corporate objectives.3

The final outcome of the decision process is likely to be
affected by situation-specific factors (E). These include all of the
unpredictable variables which relate to a specific decision setting.
Such production-related events as strikes, machine breakdowns, and
temporary increases in product output may have an impact on the
decision. Other variables might involve ad hoc changes in factor
market conditions. Examples include changes in promotional efforts,
new product introductions, and changes in prices or terms. Organiza-
tional changes such as mergers and acquisitions may also play a role in

the final outcome.4

 

'SNeth, p. 55. 21bid. 31bid. 41bid., p. 56.

53

Once the final decision to lease or purchase is made, the
participants in the decision process will have an opportunity to
monitor the outcomes (F) through the firm's internal information system
(G). This feedback loop is an important factor for future lease-purchase
decisions. As the organization gains knowledge and experience in
dealing with lease—or-buy problems, the decision process itself may
evolve into a more routinized procedure. Formal decision rules may be
adopted and the decision may be delegated to a single individual or
department. The lease marketer, in dealing with an organization of
this type, will find it very difficult to change established procedures
and analysis methods. In most cases, it will fall to the sales force
to identify the lease-purchase decision makers and attempt to effect

changes in the decision process.

Summary and Conclusions

 

This chapter has attempted to outline the major elements in the
lease marketing process. The important participants in the leasing
industry have been identified as manufacturer lessors, captives,
independents, and bank lessors. While each is seen to have its own
unique characteristics, it was pointed out that there is also a certain
amount of overlap with regard to the types of contracts written and the
services performed. Four basic types of lease contracts were identified:
financial leases, leveraged leases, sale-leaseback arrangements, and
operating leases. The central focus of this dissertation is upon the
financial lease.

It has been noted that the potential benefits of leasing are of

particular concern to the lease marketer. This chapter has viewed the

54

lease as a bundle of economic and noneconomic benefits. It was
suggested that one of the most important functions of lease marketing
is to communicate these benefits to the industrial consumer. Seven
potential economic benefits of leasing have been identified. The
realization of these benefits is seen to depend largely on situational
factors. In addition, it appears that certain types of lessors are
better able than others to generate various economic advantages.

A number of other economic and noneconomic "benefits" of leasing
have been identified. It has been shown, however, that some are of
questionable validity. Moreover, a number of the "noneconomic"
advantages appear to be special cases of Nantell's list of economic
benefits.

It has also been noted that there may be an information gap
within industry concerning the potential advantages of leasing. A
review of Wehle's empirical study suggests that many firms may be
leasing in an attempt to obtain illusory benefits. Additional research
is recommended, however, in order to focus on the more salient benefits
which are sought by industrial consumers and to identify the exact
nature of the information gap.

In the final section of the chapter, a model of the lease versus
purchase decision process was introduced. The model views the lease-
purchase decision as a special case of the industrial buying process.
Its central focus is on the perceived benefit set and the factors
which interact to determine these benefits. Of particular interest to
the present research is the individual who operates in this process as

the analyst-influencer. By applying the firm's financial analysis

55

techniques to the lease-or-buy alternatives, the analyst-influencer is
seen as an important contributor to the final decision. The particular
financial model employed by the analyst was identified as the major
factor in determining his recommendation. Given the controversy over
the appropriateness of the many available techniques, an important
Opportunity is seen to exist for lease marketers to promote analysis
models which reflect the true economic advantages of leasing. In the
following chapter, the important lease-purchase decision models are
analyzed and compared. This will set the stage for the empirical
findings on current corporate practice with regard to lease-purchase

analysis models.

CHAPTER III

A SURVEY AND SYNTHESIS OF LEASE
VERSUS PURCHASE MODELS

Introduction

 

The purpose of this chapter is to review the important lease
versus purchase methodologies which exist in the literature. The focus
will be upon the historical development of these models and their
similarities and dissimilarities. One objective of the chapter is to
demonstrate that lease analysis theory developed in an orderly and
sequential fashion as writers attempted to improve upon the models of
their predecessors. Each new model generally added one or two new
elements designed to correct what were perceived to be weaknesses in
previous approaches. This process of building upon the foundations of
previous models has led to an underlying similarity among the various
methodologies. Indeed, it can be shown that a number of models which
appear to be quite different are, in reality, formally identical.

An implicit theme of the chapter is that the form of a lease-
purchase model is, in large part, a function of the theorist's
conceptual orientation. That is, a writer's theoretical view of the
leasing problem is a major factor in determining the kind of analytical
model he will develop. Many of the early writers, for example,
considered the lease to be an alternative financing instrument to debt.
As a result, their models are lease versus borrow approaches. In

contrast, some contemporary writers view the lease as a hybrid,

56

57

containing elements of investment and financing. The models deve10ped
by these theorists attempt to consider both elements simultaneously.
In addition, the newer approaches draw quite heavily on modern capital
asset pricing theory and its implications for corporate investment
decisions.

A numerical example will be used to compare and contrast the
various approaches. The example will be used to demonstrate the
relative magnitude of the differences among the models and to make the
theoretical discussion more concrete. Whenever possible, attempts will
be made to generalize concerning consistent biases which may be present
in the various methodologies.

This chapter deals only with discounted cash flow models.
Discounted cash flow is appropriate to the lease-purchase problem
because the cash streams resulting from the decision take place over
a period of years. The discounting mechanism adjusts for the timing
differences, thus allowing the decision maker to compare the various
cash flows. Although a few models have been excluded because they are
redundant, all of the important discounted cash flow methods are
discussed. The first section of the chapter is devoted to methodologies
which employ the net present value approach. The second deals with
those models which use an internal rate of return criterion.

To facilitate comparisons among the different approaches, all of
the models have been converted to equation form using a common set of
variables. A listing of the most frequently used symbols follows.
Additional variables will be defined as they are needed.

The following symbols and definitions will be employed throughout

the remaining chapters:

58

cash purchase price of the asset,

lease payment required in year i,

depreciation charge for year i allowed for tax purposes,
interest on a loan or loan equivalent in year i (primes
igglpate different methods of computing the equivalent

total pre-tax operating costs expected to be required to
operate the asset in year i if it is purchased,

total pre-tax cash operating costs expected to occur in
year i if the firm purchases the asset, but not if the asset
is leased; this includes such things as insurance,
maintenance and property taxes covered by the lessor,

total pre-tax cash operating costs expected in year i if the
asset is leased,

expected after-tax salvage value of the asset at the end of
year n,

expected pre-tax salvage value of the asset at the end of
year n,

expected book value of the asset at the end of year n,

total cash revenues expected to be generated by the asset
in year i,

outstanding principal on a loan or loan equivalent in year i
(primes indicate different methods of computing the
equivalent loan),

payment of principal and interest on a loan or loan
equivalent in year i (primes indicate different methods of
computing the equivalent loan),

principal repayment component of the loan or loan
equivalent payments in year i (primes indicate different
methods of computing the equivalent loan),

present value of the lease payments,

useful economic life of the asset in years,

corporate average and marginal tax rate on ordinary income,

tax rate applicable to gains and losses on the disposal of
capital assets,

59

k = after-tax weighted average cost of capital for the firm,
k = the firm's opportunity investment rate,
r = pre-tax interest rate on intermediate-term debt,
rt = r(l-t), after-tax interest rate on intermediate-term debt,
r = face rate of return to lessor,
p = pre-tax cost of leasing (internal rate of return), and

= after-tax cost of leasing (internal rate of return).

Net Present Value Models

 

The Eiteman and Davisson model

 

The earliest attempt to apply the discounted cash flow technique
to the lease versus purchase problem appears in Eiteman and Davisson's
1951 monograph.1 A simplified version of their model is shown as
Equation (1):

* n-l R1 Sn
m m
where A: = the maximum profitable purchase price of the asset.

In essence, Equation (1) calculates the present value of the
lease payments plus the pre-tax salvage value foregone by leasing. Both
terms are discounted at the opportunity investment rate, which Eiteman
and Davisson define as "the most profitable rate of return from an

alternative investment of funds."2

The implied decision rule would be
*

to lease if AO < A0, where Ao equals the actual purchase price of the

asset. Thus, the comparison is between the present value cost of

leasing and the present value cost of purchase.

 

1Eiteman and Davisson, pp. 43-57. 2Ibid., p. 43.

 

 

60

While there are a number of problems with this formulation,
perhaps the most obvious is its failure to consider the federal income
tax.1 Lease payments and depreciation expense provide tax shields which
should be included in the equation. In addition, it is the sacrifice of
after-tax salvage value which should be recognized as a cost of leasing.
Sn requires an adjustment to reflect the tax rate applicable to gains
and losses on the disposal of fixed assets.

It is also possible to question Eiteman and Davisson's use of
km as the discount rate and their failure to deal with the implicit debt
financing associated with the lease. However, these considerations will
be dealt with in connection with other lease-purchase analysis models.

From the standpoint of the development of financial analysis
methodologies, Eiteman and Davisson must be credited as pioneers in the
application of discounted cash flow techniques to the lease versus
purchase problem.2 It is clear that their work led, shortly thereafter,
to the development of the "conventional methodology," which is the first

of the modern methods of lease-purchase analysis.3

 

1Eiteman and Davisson apparently believe that taxes are
irrelevant to the lease versus purchase decision. For an illustration
of their confusion on this point, see, ibid., pp. 58-64.

2Prior to the publication of Eiteman and Davisson's work, most

attempts to analyze the lease versus purchase question were either
qualitative in nature or, if they were quantitative, they did not employ
discounted cash flow techniques. See, for example: McNeill; Ernest S.
Als0pp, "Industrial Financing by Purchase Lease," The Appraisal Journal
16 (April 1, 1948): 156-64; John J. Wilson, Jr., "Industrial Financing
Through Own-Lease; 'What-Why-How' of the Method," The Controller 17
(February 1949): 60.

 

 

3Eiteman served on the doctoral committee of Albert H. Cohen who
first presented the "conventional methodology" in his Ph.D. dissertation:
Albert H. Cohen, "Long-Term Net Leasing Practice: Problems of Taxation,
Finance and Accounting" (Ph.D. dissertation, University of Michigan,
1953), pp. 137-58.

 

 

61

The conventional methodology

 

The conventional methodology is a lease versus borrow rather than
a lease versus purchase analysis. That is, the problem is viewed as one
of determining the lowest cost method of financing the firm's operations.
If the firm is in need of a certain amount of intermediate-term
financing in order to acquire the services of a capital asset, a lease
is considered to be an alternative to a bank loan. The requisite cash
flows under each alternative are discounted at an appropriate rate, and
the financing method with the lowest present value "cost" is selected.
Note that the decision to acquire the asset is not at issue.1 This
approach assumes that a previous investment analysis has determined that
the acquisition of the asset's services is profitable from a capital
budgeting standpoint. The apparent circularity in this line of
reasoning has been pointed out by Johnson and Lewellen and will be
discussed in a later section.2

The conventional approach is probably the best known of the lease
analysis methodologies. Slightly modified versions of the method are
still recommended by many contemporary textbooks.3 Rarely, however, is

a specific writer's name linked with the conventional model. While the

 

1J. Fred Weston and Eugene F. Brigham, Managerial Finance, 4th ed.

(Hinsdale, IL: Dryden Press, 1972), p. 462.

2Robert W. Johnson and Wilbur G. Lewellen, “Reply,” Journal of
.Einanpg 28 (September 1973), p. 1025. "“‘“““‘

3See, for example: Weston and Brigham, 5th ed., pp. 478-81;
Erwin Esser Nemmers and Alan E. Grunewald, Basic Managerial Finance,
2nd ed. (St. Paul, MN: West Publishin Co., 1975), pp. 320-37; George N.
Engler, Business Financial Management EDallas, TX: Business Publica-
tions, 1975), pp. 445-51; and R. L. Johnson, Financial Decision Making
(Pacific Palisades, CA: Goodyear Publishing Co., 1973), pp. 279-93.

 

 

 

 

62

best known presentation appears in Weston and Brigham's 1966 text,1 the

earliest published version of the conventional approach is found in

Cohen's 1954 monograph.2

The Cohen model

 

Cohen presents his model within the context of a sale-leaseback
transaction, but his approach is easily generalized to any type of
financial lease. As with all conventional methodologies, he assumes that
the purchase of the asset will be financed with 100 percent debt. Thus,
the net present value cost of the borrow-buy alternative is equal to the
present value of the loan payments minus the present value of the tax
shield provided by the depreciation and interest expense.3

n L. n tD

NPVC(D) = z —-—-'-——.-- '

t1.

1
. 1 .z i .
1=l (l + r) 1=l (l + r) 1

IIM:
A
N
v

1 (l + r)1

where NPVC(D) = the net present value cost of the debt alternative.
The "discounted net cost of leasing"4 is given by the present
value of the after—tax lease payments plus the present value of the

after-tax salvage value foregone by leasing:

 

1J. Fred Weston and Eugene F. Brigham, Managerial Finance, 2nd ed.

(New York: Holt, Rinehart and Winston, 1966), pp. 376-78.

2Albert H. Cohen, Long Term Leases: Problems of Taxation,
Financeland Accounting (Ann Arbor: University of Michigan Press, 1954),
pp. 87- 02.

3Cohen's original model assumed that all cash flows occurred at
the end of each six month period. For purposes of comparability,
Equations (2) and (3) have been adjusted so that cash flows are assumed
to occur at the end of each year.

 

 

 

4Cohen, Long Term Leases, p. 92.

 

63

R. n tR. V
'I _ l + n (3)

NPVC L = -
( ) 1 (1 + r)1 121 (1 + r)1 (l + r)n

1'

 

"M:

where NPVC(L) = the net present value cost of the lease alternative.
Subtracting Equation (3) from Equation (2) and rearranging, we

obtain the net present value advantage of leasing (NAL):

NAL

NPVC(D) - NPVC(L)

n Li n R1 n 1
NAL z——-,--z—————;-+z-——r-Z——T
1:] (1 + r) i=1 (1 + r) i=1 (1 + F) 1:1 (1 + r)

tIi Vn (4)
l (l + r)i (l + r)n

l
IIM:

.i

The decision rule would be to lease the asset if NAL > 0.
One of the interesting features of Cohen's approach is his failure
to specify the appropriate discount rate for Equation (4). The discount

rate he uses in his example is the pre-tax rate of interest on the loan.

1

However, he states that this choice is "purely arbitrary." Cohen's

initial example assumes that the loan rate is equal to the "face rate of

return" to the lessor,2 and he suggests that a somewhat higher rate of

 

11bid., p. 89h.

2The "face rate of return" to the lessor is the interest rate
which discounts the lease payments back to the purchase price of the
asset. It is found by solving the following equation for r1:

n R1
O=-A + z —-——-—.—
0 i=1 (1+r1)1

64

discount may be appropriate.1 Unfortunately, he does not specify how
this rate should be determined.

Cohen's failure to specify the discount rate is significant in
light of the fact that much of the contemporary debate over lease-
purchase models centers on the question of the appropriate discount
rates. Because of the ambiguity concerning the rate of discount,
Cohen's model lacks generality. As a necessary condition for a lease
versus purchase methodology to be considered a general model, it must
either designate the appropriate discount rates or, failing this, it
must at least specify a theory which describes how these rates are to
be determined.

The Weston and Craig and early Weston
and Brigham models

 

 

Cohen was not the only early writer to neglect to specify the
rate of discount. In 1960 Weston and Craig presented a model which is
virtually identical to Cohen's.2 The only difference is that Weston and
Craig assume a zero salvage value:

n L

11
NAL= z ————1-- 2
i=1 (1+r) i=

tIi

I
IIM:

11(1+r)'

Thus, the sixth term on the right hand side of Cohen's Equation (4) does

not appear in Weston and Craig's model.

 

1Cohen, Long_Term Leases, p. 89h.

2J. Fred Weston and Rupert Craig, “Understanding Lease Financing,"
California Management Review 2 (Winter 1960): 67-75.

 

65

Weston and Craig also use the pre-tax loan rate to discount the
various cash flows but give no justification for the use of this
particular discount rate. The apparent reason is that their stated
objective in developing the model is to show that "it is possible to set
up a transaction in which there is no advantage from a financial
standpoint to either leasing or owning.“1 (Indeed, their numerical
example shows a net present value disadvantage to leasing of a negligible
$4.46.) Clearly, Weston and Craig were not attempting to develop a
general lease-purchase analysis method at this particular time.

The Weston and Craig model served as a basis for the development
of the well-known Weston and Brigham lease analysis models. When Weston

wrote Managerial Finance in 1962, he presented the Weston and Craig

 

model without alteration in his chapter on short and intermediate-term

financing.2

In 1966, however, Eugene F. Brigham joined Weston as
coauthor, and an attempt was made to present a general lease-purchase
analysis methodology.3 This was accomplished by specifying the after-
tax weighted average cost of capital as the appropriate rate of

discount in the original Weston and Craig equation:

n Li n R n tR. n tD.
NAL=.Z *7“? ““""1“‘_1"+_Z _~—_L—T' 224—1-
1=1 (1+kt) 1:1 (1+ kt) I=1 (1+kt) 1:1 (1+ kt)
n tIi
_ ,3 ___._1. (6)
i=1 (1+-kt)

 

11616., p. 68.

2J. Fred Weston, Managerial Finance (New York: Holt, Rinehart
and Winston, 1962), pp. 305-308.

 

3Weston and Brigham, 2nd ed., pp. 376-81.

 

66

Equation (6) is probably the best known version of the conventional
approach. It is this model, with some slight variations, which appears
in many of the popular textbooks published in the late 1960s.1
It is interesting to consider the special case of Equation (6)
when r, the rate of interest on the loan, equals r1, the face rate of
return to the lessor.2 In this instance, L1 will equal Ri (assuming
level lease and debt payments), and Equation (6) reduces to:
tRi n tD.

_______?._ z .____;Lzr
1 (1'tkt) t=1 (1+ kt) i

tI.
NAL = '
1

11M:
"M:

1m '6')
t
Thus, the lease versus borrow decision becomes a question of comparative
tax shields. While the total tax shield under the two alternatives is
the same (that is, tRi = tDi + tli)’ the tax shields under the borrow—
buy option are greater in the early years because of accelerated
depreciation and the annuity method of calculating interest on term
loans. As a result, NAL will be negative for all values of kt greater
than zero, and the debt alternative will be preferred. In other words,
the differential timing of the tax shield cash flows favors ownership
when r = r1.3
Similar generalizations concerning the sign of NAL are not

possible when r # r1. The outcome will depend to a large extent on the

 

1See, for example: James C. Van Horne, Financial Management and
Polic (Englewood Cliffs, NJ: Prentice-Hall, 1968), pp. 264-66; Elvin F.
DonalUson and John K. Pfahl, Corporate Finance, 3rd ed. (New York:
Ronald Press Co., 1969), pp. 262-64; and James C. T. Mao, Quantitative
Analysis of Financial Decisions (New York: Macmillan Co.,il969),
pp. 323-24}

2Note that this may not be an unreasonable assumption under strong
competitive conditions.

3

 

 

 

See, for example, Weston and Brigham, 2nd ed., p. 377.

67

relative magnitudes of r, r1, and kt“ In addition, if it is assumed
that less than 100 percent financing is available under the debt
alternative or if compensating balances are required, the analysis could
shift in favor of leasing even if r = r1.1
A number of important criticisms have been leveled against the
conventional methodology. One of the earliest writers to question this
approach was Richard Vancil.2 It is Vancil's contention that the net
present value advantage of the lease calculated using the conventional
model reflects the intermingled effects of the tax shields and the
amount of financing provided by each alternative. Typically, the lease
and debt alternatives provide the firm with different amounts of
financing over the life of the asset.3 Vancil argues that it is
desirable to eliminate from the analysis the difference in the amount of
financing because alternative means of finance are always available to
the firm. In other words, the lease-or-buy decision should focus on the
differential tax effects of the two alternatives and should not be
influenced by the amount of financing provided by each plan.4 It is
this concern which led Vancil to develop his own lease-purchase model,

known as the Basic Interest Rate method.5

 

1See, for example, Mao, p. 327.

2Richard F. Vancil, "Lease or Borrow: New Method of Analysis,"
Harvard Business Review 39 (September-October 1961), reprinted in
Leasing Series (Boston: Harvard Business Review, n.d.,), pp. 79-93.

3

 

Mao, p. 328. 4Vancil, "New Method," p. 89.
51bid., pp. 79-93.

68

The Basic Interest Rate (BIR) method
Unlike the conventional model, the BIR method is not a strict
lease or borrow analysis. Indeed, the primary objective of Vancil's
technique is to eliminate the differential effects of financing from
the lease-purchase comparison. For the purchase alternative, this is
done by calculating the net present value cost of purchase as shown in
Equation (7):1
n tD.
NPVC(P) = A0 - .2: -———'—1- (7)
1=l (1+-kt)
where NPVC(P) = the net present value cost of purchase. Equation (7)
makes no assumptions concerning the method of financing the purchase.
This in in contrast to Equation (2) which explicitly assumes the
acquisition is financed with 100 percent debt:
L.

____1_____
1(1+r)' i

t0. t1.
1 1

II M:
11M:
11M:

NPVC(D) =

i 1(1+r)'11(1+r)'

Following a similar line of reasoning, one might expect the
BIR method to calculate the cost of leasing as the present value of the
lease payments net of the present value of the tax shield provided by
the lease expense:

R.
1

__—-—-——T—-

1 .
l (1+-kt) 1

tRi
1————(1+kt). (8)

11M:
11M:

NPVC(L) =
1

However, Vancil argues that the lease payments include an implied

 

1Vancil's original model assumed a zero salvage value. For his
recommended treatment of salvage, see, Richard F. Vancil, "Lease or
Borrow: Steps in Negotiation," Harvard Business Review 39 (November-
December 1961), reprinted in Leasing Series (Boston: Harvard Business
Review, n.d.), pp. 94-109.

 

 

69

interest charge which must be removed in order to make the lease
alternative comparable to the purchase alternative.1 This is done

by adjusting both terms in Equation (8). First, the implicit financing
in the tax shield term is neutralized by backing an implied interest tax
shield out of the tax savings provided by the lease payments. Vancil
makes this adjustment because there is a tax advantage in writing off

2 That is to

the lease payments instead of the depreciation expense.
say, the present value of the tax savings from Equation (8) will exceed
the present value of tax savings from Equation (7):

tR.

1 >

1 .
l (1+-kt) 1

tD.

.___;L__? (9)
1 (1+kt)

Ill"):
"M:

.i

Vancil argues that this is not a true advantage, however, since alterna—
tive debt financing (and an interest tax shield) could be obtained if
the lease commitments are not undertaken.

Under the assumption that alternative debt financing is available,
Vancil constructs an "equivalent loan" in order to determine the amount
of the interest tax shield that should be removed from the lease

3

payments' tax shield. The equivalent loan is meant to represent the

bank loan which would be available to the firm if it does not enter

 

1Under a "full-payout" or financial lease, the sum of the lease
payments exceeds the cost of the asset. Thus, Vancil views the excess
over the purchase price as the implicit rate of ”interest” earned by
the lessor.

2Myron J. Gordon, "A General Solution to the Buy or Lease
Decision: A Pedagogical Note," Journal of Finance 29 (March 1974):
247-48.

3McEachron was actually the first to apply the equivalent loan
concept to the lease or purchase decision. See, William D. McEachron,
"Leasing: A Discounted Cash-Flow Approach," The Controller 29 (May
1961): 213-19.

 

 

70

into the lease. Thus, it must be "equivalent“ to the lease in its
amount and in the timing of its payments.

Vancil creates the loan by assuming a principal amount Ao equal
to the purchase price of the asset, and an interest rate r equal to the
firm's pre-tax cost of intermediate-term debt. The latter is the Basic
Interest Rate and is defined as the minimum rate the firm would have to
pay to secure an equivalent amount of funds for an equivalent time
period. The lease payments R1 become the repayments of interest and

principal on the loan. Thus, if we assume the following:1

A0 = $15,000

Ri = $4,200
r = 8 percent, and
n = 5 years,

an amortization schedule for the equivalent loan would be as shown in
Table 1.2 Note that the lease payments in the second column ”overamor-
tize” the principal amount of $15,000. This is because the return
implicit in the lease (12.38 percent)3 exceeds the basic interest rate

of 8 percent.

 

1These figures are taken from the example which appears in
Robert W. Johnson and Wilbur G. Lewellen, "Analysis of the Lease-or-Buy
Decision," Journal of Finance 27 (September 1972), p. 820.

2To be consistent with Johnson and Lewellen's example, Table 1
assumes that the lease payments are due at the end of each year.

3Calculated as follows:
n R.
0=-A0+ 22 ———'—-—-—-1=-
i=1 (1 + r1)
5 4200
O = -15,000 + X -———L———-— r = .1238

i=1 (1+ r1)1 1

 

71

TABLE 1

AMORTIZATION SCHEDULE FOR VANCIL'S
EQUIVALENT LOAN

 

 

 

RI 1: . 01. 1’1.
End of "Loan" 1 "Pr1nc1pal" Rema1n1ng
Year Payment "Interest" Repayment Balance
0 --- --- --- $15,000
1 $ 4,200 $1,200 $ 3,000 12,000
2 4,200 960 3,240 8,760
3 4,200 701 3,499 5,261
4 4,200 421 3,779 1,482
5 4,200 119 4,081
$21,000 $3,401 $17,599

 

The present value of the tax shield provided by the "equivalent
interest" of column 3 enters Equation (8) as a positive number in order

to reduce the tax savings provided by the lease payments:

n R1 n tRi n t1;
NPVC(L) = z ——-————7-- 2 """"1'+ z ’"““‘T (8')
i=1 (1+-kt) i=1 (1+ kt) i=1 (1+-kt)

where 1% = the interest on the equivalent loan. Thus, the first
adjustment to Equation (8) removes the differential financing element
from the lease tax shield.
The second adjustment corrects for the incremental cost of the
higher interest rate implicit in the first term of Equation (8').
Vancil views the Basic Interest Rate as "an unavoidable cost of any
1

financing plan." As a result, he “penalizes” the lease alternative

to the extent that it involves an interest rate which is higher than

 

1Vancil, ”New Method,” p. 90.

 

 

72

the BIR. This is done by discounting R1 at the Basic Interest Rate
instead of the cost of capital:

n Ri tRi n t1;
NPVC(L) = z ———————- - + z -—-———-—- (8”)

ifl 04-w' i-Iu+kn' i-Iu+k9'

M3

The full impact of this adjustment will be seen more easily when
Equation (8") is subtracted from Equation (7) in order to determine the

net present value advantage of the lease.1

NAL = NPVC(P) - NPVC(L)
n R. n tD n tRi
NAL = A0 - z -———l——7-- z ‘"“l"1'+ z 1
i=1 (1 + r) 1:1 (1+-kt) i=1 (1+-kt)
n t1;
- >3 -—-——--1.- (9)
i=1 (1+kt)

Equation (9) has been rearranged so that the cash outflows under each
alternative are represented by the first two terms on the right hand
side and the tax savings are represented by the last three terms.2 The
difference between the first two terms represents what Vancil calls the
"lessor's premium."3 It is the difference between the purchase price
outflow and the present value of the lease payments outflow. As long as

the implicit interest rate on the lease exceeds the cost of alternative

 

1The indexing of Equation (9) assumes that lease payments are due
at the end of each year. While Vancil's model assumes prepayment, the
adjustment has been made to facilitate comparisons with other models.

2This is similar to the approach taken by Bower. See, Richard S.
Bower, "Issues in Lease Financing," Financial Management 2 (Winter 1973),
p. 26.

 

3Vanci1, ”New Method," p. 92.

73

means of finance (the BIR), the lessor's premium in Equation (9) will be
negative. In other words, the lease will be charged with an additional
amount reflecting the incremental interest cost of the lease over and
above the firm's Basic Interest Rate. From the lessor's standpoint,
this premium represents "a payment . . . for assuming the auxiliary
financing costs connected with the transaction and for his profit or fee
for arranging the transaction."1 In the special case in which r = r1,
the first two terms would cancel, and the net advantage of leasing

would be determined by the present value of the comparative tax shields.
This is analogous to the special case presented in Equation (6').

The last two terms in Equation (9) represent what Vancil refers
to as the "equivalent depreciation" tax shield.2 The net "equivalent
depreciation" shield enters as a positive number to offset the tax
savings on the depreciation foregone by leasing rather than purchasing.

To the extent that,

n tR.

1
.2 '_—___—ET . '——‘—_—Ti > .
1=l (l-fkt) 1=l (1+-kt) 1

t0.
1

i
1 (1 +kt)

t1!
1

M:

"M:

the tax effect would favor leasing. However, no generalizations can be

made concerning a consistent bias in Equation (9).3 As in the case of

 

'Ibid. It should be pointed out that r, need not exceed r in
order for the lessor to make a profit. Factors such as accelerated
depreciation, the federal income tax rate, the investment tax credit,
and estimated residual values may make the lease profitable even if
r < r.

1

2Ibid., p. 91.

3This is in agreement with Findlay's assessment. See, M. Chapman
Findlay, III, "Financial Lease Evaluation: Survey and Synthesis,” paper
presented at the Eastern Finance Association meeting, Storrs, CN,
April 12, 1973, PP. 2—3.

74

Equation (6), much will depend on the relative magnitudes of r, r1, and
kt'
Vancil's original objective in neutralizing the financial element
in Equation (9) was "to eliminate the difference in the amount of
financing provided when comparing specific proposals."] However,
several authors have pointed out that Vancil's use of the equivalent
loan device overcomes a more important criticism of the conventional
lease versus borrow model.2 Since leasing typically provides more
financing than debt, the firm will face higher fixed charges with the

lease alternative than with the debt alternative.3

These higher fixed
charges will raise the financial risk of the firm and may cause
investors to increase the required rate of return on the firm's

securities.4

This "capital structure effect" becomes an implicit cost
of lease financing. The use of the equivalent loan comes very close
to holding financial risk constant in comparisons between lease and
purchase cash flows. The entry of the "equivalent interest” tax
shield as a negative number in Equation (9) is, in effect, an offset
against the impact of the lease on the overall cost of capital of the
firm.5
At this point it may be useful to introduce a numerical example

in order to make explicit the differences between Vancil's model and

the conventional methodology. The example which appears in Johnson and

 

1Vancil, "New Method,” p. 89.

2See, for example, Mao, pp. 328-29; Findlay, pp. la-lb; and
Bower, p. 30.

3Mao, p. 328. 4Van Horne, pp. 220-44.

5Findlay, p. la; and Bower, p. 30.

75

Lewellen's well-known article will be used for this purpose.1 It will
be particularly convenient to employ the Johnson and Lewellen figures
since this example was used to construct Vancil's equivalent loan in
Table 1.

Johnson and Lewellen assume the following values:

A0 = $15,000 r = 8 percent
Ri = $4,200 t = 50 percent
n = 5 years kt = 12 percent

The lease is assumed to have a term of 5 years. If the asset is
purchased, it will be fully depreciated over its useful economic life
using the sum of the years' digits method. The depreciation schedule
is shown as Table 2. All cash flows, with the exception of the
purchase price, are assumed to occur at the end of each year. An
amortization for a five-year 8 percent bank term loan of $15,000 is

given as Table 3.

TABLE 2

DEPRECIATION SCHEDULE FOR THE JOHNSON
AND LEWELLEN EXAMPLE

 

 

End of Year Depreciation Expense

 

$ 5,000
4,000
3,000
2,000
1,000

$15,000

01-5me

 

 

1Johnson and Lewellen, "Lease-or-Buy,” p. 820.

76

TABLE 3

TERM LOAN AMORTIZATION SCHEDULE FOR THE JOHNSON

AND LEWELLEN EXAMPLE

 

 

 

End of Installment Principal Remaining
Year Payment Interest Repayment Balance
1 $ 3,757 $1,200 $ 2,557 $12,443
2 3,757 995 2,762 9,681
3 3,757 774 2,983 6,698
4 3,757 536 3,221 3,477
5 3,757 280 3,477
$18,785 $3,785 $15,000

 

The Johnson and Lewellen example assumes values for two
additional variables which are not included in the conventional model
of Equation (6) or Vancil's Equation (9). First, a pre-tax salvage
value of $1,500 is assumed at the end of the fifth year. It is further
assumed that the tax rate applicable to gains and losses on the disposal
of fixed assets is 30 percent. As such, the after—tax salvage value is

calculated as follows:

Vn = Sn - tg(Sn - Bn)
where Vn = after-tax salvage at the end of year n,
Sn = pre-tax salvage at the end of year n,
t9 = tax rate applicable to gains and losses on fixed assets, and
8n = book value at the end of year n.

For the Johnson and Lewellen problem, pre-tax salvage is $1,050:

Vn = $1,050 = $1,500 - .30($1,500 - O).

 

77

The second variable assumed by Johnson and Lewellen is 01, the
pre-tax operating costs expected to occur in year i if the asset is
purchased, but not if it is leased. This arises because the example
assumes the lessor will pay a portion of the asset's operating costs.
Thus, 0i represents costs which will be avoided if the asset is leased.
These costs are assumed to be $1,000 per year over the term of the
lease.

To facilitate comparisons with models which will be presented
later in the chapter, these additional variables will be added to
Equations (6) and (9). In each case, their treatment will be consistent
with the theoretical framework of the model. For example, in a
subsequent article, Vancil indicated that after-tax salvage value
should be discounted at kt because it is ”not contractual in nature.”1
Following a similar line of reasoning, it is assumed that Vancil would
discount the after-tax operating costs avoided by leasing at the same
rate, since these too are non-contractual cash flows. This treatment of
Oi is reinforced by the fact that Vancil discounts all of the tax
shields at kt’ despite the fact that these are not risky operating
flows.

With the addition of these two variables, Equation (9) would

look as follows:

n R1 n tD. n tR.
NAL=Ao‘Z’—"—T‘Z——L—T+Z '1.
i=1 (1 + r) i=1(1+kt) i=1(1+kt)
n tI! n O (1- t) V
- .2 __+_1__1.+ .2 ._.1_._.__1.__ ____r_'___fi_ (9')
1-1 (1 kt) 1-1 (1+kt) (1+kt)

 

1Vancil, ”Steps in Negotiation,” p. 95.

78

The present value of the after-tax operating savings associated with
the lease enters as a positive number, since these savings are a
benefit of leasing. The present value of after-tax salvage, on the
other hand, enters as a negative number, since this is a benefit which
is foregone by leasing.

Applying this equation to the Johnson and Lewellen example, we

find that the net present value advantage of leasing is a negative $143:

- $143 = $15,000 - $16,769 - $5,813 + $7,570 - $1,337 + $1,802
— $596 (9')

In other words, the Basic Interest Rate method favors the purchase
alternative for this particular numerical example.
In a similar manner, Equation (6) may be adjusted to account for

operating savings and salvage value:

n Li H R. 11 t0. n tR'
NAL= I: *7”? _“]‘_f‘ X '—1_i'+ Z “l“?
i=1 (1+kt) 1=1 (1+kt) (=1 (1+kt1 1:1 (1+kt)
n tI. n O.(l -'t) V
_ g ————l————-+ 2 -l—--- - ———-IL*“ (6")

i . i n
1 (1+ kt) 1 1 (1+ kt) (1+ kt)

Both 01(1 - t) and Vn have been discounted at k in keeping with the

t
conventional methodology's use of a single discount rate for all cash
flows. The terms of Equation (6") have been rearranged to facilitate
comparisons with Equation (9').

Application of the conventional model's equation to the numerical

example results in a net present value advantage to leasing of a

negative $92:

79

- $92 = $13,543 - $15,140 - $5,813 + $7,570 - $1,458 + $1,802
- $596 (6")

Once again, the purchase is the preferred alternative for the Johnson
and Lewellen example.

A comparison of the present values of the components of
Equations (9') and (6") indicates that they differ with respect to only
three terms. First, the initial term in Equation (6") is the present
value of the loan payments discounted at kt’ whereas the comparable
term in Equation (9') is the purchase price of the asset. This
difference is accounted for by the fact that Equation (6”) assumes the
purchase is financed with 100 percent debt, while the BIR method of
Equation (9') assumes a "cash purchase."1

The second difference concerns the present value of the lease
payments in each equation. Vancil's model discounts the annual lease
payments at the debt rate in order to penalize the lease for its higher
implicit interest charge. This results in a present value of $16,769.

In Equation (6”) the lease payments are discounted at k , resulting in

t
a present value of $15,140. Note that this present value closely
approximates the purchase price of $15,000. The reason for this is
that kt is very close to r1 (12 percent versus 12.38 percent).

The final difference in the two methods concerns the calculation
of the interest tax shield. In Equation (6”) the interest expense is
calculated under the assumption that the purchase will be financed with

an 8 percent bank loan in the principal amount of $15,000. The interest

expense from Table 3 provides the tax shelter which enters Equation (6").

 

1Vancil, ”New Method," p. 87.

80

The interest tax shield in Equation (9'), on the other hand, is an
"equivalent interest" tax shelter and is provided by the "interest"
calculated in Table l. The present value of the equivalent interest
tax shield is $121 less than the shield calculated under the conventional
borrow-and-buy assumption.

These various differences tend to net out, so that the net
present value advantage of the lease generated by the two models is
very close, and the decision in favor of purchase is the same. It is
likely that under normal lease versus purchase assumptions, both models

will lead to the same decision.

Criticisms of the conventional and BIR models. Two important
criticisms of the conventional methodology have already been discussed.
Both relate to the fact that different amounts of financing are
involved in the lease and purchase alternatives. The first concerns
Vancil's original argument that the differential financing element
should be eliminated from the analysis because alternative sources of
funds are available to the firm. The second points out that Vancil's
attempt to neutralize the implicit debt financing of the lease adjusts
for the impact of the higher fixed charges of leasing on the firm's
cost of capital.

Two other important criticisms apply to both the conventional
method and the Vancil model. The most significant relates to the fact
that both models discount relatively risk-free cash flows at the firm's
weighted average cost of capital. The use of kt as a discount rate is
only appropriate for cash flows with risk characteristics equal to the

risk of the average investment cash flows of the firm. This is because

81

kt "embodies a risk premium for the firm as a whoie."1 As such, kt
should not be applied to cash streams which are nearly risk free.

The conventional model is perhaps the worst offender in this
respect since it discounts all cash flows at the cost of capital. These
include the contractual flows represented by the loan and lease payments
as well as all of the tax shields. The contractual flows are relatively
riskless since they represent legal obligations of the firm which must be
paid in order to avoid bankruptcy.2 Similarly, the tax shields provided
by depreciation, interest, and lease expense are highly certain streams,
representing, in effect, financial transactions with the government.3
The major source of risk associated with these particular tax shields
is political in nature and would result from a change in the corporate
income tax rate.4

A similar criticism applies to Vancil's use of kt as the
discount rate for the tax savings of Equation (9). However, his use of
r as the rate of discount for the lease expense is, in effect, an
adjustment for the relative certainty of this payment stream. Although
his discussion of this point is somewhat ambiguous, it is clear that
this was not Vancil's original intention. As discussed previously, the
use of r as the discount rate for R1 is designed to penalize the lease

for having an implicit interest rate which exceeds the BIR.5

 

1Van Horne, 3rd ed., p. 588.
2Neston and Brigham, 5th ed., p. 480n. 3FindIay, p. 2.

4A discussion of the appropriate discount rates for Oi(l - t) and
Vn will be deferred to a later section since these variables were not
included in the original models.

5Vancil, ”New Method," p. 90.

 

82

The second criticism which applies to both the conventional and
BIR methods is that they view the lease-purchase analysis as a pure
financing decision. In other words, it is assumed that a previous
investment analysis has determined that a purchase of the asset is
profitable from a capital budgeting standpoint. As Vancil states:
The first step in the analysis of financial leases . . .
is to compare the alternative of purchasing the equipment for
cash with the alternative of continuing the status quo. This
is another routine investment decision. If purchase does not

appear desirable, a financial lease will probably not be
desirable either. . . .

Thus, the consideration of a financial lease should begin
only after a company has previously decided that the purchase
of a piece of eqpipment is desirable.1
That is, the analysis models of Equations (6) and (9) are designed to
determine the lowest cost method of financing the transaction and are
not concerned with the decision to acquire the use of the asset.
This separation of the acquisition and leasing decision has been
criticized by Johnson and Lewellen who point out that:
If one unhinges the two, one can never allow a very
attractive lease to reverse an original negative purchase
decision; indeed, the lease analysis would never be
undertaken if the NPV of purchase were unattractive.2
They go on to note that "almost any asset is acceptable at some
sufficiently low price, even if that low price happens to take the form
of a lease arrangement."3 Thus, Johnson and Lewellen conclude that the
lease alternative is inextricably linked to the acquisition decision and
is not a separate, purely financial, decision.4
In fairness to Vancil, it should be pointed out that he

recognizes the possibility that an extremely low rate lease might be

1

 

Ibid., p. 86. 2Johnson and Lewellen, ”Reply,” p. 1025.

4

3Ibid. Ibid.

83

attractive when a purchase proves to be unprofitable. However, he
considers this to be a "highly unusual case,"1 and his Basic Interest
Rate method makes no provision for such an eventuality.

A final criticism of the Basic Interest Rate approach concerns
Vancil's method of constructing the equivalent loan. It will be recalled
that Vancil's loan is for a principal amount equal to the purchase price
of the asset and that the assumed interest rate is r, the firm's
pre-tax cost of debt capital. As shown in Table 1, the use of the
annual lease expense as the repayment of interest and principal leads to
an "over-amortization" of principal when r1 > r. One may reasonably ask
if a loan constructed in this fashion is really "equivalent" to the
lease and if the interest tax shield generated by such a loan is the
appropriate "equivalent interest" cash flow. This same question was
asked by Bower, Herringer, and Williamson when they developed an
alternative lease versus purchase model in 1966.2 Bower et a1.
construct a loan equivalent which is amortized at the same proportional
rate as the lease, in the belief that "the proper assumption is that a
lease payment schedule of any configuration [should be] matched by a

3 The actual

loan or series of loans with the same configuration."
method of constructing this equivalent loan will be covered in the

following section.

 

1Vancil, "New Method," p. 86.

2Richard S. Bower, Frank C. Herringer, and J. Peter Williamson,
"Lease Evaluation," Accounting Review 41 (April 1966): 257-65.

3

 

Ibid., p. 260.

84

The Bower, Herringer, and Williamson model

Mathematically, the Bower, Herringer, and Williamson (BHW) model
is virtually identical to the expanded version of the BIR method given
by Equation (9'). The only difference lies in the calculation of the
equivalent interest tax shield. This is represented by the double

primes on the fifth term on the right hand side of the BHW formulation:1

n R. n tD. n tRi
NAL = A0 - 2 ————l——?-- 2 1 1 + z 1
i=1 (1 + r) 1=1 (1+ kt) i=1 (1+ kt)
n tIV n O.(l- t) V
_ z ____;L__,.+ Z _l______r _ ____IL___ (10)

Both Oi(l - t) and Vn are included in the original presentation of this
2

model, and both are discounted at kt’

Despite the mathematical similarity of the two models, the
conceptual-theoretical approach of Bower and his colleagues is quite
different from that of Vancil. For example, BHW are the first to relate
the lease or purchase decision to the objective of maximizing

3

shareholder wealth. As such, they do not talk in terms of the “cost”

 

1It is interesting to note that Bower, Herringer, and Williamson
were the first to express their model in semiequation form. The other
models which have been discussed up to this point have been converted
from tabular to equation form for the purposes of comparability.

2BHW apply the ordinary income tax rate t to pre-tax salvage
value. Thus far t has been used as the tax rate applicable to gains
and losses on the gisposal of fixed assets. The latter is the more
general form since it allows for the possibility that t may not equal
t . See, Johnson and Lewellen, "Lease-or-Buy,” p. 819n.

9
3Modern financial theory is premised on the assumption that the
objective of the firm is to maximize shareholder wealth. See, for
example, Ezra Solomon, The Theory of Financial Management (New York:
Columbia University Press, 1963), pp. 15-25; James T. S. Porterfield,

 

85

of the lease alternative but rather in terms of "how the market value of
the firm will be affected by the lease choice.“1
In addition, their use of r as the discount rate for the lease
payments is a recognition of the greater certainty of this contractual
cash flow. This is reinforced by the fact that BHW do not employ the
term "lessor's premium" in describing the difference between the first
two terms of Equation (10):
n R.
AO - .2 -——-¥L—-T (ll)
1=1 (l + r)
BHW refer to this as the financial advantage or disadvantage of the
lease and state that it represents the difference between "the market

2 Their use of

value of the lease and the loan that could replace it."
the term "market value" implies that investors recognize the greater
certainty of the lease payment stream and apply a lower discount rate
to this flow in valuing the firm. They go on to state that:
The rates kt and r and the optimal mix of debt and

equity are related to the risk in the firm's flows. If

leasing changes this risk, . . . then lease and loan

alternatives can be evaluated using different rates.3
Thus, we see for the first time a recognition of the fact that the
differential risk of the cash flows involved in the leasing analysis

require the use of different risk-adjusted discount rates. It may be

 

Investment Decisions and Capital Costs (Englewood Cliffs, NJ: Prentice-
Hall, 1965), pp. 5-19; and Van Horne, 3rd ed., pp. 6-9.
1Bower, Herringer, and Williamson, p. 259.

2Ibid. The authors assume that the equivalent loan is for
principal amount A0.

3Ibid.. pp. 259-60.

86

said that this recognition stems directly from their use of shareholder
wealth maximization as the objective of the firm, and it underscores
the dependence of normative theory on a precise specification of goals.

Unfortunately, Bower, Herringer, and Williamson do not recognize
that the tax shields generated by the lease and purchase alternatives
are also highly certain flows. They take the same approach as Vancil
in discounting these flows at kt' Similarly, it has been argued that
the operating expenses assumed by the lessor "are fixed charges subject
to little or no uncertainty,"1 and should, therefore, be discounted at
a relatively low rate.2 On the other hand, Vn is a random variable
subject to a great deal of uncertainty. Thus, a discount rate in the
vicinity of kt may be justified in the case of after-tax salvage.

The important computational difference between the Vancil and BHW
models concerns the calculation of the equivalent interest tax shield.
As stated previously, BHW's equivalent loan has payments which are
proportional to the lease expense in each period. The proportion is
equal to the purchase price of the asset (the required loan) divided by
the present value of the lease payments. Thus, the repayment of princi-

pal and interest in each period would be calculated as follows:
L. = R.IIAOI/<ao)1 (12)

where L; = BHW's equivalent loan payments, and

R.
1

l (l + r)1

”M:

J :
0 i

 

1Gordon, p. 247.

2A similar and somewhat more complex argument has been made by
Findlay, p. 4, and will be discussed in a later section.

87

This method of constructing the equivalent loan avoids the
problem of over-amortization. Table 4 demonstrates the BHW method
using the Johnson and Lewellen example. It is interesting to note that
the loan constructed in Table 4 is identical to the term loan of Table 3.
This results because of the assumption of level lease and debt payments
and the assumption that both payments are made at the same time during
the year. As long as these two assumptions hold, the BHW method will
generate an interest tax shield which is equal to the one assumed by

the conventional model.

TABLE 4
AMORTIZATION SCHEDULE FOR BHW'S EQUIVALENT LOAN

 

 

 

Ri L1 1: . 01 P1
End of Lease ”Loan" - 1 ”Pr1nc1pal" Remaining
Year Payments Payments "Interest” Repayment Balance
0 --- --- --- --— $15,000
1 $ 4,200 $ 3,757 $1,200 $ 2,557 12,443
2 4,200 3,757 995 2,762 9,681
3 4,200 3,757 774 2,983 6,698
4 4,200 3,757 536 3,221 3,477
5 4,200 3,757 280 3,477
$21,000 $18,785 $3,785 $15,000

 

Substituting the previously calculated values from Equation (6”)
and (9') into Equation (10), we find that the BHW model gives an NAL of

-$264 for the Johnson and Lewellen example:

- $264 = $15,000 — $16,769 - $5,813 + $7,570 - $1,458
+ $1,802 - $596 (10)

88

This amount is $121 less than the net present value advantage of the
lease given by the BIR equation. The total difference is accounted for
by the larger interest shield generated by BHW's equivalent loan. For
a given lease-purchase analysis, the BHW method will be less favorable
to the lease as long as r1 > r. When r1 = r, the two methods will give
identical results, and when r1 < r the BHW method will be more

favorable to the lease than Vancil's method.

The Bierman and Smidt model

 

All of the models presented thus far fail to adjust for the
relative certainty of the tax shields generated by the lease and
purchase options. The first model to make this adjustment was
presented by Bierman and Smidt in the second edition of their well-known

work, The Capital Budgeting Decision.1 Bierman and Smidt view the lease-

 

purchase analysis as a financing decision in which all cash flows are
discounted at the after-tax cost of debt. They point out that

the main justification for treating these financial cash
flows as essentially certain . . . is that their amounts
and timing are largely determined by legal contracts that
the firm acquiring the asset will have to fulfill. The
lease contract determines the amounts and timing of the
lease payments; the debt contract determines the amounts
and timing of the debt repayments. . . . The depreciation
expense charges allowed for tax purposes are not contractual,
but they are fixed by law and in theppresence of a large
amount of other income and stable tax rates are reasonably
certain.2

The Bierman and Smidt model is a borrow versus lease analysis.

That is, the decision is between financing the acquisition of the asset

 

1Harold Bierman, Jr. and Seymour Smidt, The Capital Budgeting

Decision, 2nd ed. (New York: Macmillan Co., 1966), pp. 218-27.
2

 

Ibid., p. 255 (Italics added).

 

89

with a lease or with a term loan equal to the purchase price of the
asset. Thus, the net present value cost of the debt alternative is
equal to the present value of the after-tax loan payments less the

present value of the tax shield provided by the depreciation expense:

n Qi n (1-t)Ii n tDi
NPVC(D) = Z --—--<T'+ Z ----7-- 2 --—----1F (13)
i=1 (1'trt) i=1 (li'rt) i=1 (1+ rt)

where rt = (1 - t)r. Note that the loan payments have been broken down

into a principal repayment component Q1 and an after-tax interest
component (1 - t)Ii' This is because the after-tax debt rate is used
to discount these flows. It can be shown that discounting Qi and

(1 - t)Ii at r is equivalent to discounting the pre—tax loan payments

t

Li at r. This, of course, is equal to the principal of the loan A0.

Thus, the first two terms of Equation (13) reduce to the purchase

price of the asset:

n 01 n (1 't11i n Li
2 ———————7-+ 2 ———————?—= z 1 = A0 (14)
i=1 (l'trt) i=1 (li‘rt) i=1 (1 + r)
and Equation (13) becomes
n tDi
NPVC(D) = A0 - Z -—-————7- (13')
i=1 (1+rt)

Bierman and Smidt calculate the net present value cost of the
lease as the present value of the after-tax lease payments:
R. n tR.
z 1

i=1 (1+rt)1 i=1 (1+rt)'

where both flows are discounted at rt to adjust for their relative

certainty.

90

The net present value advantage of the lease is determined by
subtracting Equation (15) from Equation (13'):

R1 -

l (l +rt)1 i

tDi i +
l (1+-rt) i

tRi
NAL = A -

0 (16)

"M:
II M:
”M:

i l (1+-rt)1

where the terms have been rearranged to facilitate comparisons with other
lease analysis models.

A unique feature of the Bierman and Smidt method is their
recommendation that an investment analysis be performed after the
borrow versus lease analysis has been completed. As in the case of
the models which have been discussed previously, Bierman and Smidt
separate the acquisition and financing decisions. However, unlike the
previous models, they perform the capital budgeting analysis under the
assumption that the lowest cost method will be used to finance the
investment. This use of an ex post investment analysis overcomes
Johnson and Lewellen's criticism that prior justification of the
acquisition on an ownership basis can never allow a bargain lease
opportunity to reverse an initially unfavorable purchase decision.1

Bierman and Smidt's model makes an important contribution to the
development of lease purchase analysis methodologies. Their use of a
risk-adjusted rate to discount the tax shields represents an important
conceptual breakthrough in this field. Without exception, subsequent
net present value models have attempted to adjust for the degree of
risk associated with each of the cash flows. For example, in the 1969

and 1972 editions of Managerial Finance, Weston and Brigham altered

 

their original model by discounting all of the contractual and tax

 

1Johnson and Lewellen, "Reply," p. 1025.

91

savings flows at the after-tax debt rate.1

Some of the more interesting
aspects of Weston and Brigham's revised model will be discussed in the

following section.

The Weston and Brigham model (1972)

 

The lease analysis model which appears in the fourth edition of

Managerial Finance is an important methodological technique.2 Because

 

of the widespread use of the Weston and Brigham text, it is one of the
best-known of the contemporary models. As we have seen, however, its
theoretical base is firmly rooted in the conventional methodology

3 In addition, it can be demonstrated that

developed by Cohen in 1953.
Weston and Brigham's revised model is conceptually equivalent to both
the Bierman and Smidt and the Johnson and Lewellen approaches.

The major difference between the revised Weston and Brigham
model and the earlier version given by Equation (6) is that rt has
replaced the cost of capital as the discount rate in order to adjust

for the "relative certainty" of the cash flows.4 The other change is

that Vn and 0i have been added to the equation:

 

1J. Fred Weston and Eugene F. Brigham, Managerial Finance,

3rd ed. (New York: Holt, Rinehart and Winston, 1969), pp. 533-37; and
Weston and Brigham, 4th ed., pp. 462-68.

 

2Weston and Brigham, 4th ed., pp. 462-68. The same model
appeared in the third edition of Managerial Finance; however, the
discussion will be confined to the 1972 presentation.

3

 

Cohen, "Long-Term Net Leasing," pp. 137-58.
4weston and Brigham, 4th ed., p. 464.

O.(l-t) V
1 1 _ n n (17)
1 (li'rt) (li'kt)

 

"M:

n
_ z .______?_+
=1 (1 + rt) 1
Note that only the after-tax salvage value is discounted at kt' This is
because Weston and Brigham assume that salvage ”is about as risky as the
firm's average asset."1
If we ignore for the moment the trivial difference that Weston
and Brigham include Vn and 0i in their equation and Bierman and Smidt do

not, it is a simple procedure to show that the two models are equivalent.

Bierman and Smidt's Equation (16) may be rewritten as follows:

n O. n (1 -t)I. n R. n tD.
NAL = z ————l——7-+ z ————-——é} - z -———¥L——T - z 1 1
i=1 (1-trt) i=1 (1-frt) i=1 (1-+rt) i=1 (1+-rt)
n tRi
+ z -—-————-r (16')
i=1 (l-frt)
since by expression (14):
n Qi n (l -'t)Ii
2 1 + z i = A0 (14)
i=1 (1+-rt) 1=1 (l-frt)
However, recognizing that
n O, n (l -t)I n Li n tIi
.2 1 + 2 ———-~—-—= z ———————7—- z 1 (18)
1=1 (1+-rt) 1=1 (l-frt) i=1 (1+-rt) 1=1 (1+-rt)

 

1Ibid., p. 464n.

93

and substituting into Equation (16') and rearranging, we may write the

Bierman and Smidt model as:

n Li n R1 n tDi n tR.i
NAL = .2 '__-_-_TT ' .2 '_-____TT " .2 '____—__T'+ .2 '—_____TF
1=1 (1+-rt) 1=1 (1+-rt) 1=1 (1+-rt) 1=1 (1+-rt)
n tIi
.. z ——-—'i— (16”)
i=1 (1+-rt)

In this form it may be seen that Bierman and Smidt's approach is
identical to Weston and Brigham's Equation (17). The only difference is
that Weston and Brigham recognize the existence of salvage value and
allow for the possibility of operating costs which are covered by the
lessor.

There is another difference between the models, however, which
relates to the separation of the acquisition and financing decision.
Both methods treat the problem as a financing decision. As Weston and
Brigham point out, the decision to acquire the asset is not at issue in

their analysis. They assume that "this decision was made previously as

 

part of the capital budgeting process."1 An ex ante investment analysis,
however, requires knowledge of the method of acquiring the asset's
services (lease or purchase). As was pointed out previously, it is
common to assume that the asset will be purchased for the purposes of
the investment decision, and this approach may lead the firm to reject a
particularly attractive lease. The Bierman and Smidt method of

determining the asset's investment worthiness after the lease or buy

 

1Ibid., p. 462 (italics added).

94

decision has been made is clearly the preferred approach if the

investment and financing decisions are to be separated.1
For purposes of comparison, the revised Weston and Brigham model

may be applied to the Johnson and Lewellen example. The calculations

for Equation (17) are as follows:

$429 = $16,725 - $18,698 - $6,852 + $9,349 - $1,725 + $2,226
- $596 (17)

It should be noted that this is the first model investigated to generate
a positive NAL for the Johnson and Lewellen problem.2 A summary of the
net present value advantage of leasing generated by each of the models is
shown as Table 5. The major reason for the reversal of sign in favor of
leasing is the use of the lower discount rate in the Weston and Brigham
equation. Since the benefits of leasing exceed the "costs" of leasing
in the later years of the asset's life, the use of a lower rate of
discount tends to give additional weight to these benefits. The result
is a decision in favor of the lease alternative.

A second, more controversial, model which also tends to favor
the lease option has been developed by Johnson and Lewellen. A detailed

analysis of this approach follows.

 

1It should be pointed out that a number of contemporary theorists
believe the financing and investment decisions should not be separated.
This issue will be discussed in a later section.

2Expansion of the Bierman and Smidt model to include Vn and 0.
would, of course, generate an identical NAL.1

95

TABLE 5

NET PRESENT VALUE ADVANTAGE OF LEASING GENERATED
BY FOUR LEASE ANALYSIS MODELS

 

 

 

Model NAL
Conventional Model -$92
Basic Interest Rate Model -$143
Bower, Herringer, Williamson Model -$264
Weston and Brigham Model (1972) +$429

 

The Johnson and Lewellen model

 

The Johnson and Lewellen model makes clear the fact that one's
conceptual definition of leasing is a major determinant of one's
analysis method. Until now, all the approaches we have considered
view the lease analysis as a financing decision. Johnson and Lewellen,
on the other hand, view lease versus purchase as an investment decision.
The result is a model which, at least on the surface, is quite different
from its predecessors.

Johnson and Lewellen build their model on the assumption that the
normative framework of capital budgeting provides the appropriate
theoretical base for lease-purchase decisions. They argue that a lease
contract is simply "a long-term acquisition-of—services arrangement
which differs in time profile but 222.10 financing impact from the
alternative . . . we call 'purchase.'”1 They go on to state that

just as the purchase price of the equipment involved would
be regarded as an outlay to be financed by some long-term
package of debt and equity funds, so should the obligations

under the lease. The fact that the relevant payments are
spread out over a period of years rather than being

 

1Johnson and Lewellen, "Lease-or-Buy,“ p. 816.

96

concentrated in an immediate lump sum does not justify a
difference in the principle of their treatment, nor in
one's view of the implicit composition of their financing.

This view of a lease as something to be financed rather than as a
source of financing is the major conceptual difference between Johnson
and Lewellen and previous theorists. It leads them to conclude that
the addition of any form of interest charge or interest tax shield to
the cash flows is incorrect because it is "inconsistent with the general

normative framework for capital budgeting."2

They point out that
received doctrine in capital budgeting recommends the use of a composite
cost of capital to discount all cash flows associated with an investment.
Since this discount rate includes the explicit finance charges related
to dividend and interest payments (as well as implicit charges connected
with the risks borne by the shareholders), the inclusion of financing
charges would involve double-counting.3
Johnson and Lewellen's lease analysis model is derived from two

equations which are expressed in the traditional capital budgeting

framework. Equation (19) defines the net present value of the purchase:

 

 

n (Z -C.) - t(Z.-C -D ) S - t (S -B )
NPV(P) = z i 1 11 1 1 + n g n n n _ A0 (19)
1=1 (l + kt) (l + kt)
where Z, = expected cash revenues generated by the asset in year i,

C.

1 pre-tax cash operating costs expected to be required to

operate the asset in year i if it is purchased,
and all other variables are defined as before. Equation (19) is the

familiar capital budgeting equation with the firm's after-tax cost of

 

'Ibid. 2Ibid., p. 817. 31bid., p. 815.

97

capital as the discount rate.1 Note that, in keeping with the above
discussion, no financing charges are included in the equation.

In a similar fashion, Johnson and Lewellen define the net present
value of the lease option:

[Li-(Ci-OQ](l-t) n R

 

n .
NPV(L) = Z 1. - Z ““‘i’
i=1 (1 + kt) i=1 (1+rt)
n tR.
+ z ————J-—7- (20)
i=1 (l-Frt)

where Ci - O. pre-tax cash operating costs expected in year i if the

1
asset is leased and all other variables are defined as before.

Equation (20) is nothing more than the capital budgeting framework
applied to the leasing option, the only alteration being the use of rt
to discount the lease payments and their tax shields. Johnson and
Lewellen justify this deviation from conventional theory on the basis of
the greater certainty of the contractual lease payments.

Subtracting Equation (19) from Equation (20), we derive the

expression for the net present value advantage of the lease:2

 

NAL = NPV(L) - NPV(P)
n R. n tDi n tR.
NAL = A0 - 2 ' 1 - z i + z 1 1
i=1 (1+rt) 1=1 (1+kt) i=1 (1+rt)
n O.(1-t) V
+ 2 _I._.___1,___._.n__n_ (21)
i=1 (1+kt) (1+kt)
1

Johnson and Lewellen exclude working capital outlays and recov-
eries under the assumption that they are symmetrical as between lease
and purchase.

2It should be pointed out that Johnson and Lewellen express

98

). Note that several

where Vn has been subst1tuted for Sn - tg(Sn - Bn

of the cash flows drop from the equation because they are common to both
sides of the comparison. Since these flows involve the revenue
generated by the asset and the operating costs associated with purchase,
Equation (21) is insufficient by itself to make the lease-purchase
decision. This is because when NPV(P) and NPV(L) are less than zero,
Equation (21) will favor one of the alternatives even though they both
generate negative present values. The decision will be in favor of
leasing when |NPV(P)| > |NPV(L)| and will be in favor of purchase when
|NPV(P)| < |NPV(L)|.1

As a result, Johnson and Lewellen view Equation (21) as the
second step in the lease-purchase analysis.2 The first step is the
calculation of the net present value of the purchase as a straight
investment.3 If the purchase appears to be unprofitable because
NPV(P) < O, the second step of calculating NAL must still be taken
since it is possible that NPV(L) > O. In this way Johnson and Lewellen
allow for the existence of unusually attractive lease terms that are

sufficient to reverse an initial negative purchase decision.4

 

Equation (21) in terms of the net present value advantage of the purchase
rather than the lease. This has been reversed here for comparison with
other models.

1Baruch Lev and Yair E. Orgler, ”Analysis of the Lease-or-Buy
Decision: Comment,“ Journal of Finance 28 (September 1973), p. 1023.

 

2Johnson and Lewellen, "Lease-or-Buy,” p. 822; and Johnson and
Lewellen, "Reply," pp. 1027-28.

3Johnson and Lewellen point out that this would involve the use of
Equation (19) with the inclusion of working capital outlays and recov-
eries. See, Johnson and Lewellen, "Reply," p. 1028n.

4Johnson and Lewellen, "Lease-or-Buy,“ p. 822.

99

Criticisms of the Johnson and Lewellen model. The Johnson and

 

Lewellen approach to the lease-purchase decision has created a great
deal of controversy. Indeed, after the publication of their article,

the Journal of Finance received 19 "Comments” on the methodology. Four

 

of these were eventually published along with Johnson and Lewellen's
"Reply" in the September 1973 issue.1 Subsequent articles by a number
of financial theorists have also taken issue with Johnson and Lewellen.2
Disagreement with their approach centers on two issues. The
first is the premise that a lease is simply "a long-term acquisition-of-
services arrangement"3 which does not differ in financing impact from a
purchase. The major practical implication of this position is the
exclusion of an interest tax shield from Equation (21). The second
major point of disagreement is Johnson and Lewellen's use of the cost of
capital to discount seemingly riskless cash flows. Of particular
concern to critics is the use of kt to discount the depreciation tax
shield, although Findlay also takes issue with the use of kt to
discount 01(1 - t).4

Johnson and Lewellen's position that a lease is merely an

acquisition-of—services contract lies at the heart of their approach

 

1Robert A. Clark, Joan N. Jantorni, and Robert R. Gann, “Analysis
of the Lease-or-Buy Decision: Comment," Journal of Finance 28
(September 1973): 1015-16; Peter Lusztig, “Analysis of the Lease-or-Buy
Decision: Comment," Journal of Finance 28 (September 1973): 1017-18;
Harold Bierman, Jr., "Andlysis of the Lease-or-Buy Decision: Comment,”
Journal of Finance 28 (September 1973): 1019-21; and Lev and Orgler,
pp. 1022-23.

 

 

2See, for example, Findlay, pp. 4-6; Bower, ”Issues in Lease
Financing," pp. 29-30; Schall, ”Lease-or-Buy,” p. 1211; and Nantell,
"Lessor's Pricing," pp. 5-9.

3Johnson and Lewellen, "Lease-or-Buy,” p. 816. 4Findlay, p. 6.

100

to lease-purchase analysis. In essence, they deny the "capital
structure effect" of leasing discussed earlier in the chapter. That
is, they do not believe that a firm's contractual commitments to make
lease payments are viewed by investors as equivalent to long-term debt
commitments.1 Hence, they do not accept the view that shareholders
perceive greater risk with leases which, in turn, causes them to raise
the firm's equity capitalization rate.

Financial theorists have had difficulty accepting Johnson and
Lewellen's position. Lease commitments do not differ substantially from
interest and principal repayments under debt obligations. Since default
on a lease contract may just as surely force a cessation of operations
as default on a debt instrument, it seems reasonable to conclude that
investors view leasing as a debt-surrogate. This position is at least
partially reinforced by the empirical data of Vancil and Anthony.2
Moreover, Johnson and Lewellen provide no solid theoretical or empirical
evidence in support of their position. One is asked to accept their
acquisition-of—services view of leasing merely as an article of faith.

It appears that Johnson and Lewellen's position on this issue
stems from a misunderstanding of the equivalent loan device used by
many lease analysis models. In their "Reply” article they state that
"the designation of full debt financing as the acquisition alternative
to leasing clearly attaches one form of finance to one asset.”3 They
correctly point out that this approach ”has been refuted . . . by every

major writer in corporate finance during the last 20 years."4 As a

 

1Johnson and Lewellen, ”Reply,” p. 1024. 2Vancil and Anthony.

3Johnson and Lewellen, "Reply,“ p. 1024. 4Ibid.

101

result, they argue for the exclusion of financing charges from the
analysis under the mistaken impression that the inclusion of any
interest-related cash flow implies a lease versus borrow analysis.
While it is true that the methods we have reviewed in this chapter thus
far take a lease-or-borrow perspective, it is not true that the entry of
an interest tax-shield in the equation implies 100 percent debt
financing of the purchase.1 What Johnson and Lewellen fail to
recognize is that the equivalent loan device seeks to neutralize the
capital structure effect of leasing and does not necessarily attempt to
associate a particular form of financing with the purchase alternative.2
As a result of this misunderstanding, Johnson and Lewellen opt
for a capital budgeting approach which excludes all interest-related
flows from the analysis. This "separation of the acquisition and

”3 as they refer to it, is a means of overcoming the

leasing decisions,
problems which they perceive in the lease-or-borrow models of their
predecessors. As Findlay points out, however, the lease itself violates
the separation theorem in that components of investment and financing
are present in any decision to lease an asset.4 Lev and Orgler agree

with Findlay. They take the position that the lease-or-borrow approach

 

1Findlay, p. la.

2Johnson and Lewellen's misunderstanding of this point may be
seen in their criticism of the Vancil and the Bower, Herringer, and
Williamson models. They make it quite clear that they do not understand
the reason for the inclusion of only the interest tax shield in these
models and not the full interest charge on the loan. See, Johnson and
Lewellen, "Lease-or-Buy," p. 817.

3Johnson and Lewellen, ”Reply,” p. 1025. 4Findlay, pp. la-lb.

102

is reasonable "since the two alternatives . . . are equivalent from the
point of view of financial risk."1
Whichever view is correct, the question becomes moot with regard
to Johnson and Lewellen's model since it can be shown that Equation (21)
implicitly assumes 100 percent debt financing of the purchase.
Specifically, Johnson and Lewellen's model implies the loan which is
explicit in Weston and Brigham's Equation (17). It is one of the

ironies of the development of lease analysis models that Johnson and

Lewellen's approach is found to be formally identical to a lease-or-

borrow method.2

It is a simple procedure to show that Equation (21) implies the
Weston and Brigham loan. From Equations (14) and (18) above, it is

clear that

n Li
A : Z —————————.—-

0 i=1 (1+rt)1 i

tI.
‘ (22)

"M:

1 (1+-rt)i

In other words, the purchase price of the asset is equal to the present
value of the loan payments less the present value of the interest tax
shield, where both are discounted at the after—tax debt rate. (Recall
that in the Weston and Brigham method the loan is for principal amount
A0 at interest rate r = rt/(l -t). Substituting the right hand side of
Equation (22) into the Johnson and Lewellen formulation and rearranging

terms:

 

1Lev and Orgler, p. 1023.

2This is particularly true in light of the fact that Johnson and
Lewellen specifically criticize Weston and Brigham for assuming the
purchase is financed with 100 percent debt. See, Johnson and Lewellen,
"Lease-or-Buy," p. 817.

 

103
n L. n R. n tDi n tRi
i=1 (l-frt) 1=1 (1+ rt) 1=1 (l-Fkt) 1=1 (1+-rt)
n tI. n O.(l -‘t) V
- z ————l——?-+ 2 1 1 — n n (21')
1=1 (l-frt) 1=1 (1+-kt) (1+-kt)

it can be seen that Equation (21') is formally identical to Weston and
Brigham's Equation (17).1 The only difference between the two models

is that Johnson and Lewellen discount tDi and 01(1 - t) at kt while
Weston and Brigham discount these terms at rt. Nantell argues that this
is not a conceptual difference, however.2 He points out that it is the
objective of both methodologies to discount these flows at the
"appropriate risk-adjusted rate."3 The only real difference of opinion
concerns the question of what this rate should be.

Although this difference of opinion does not constitute a
conceptual difference, it is clearly a practical difference with regard
to the net present value advantage of the lease. This may be seen when
we apply Equations (17) and (21) to the Johnson and Lewellen example.
Previously we determined that Weston and Brigham's Equation (17)
generated an NAL of +$429. In comparison, Johnson and Lewellen's

Equation (21) calculates the net advantage of the lease at +$l,044:

$1,044 = $15,000 - $18,698 - $5,813 + $9,349 + $1,802 - $596 (21)

 

1A number of writers have pointed out that Johnson and Lewellen's
method includes an implicit loan. See, for example, Findlay, p. 5;
Bower, "Issues in Lease Financing," p. 30; and Nantell, "Lessor's
Pricing," pp. 7-8.

2 3

Nantell, "Lessor's Pricing,” p. 8. Ibid.

 

 

104

The total difference between the models of $615 is accounted for by the
differential dsicount rates applied to tDi and 01(1 - t).

It was pointed out at the beginning of this section that the
second major criticism of Johnson and Lewellen concerns their use of kt

to discount these cash flows. Most critics are particularly concerned

1 They note

with the application of kt to the depreciation tax shield.
that a firm which has sufficient other income or has available the use

of carrybacks or carryforwards may treat the depreciation tax shield as
essentially riskless and discount it at a relatively low rate. Johnson
and Lewellen's position is further weakened by the fact that they
discount the lease payments and the lease payments' tax shield at the
after-tax debt rate. This appears to be totally inconsistent with

their treatment of tDi.

In their reply to these criticisms Johnson and Lewellen make two
points. First, they protest that their critics look only at Equation (21)
in isolation, without considering its origin. They point out that
Equation (21) is derived from two equations which are constructed in
accordance with received capital budgeting theory, and that such theory
recommends the use of a composite cost of capital as the discount rate
for all cash flows. Hence, they argue that if Equations (19) and (20)
”are appropriate in their own terms,"2 Equation (21) cannot be otherwise.

Their second argument is designed primarily to shore up their

first. They recognize that it is necessary to defend the use of kt as

 

1See, for example, Clark, Jantorni, and Gann, pp. 1015-16; Lusztig,
p. 1017; Lev and Orgler, p. 1022; and Bower, ”Issues in Lease Financing,”
p. 29.

2Johnson and Lewellen, "Reply,” p. 1027.

105

the discount rate for tDi on its own merits, and that it is not possible
to simply "finesse" Equation (21) to prove their point. As a result,
they fall back on the argument that

the firm's ability actually to realize the intended package

of tax-savings-cum-salvage is as uncertain as the prospect

that the project involved will work out as predicted. If

it does not, the fixed assets acquired will very likely

have to be disposed of at distress prices, and/or additional

costs of removal or transfer to other uses will be incurred.1
In other words, they believe that the nearly riskless depreciation tax
shield and the highly risky after-tax salvage value average out to
equal the risk of the overall investment project. Thus, they consider
it appropriate to apply the firm's weighted average cost of capital to
these flows in Equation (21).

The fallacy in this line of reasoning has been pointed out by

Findlay.2 He concedes that Johnson and Lewellen are correct in noting
that the depreciation tax shield is a part of the total cash flow which

is discounted at k in capital budgeting analyses. However, he

t
maintains that it is incorrect to conclude that when such a flow is
foregone (as when a decision is made to lease rather than purchase) it
should be discounted at the overall cost of capital. As he points out,
the components of a cash flow of a given risk character need not be of
the given risk nor discounted at the rate which is applicable to the

3

total flow. It is certainly possible for a very risky cash stream to

have components which are riskless.4 As was indicated previously, the

 

1Ibid. 2Findlay, p. 6.

3Findlay notes that if this were not true ”it would be necessary
to reformulate the theory of finance." See, Findlay, p. 6.

4Consider, for example, the high beta firm whose operating income
includes earnings on riskless government securities.

106

presence of other income or carryback and carryforward options will allow
the firm to discount tDi at a relatively low rate. As for Johnson and
Lewellen's argument that the use of kt to evaluate tDi and Vn "averages
out" the risk of the two flows, Findlay notes that only by chance would
kt reflect the appropriate rate for the combined flows.1

Findlay also takes issue with Johnson and Lewellen's use of the
cost of capital to discount the after-tax operating savings associated
with the lease. It was noted earlier that 0i generally represents such
expenses as insurance, maintenance, and property taxes which are subject
to little or no uncertainty. As a result, 01(1 - t) should be discounted
at some approximation of the riskless rate. Findlay notes that the more
a given flow adds to the risk of a firm, the more eager the firm should
be to allow the lessor to assume that flow.2 Johnson and Lewellen's use
of kt’ however, has just the opposite effect. The after-tax operating
costs represented by 01(1 - t) are a benefit of leasing. They are
expenses the firm will be able to avoid by entering into the lease
contract. However, the use of a relatively high discount rate for this
term will reduce its present value and will lower the net present
value of leasing generated by Equation (21).

Despite its errors of omission and commission, Johnson and
Lewellen's model represents an important step in the development of
lease versus purchase methodologies. Their articles and the various
comments and criticisms of their position have focused attention on some
of the very basic issues in leasing theory. Johnson and Lewellen's

unconventional "capital budgeting" approach demonstrates that there

 

1 2

Findlay, p. 6. Ibid., p. 4.

107

are alternative conceptual frameworks which may be used to approach the
problem. This has forced other theorists to reexamine and to attempt to
justify the lease-as—financing approach which stands as the conventional
wisdom in financial theory. Johnson and Lewellen's challenge to the
conventional wisdom has set off a new wave of interest in leasing and
has caused many writers to crystalize their views on leasing theory.

The result has been a series of articles surveying and synthesizing
existing methods and proposing new models. It is to these articles that

we now turn our attention.

The Schall model

 

The lease versus purchase model developed by Lawrence Schall is
derived under the assumption that the objective of the firm is to

1 Schall's model simultaneously considers

maximize shareholder wealth.
the financing and investment aspects of the decision. In this regard,
the following criteria are applied:

An asset should be obtained only if the result is an

increase in shareholder wealth; the method of financing

should be that which raises that wealth by the greatest

amount.2

Schall does not believe in separating the investment and

financing decisions in lease-purchase analyses. He believes the
financing element to be an integral part of the acquisition decision,
since "the asset may be profitable under one financing method but not

3

under another." One of the unique features of Schall's model is that

he does not necessarily assume the purchase will be financed with

 

1Schall, ”Lease-or-Buy," pp. 1203-14. 2

3

Ibid., p. 1203.
Ibid., p. 1208.

108

100 percent debt. His approach is to determine the financing method
which results in the greatest change in shareholder wealth, and to
acquire the asset if that change in wealth is positive.1

Another unique feature of Schall's method is that his final
decision rule consists of two equations. The first calculates the

change in shareholder wealth resulting from the lease:2

 

n [71- 461-61)] (1—t) n 12‘,
5W(L) = .2 i - .2 -———-——1r
1=1 (1 + ka) 1=1 (1+ kb)
n tR}
+ 2 1 (23)
i=1 (1-fkb)
where
6W(L) = the change in shareholder wealth (W) as a
consequence of the lease,
ka and kb = the discount rates applied by the market in

evaluating the respective cash flows,3
and the bars over the previously defined variables represent their
expected values.4 The change in wealth resulting from the purchase is

given by Equation (24):

 

1Ibid. It should be noted that leasing is considered to be one
of the alternative means of financing the asset's acquisition.

2This is, in essence, the net present value of the lease. Schall's
symbols will be adopted, however, because of his use of market determined
discount rates to calculate the present values.

3Since R1 and tRi differ only by a scale factor, the discount
rate k is appropriate for both. Similar reasoning applies to any other
variab1es in Equations (23) or (24) which are multiplied by (1 - t) or t.
See, Schall, "Lease-or-Buy," p. 1207n.

4In an attempt to be as consistent as possible with Schall's
symbols, bars will be included over all variables. It is understood that
the distributions of some of these variables may have zero variances.
See, ibid., p. 1208n.

 

6W(P) = g (Z1-C1) - t(Zi-C1)+ to]. + 3n - tg(sn-Bn)
1=1 (1+ k )1
n tr,
+ z -—-—-—1.—-A0 (24)
1:1 (1+kd)
where
6W(P) = the change in shareholder wealth as a consequence of
the purchase,
kC and kd = the discount rates applied by the market in evaluating

the respective cash flows,
and the bars, again, refer to the statistical expectations of the
variables.

Equations (23) and (24) demonstrate that lease-or-purchase
analysis consists of two decisions which are made simultaneously: the
investment or acquisition decision and the financing decision. This may
be seen by considering each equation in turn. First, Equation (23)
represents the application of the standard capital budgeting framework
to the lease alternative. Thus, if Equation (23) generates a positive
value for 6W(L), acquisition of the asset's services by leasing
represents a profitable investment. Furthermore, if 5W(L) > 6W(P),
leasing represents the appropriate (i.e., shareholder wealth maximizing)
method of financing the acquisition. Equation (24), on the other hand,
represents the standard capital budgeting framework for purchase, with
one important difference. This equation includes an interest tax shield
generated by any additional debt the firm may issue to finance the
purchase of the asset. The inclusion of this term allows the firm to
compare the method of financing the purchase with the lease financing

option. Thus, if 6W(P) is positive and greater than aW(L), purchase

 

110

represents the most profitable investment and the optimal method of
financing the asset's acquisition.

It should be noted that Equation (23) and Equation (24) are very
similar in form to Johnson and Lewellen's Equations (19) and (20).
Indeed, the only difference is that Schall uses four market-determined
discount rates and includes the interest tax shield in the purchase
equation. Each of these differences will be considered in turn since
they lie at the heart of Schall's approach to lease versus purchase
analysis, and they clearly differentiate Schall's model from that of
Johnson and Lewellen.

Schall justifies the use of multiple, market-determined discount

1

rates on the basis of his Value Additivity Principle or VAP. The VAP

is a derivative of modern capital asset pricing theory and is an

2 The Value Additivity

extension of the homemade diversification theorem.
Principle states that, given capital markets which are perfect with zero

transaction and information costs, "the total value of any stream Yt

 

1Lawrence D. Schall, "Asset Valuation, Firm Investment, and Firm
Diversification," Journal of Business 45 (January 1972): ll-28.

 

2A . . . .

n excellent rev1ew of contemporary capital asset pr1c1ng theory
will be found in Jack Clark Francis and Stephen H. Archer, Portfolio
Anal sis (Englewood Cliffs, NJ: Prentice-Hall, 1971), pp. 111-44; and
in Michael C. Jensen, "Capital Markets: Theory and Evidence," Bell
Journal of Economics and Management Science 2 (Autumn 1972): 357-98.

The seminal works in the development of the homemade diversification
theorem include: William W. Alberts and Joel E. Segall, eds., Ihg_
Corporate Merger (Chicago: University of Chicago Press, 1966), pp. 235-
87; Stewart C. Myers, "Procedures for Capital Budgeting Under Uncer-
tainty," Industrial Management Review 9 (Spring 1968): 1-19; and Jan
Mossin, "Security Pricing and Investment Criteria in Competitive
Markets," American Economic Review 59 (December 1969): 749-56.

 

 

 

111

received by investors in the market is independent of how it is divided

into the separate income streams of one or more firms, (Y1,..., Y”), in

1

being made available to the market. Mathematically, this may be

expressed as follows:

n n
If Yt = ~§ Y1, then V[Yt] = -E V[Yi] (25)
1-1 1—1
where
(Y],..., Y ) = any arbitrary division of Yt into separate after-
" tax debt or equity streams, and
V[Y] = equilibrium market value of stream Y.

As Schall points out, "a major implication of the VAP is that any
investment is to be valued solely in terms of the incremental after-
corporate-tax returns it generates and without any regard to the
stochastic relationship of those returns to the earnings produced by

2 In other words, each cash flow should

the other assets of the firm."
be discounted at the rate which investors would apply to the flow if it
were available individually in the market. This rate will, of course,
be a function of the risk of the stream.3

According to Schall, it is likely that the four discount rates in

Equations (23) and (24) will be unequal. For example, it is improbable

 

1Schall, "Lease-or-Buy," p. 1204.

2Ibid. This is, in essence, a restatement of the homemade
diversification theorem.

3Schall notes that the VAP holds in the multiperiod case with
risky and riskless debt and is valid regardless of how investors value
cash flows. However, the relation given by Expression (25) is derived
from "the single period, homogeneous expectations, riskless debt,
mean-variance capital asset pricing model." See, Schall, "Lease-or-Buy,"
p. 205n.

112

that ka would equal kC since the cash streams they discount would, in
general, have different distributions. Similarly, kb # kd because of
the differential risk characteristics of the lease and debt
alternatives.1

It should be noted that Equations (23) and (24) employ composite
discount rates for the operating flows associated with the investment.
That is, ka and kc are used in evaluating total cash flows made up of
streams which have varying degrees of risk. For example, kC is used to
discount a risky flow (7} - 0}) as well as a riskless flow tDi' This
presents no particular problem, however, since ka and kC are defined as
the market determined rates appropriate to the composite cash flows. A '
problem does arise, however, in analyses such as Johnson and Lewellen's
when composite cash streams are disaggregated and the rate which is
appropriate to the entire stream is applied to riskless components of
that stream. Thus, Johnson and Lewellen's use of kt to discount tDi
does not appear to be appropriate, while Schall's composite rate of kC
is, by definition, the correct rate for the operating flow in
Equation (24).

As noted previously, Schall does not attempt to separate the
acquisition and financing decisions in lease-purchase analysis. In
this respect his model is truly unique. The interest tax shield which

enters Equation (24) is not an equivalent tax shield nor does it

 

ISchall indicates that these differences may arise from the fact

that lease payments are tax deductible whereas the tax deductibility of
interest may be limited by the government. In addition, bond indentures
and loan covenants generally place more restrictions on the firm than
lease agreements.

113

represent 100 percent debt financing of the purchase.1 It is the tax
shield resulting from "the additional interest which would be incurred
by the firm were the asset purchased using the preferred (shareholder
wealth maximizing, i.e., 6W(P) maximizing) method of purchase
financing."2 According to Schall, the optimal financing mix could
involve the issuance of new debt or equity, the reduction of current
dividends or the use of cash which would otherwise be retained if the
asset were not purchased.3 Thus, the value of t1} might equal zero if
debt is not an appropriate component of the financing plan.

Implicit in Schall's approach is the recognition that a financial
lease is, by its very nature, a hybrid. That is, a leasing decision
must necessarily involve considerations of both investment and finance.
As Johnson and Lewellen point out, the application of a pure financing
approach to lease-purchase decisions may lead the firm to reject an
especially attractive lease.4 In addition, the specification of full
debt financing as the alternative to leasing makes a presumption that
such financing is optimal from the standpoint of shareholder wealth
maximization. 0n the other hand, a pure investment approach (such as
that proposed by Johnson and Lewellen) ignores the fact that the lease
provides the firm with an alternative means of financing the asset's

acquisition.

 

1Schall notes that it is particularly unlikely that the purchase
would be 100 percent debt financed if the debt and lease obligations are
not considered equivalent. See, Schall, "Lease-or-Buy," p. 1207.

2Ibid.. pp. 1206-7. 31bid., p. 1203n.

4Johnson and Lewellen, "Reply,” p. 1025.

114

Schall recognizes that the very nature of the lease versus
purchase decision makes it impossible to separate investment and
financing considerations. As he points out,

whether acquisition is justified may depend upon how the

asset is financed. The asset may be profitable under one

financing method but not under another, e.g., leasing and

not purchase may produce a net gain.1
0n the other hand, purchase with 80 percent debt and 20 percent equity
may be more profitable than leasing.2 To reiterate Schall's position,
the proper approach is to determine the type of financing producing
the highest 6W (i.e., the best method of financing), and to acquire the
asset only if that highest 6W is positive.

Schall's model represents a significant advancement of leasing
theory. In addition to being the first model derived from the single-
factor capital asset pricing model,3 it is the first approach to attempt
a simultaneous optimization of both the financing and investment

decisions. From a theoretical standpoint, Schall's approach is clearly

the most rigorous model developed to date. As is so often the case,

 

1Schall, "Lease-or-Buy," p. 1208.

2See, for example, Schall's numerical example: ibid.,
pp. 1209-10.

3Schall's Value Additivity Principle is derived under the
assumption of a single-period model with homogeneous expectations, the
existence of riskless debt, Markowitz efficient diversification by
investors, and no taxes or transactions costs. This model is generally
associated with the following theorists: Jack L. Treynor, "Toward a
Theory of Market Value of Risky Assets" (1961, typewritten); William F.
Sharpe, "Capital Asset Prices: A Theory of Market Equilibrium Under
Conditions of Risk," Journal of Finance 19 (September 1964): 425-42;
John Lintner, "Security Prices, Risk and Maximal Gains from Diversifica-
tion," Journal of Finance 20 (December 1965): 587-615; and Jan Mossin,
;Eguggibrium in a Capital Asset Market," Econometrica 34 (October 1966):

 

115

however, abstract theoretical approaches pose significant operational
problems.

One such problem is the estimation of the appropriate discount
rates in Equations (23) and (24). Since ka through kd are defined as
market determined rates, Schall states that "the firm must estimate the
k by observing market rates on comparable streams."1 For example, he
suggests that ka may be approximated by observing the returns and market
values of all-equity firms that own comparable assets and earn
[2} - (C; - 0%)](1 - t). The practical problems involved in such an
estimating procedure are obvious. Schall recognizes this fact and
suggests that, in practice, only general estimates are possible.2
Thus, he concludes that "for the practitioner . . . the analysis here is
meant to suggest that some attempt should be made to adjust for
individual asset risk even though a precise determination is
impossible."3

Schall offers an alternative approach which may be used to
determine kb and kd' He notes that it is more common, and perhaps more
accurate, to view R1 and Ii as the contractually determined lease and

4 As a

interest payments rather than their statistical expectations.
result, kb and kd would become the risk-adjusted rates used by investors
in evaluating the highly certain lease and interest obligations.5 Schall

suggests that if the risks of R1 and Ii are similar, they may both be

 

1Schall, ”Lease-or—Buy," p. 1208. 21bid., p. 1209. 31bid.

41bid., p. 1208n.

5This is the approach Schall takes in his numerical example, see,
ibid., pp. 1209-10.

116

1 Thus, we see a return to the use of

approximated by the debt rate rt.
rt as an approximation of the riskless rate for contractual streams.
A second practical problem concerns the determination of the
optimal financing mix for the purchase alternative. Schall provides
little guidance in the area, but implicit in his presentation is the
notion that the firm should seek to maintain some target debt-equity
ratio. He notes that Equation (24) leads to "the familiar conclusion
that the tax deductibility of interest encourages financing entirely

with debt."2

That is, 6W(P) increases as Ii increases. Schall implies
that the firm should fall back on Modigliani and Miller's suggestion of
a target debt to equity ratio to avoid the untenable conclusion that the
firm should be financed with 100 percent debt.3 Of course, the
practitioner is left with the problem of determining the optimal ratio
as well as the determination of the optimal financing mix for each
specific asset acquisition. One possible approach would be to finance
each purchase with the firm's target proportion of debt and equity.
However, equity flotation costs would make this impractical for
relatively small acquisitions. As a result, it is difficult to
generalize with respect to the method of determining the purchase
financing.

A related problem concerns the question of differential

financial risk between the lease and purchase options. It was noted

in the discussion of Vancil's model that a meaningful lease-purchase

 

11bid. 21bid., p. 1206.

3Franco Modigliani and Merton H. Miller, ”Corporate Income Taxes
and the Cost of Capital: A Correction," American Economic Review 53
(June 1963): 433-43.

 

117

comparison requires an equivalence of financial risk between the
alternatives. However, Schall has abstracted from this problem by
deriving his Value Additivity Principle under the assumption that
capital markets are perfect with no transaction or bankruptcy costs.1
Of particular importance is the assumption that bankruptcy is
frictionless. That is, if bankruptcy occurs, the firm's assets can be
sold at their economic values without selling or legal expenses. As
Van Horne points out, when bankruptcy costs are significant, projects
may no longer be evaluated without regard to their stochastic
relationship with the firm's other assets.2 This is because the
probability of bankruptcy is a function of a firm's total risk, not
just its systematic component.3 Thus, as Schall himself points out, the
existence of capital market imperfections (including bankruptcy
transaction costs) may invalidate the Value Additivity Principle.4
In this instance, the firm would have a "portfolio problem" and assets
would not be valued individually.5
The implications for the practitioner are clear. Some
consideration must be given to the implicit capital costs associated
with lease financing. To the extent that the fixed commitments under
the lease exceed the fixed charges resulting from purchase financing,

financial risk may be increased and the firm's overall cost of capital

‘

1Schall, "Asset Valuation," p. 13. 2Van Horne, 3rd ed., p. 209.

31bid.

4Schall, "Asset Valuation," pp. 26-27, and ”Lease-or-Buy,”

P. 1209n.

5Schall, "Lease-or-Buy,” p. 1209n.

118

may be raised. On the other hand, if some investors perceive less
financial risk with leasing (because of its off balance sheet
accounting treatment), then leasing may have a more favorable impact on
the cost of capital than an equivalent amount of debt. It is this last

possibility which concerns M. Chapman Findlay.

Findlay's Net Present Value model

Findlay takes the position that net present value models are not
well suited for dealing with financial risk differences between the lease
and purchase alternatives. He believes that they are able to consider
investment risk differences through the use of risk-adjusted rates and
certainty equivalents, but that the nature of the NPV summary measure
makes it difficult to analyze the differential capital structure effect
of the lease and purchase options.

The difficulty arises because a negative NAL is generally
interpreted as an unambiguous decision to reject the lease. This may
not be a correct decision, however, if the lease is viewed as adding
less financial risk to the firm than an equivalent amount of debt
financing. The question becomes: how negative must the NAL be before
a clear reject decision is indicated?

Findlay believes that the summary measure generated by internal
rate of return (IRR) methods is better suited to address this question.1
Most IRR models calculate an after-tax cost of leasing expressed as a

percent. As indicated earlier, the after-tax internal rate of return is

 

1It should be noted that Findlay believes NPV models are better
able to deal with investment risk differences than IRR models. However,
it is quite possible to deal with investment risk within an IRR frame-
work through the application of certainty equivalent and risk adjustment
factors. This issue will be discussed later in the chapter.

119

given by pt. Findlay notes that when the lease and the alternative loan
are equivalent from the standpoint of financial risk, pt may be compared

, a clear decision

directly with the after-tax debt rate r If pt > r

t’ t
in favor of purchase is indicated. However, if the lease is perceived
as adding less financial risk to the firm, a percentage cost of leasing
which exceeds rt is less clear-cut in its implications.

Findlay notes that the theoretical solution is to compare pt
with the "equi-marginal opportunity cost of leasing in the optimal
capital structure."1 However, since the present state of the art in
financial theory does not allow for a precise computation of this rate,
Findlay suggests that a top management policy decision arises. He
points out that kt sets the upper bound for decision making. That is,
if the lease is viewed as adding no financial risk to the firm, pt
would be compared with kt' Thus, the use of an internal rate of return
criterion sets upper and lower limits on the range of pt for decision
making purposes. This makes it much easier for practitioners to deal
with situations in which financial risk differences are assumed to exist
between the lease and the loan.

For example, if management believes that leasing has a more
favorable effect on the cost of equity capital than debt, they may be

willing to enter into a lease contract despite the fact that > r

pt t'

The amount by which pt exceeds r may be viewed as the "price" the firm

t
is willing to pay to keep the fixed commitments off the balance sheet.
Findlay believes that it is easier for management to make this decision

in terms of percentage rates than net present values.

 

1Findlay, p. 13b.

120

In view of the Chapter II discussion of off balance sheet
financing, it appears unlikely that firms will be able to gain by
attempting to “disguise" their contractual commitments in the form of
leases. However, Wehle's study indicates that some firms believe the
disclosure requirements of leases are an advantage in dealing with less
sophisticated statement users.1 Thus, Findlay's approach may appeal to
some segments of industry.

Findlay recommends a dual approach to lease versus purchase
analysis. He believes that the choice of the analysis model depends
upon the situation at hand; and he divides potential leasing situations
into two broad categories.2 The first is the situation in which leasing
”is a readily-available, homogeneous source of finance."3 That is,
leasing is available on similar terms for a wide variety of assets. As
such, it may be viewed as a regular source of financing and should have

4 The

some optimal proportion in the firm's capital structure.
alternative to leasing in this instance is seen to be debt, and Findlay
recommends the use of an IRR model in order to deal effectively with
potential financial risk differences between leasing and borrowing. The
second situation occurs "when leasing is only available for a limited

5

number of assets at irregular intervals." In this instance, "the

 

1Wehle, p. VI-56.

2Findlay also adds a third situation in which the asset may only
be leased. He recommends a NPV approach in this instance. See,
Findlay, p. 14.

31bid., p. 1a.

4

For a discussion of this point, see Van Horne, 3rd ed., pp. 596-
97.

5Findlay, p. la.

121

notion of leasing having some optimal weight in the capital structure

at a stable long-run cost is less compelling."1

Thus, leasing is
viewed as a means of acquiring an asset on a one-time basis at extremely
attractive terms rather than as a continuous source of low-cost finance.
In such a situation, Findlay recommends his NPV approach.2

Findlay's model is similar to the approaches of Bierman and
Smidt and Weston and Brigham.3 Indeed, it will be shown that under
certain conditions the three models generate identical net present

values. The unique feature of Findlay's model is his application of a

certainty equivalent framework to a net present value model:4

 

n R1 n tRi n tDi
NAL = A0 - .2 -——————<r-+ .2 -———————f - z -——————:r
1=1 (1+-rt) 1=1 (1+-rt) 1=1 (1+-rt)
n w.0.(1-—t) AV
‘32 H 1'—'1—ri (26)
1=1 (1+-rt) (1+-rt)
where 01 = a risk adjustment coefficient, and

A a certainty equivalent coefficient.

The after-tax debt rate rt is applied to the lease payments, the
lease payments' tax shield, and the depreciation tax shield as an

approximation of the riskless rate. The adjustment factor A applied to

 

11bid., p. 13.

2Findlay's IRR model will be covered later in this chapter.

3Bierman and Smidt, 2nd ed., pp. 218-27; and Weston and Brigham,
4th ed., pp. 462-68.

4It should be noted that Findlay derives Equation (26) under the
assumption of an equivalent loan equal to the present value of the lease
payments discounted at r. For a discussion of the derivation of
Equation (26), see, Bower, "Issues in Lease Financing,” p. 26, pp. 33-34.
Findlay's derivation appears on pages 7-10 of his paper.

122

the after-tax salvage value is a normal certainty-equivalent coefficient
which takes on values between 0 and 1.00 and varies inversely with the
risk of V".1 The coefficient 01, on the other hand, is not a certainty
equivalent but rather a risk adjustment factor which assumes values
equal to or greater than 1.00 and varies directly with the risk of Oi°
This results from the fact that the greater the risk of 0i the more
willing the firm will be to lease and allow the lessor to incur these
operating expenses.2 In most instances, however, 0i will represent
fixed costs with no uncertainty and 01 will equal 1.00.3
In the special case in which 01 = 1.00 and A/(l + rt)n equals

l/(l + kt)", it can be shown that Equation (26) generates an NAL which
is identical to that of Weston and Brigham's Equation (17).4 By
Equations (14) and (18), we see that:

Li -
1(1+rt)1 1'

tIi
————————1. = A0 (27)
l (l-trt)

NM:
"M:

.i

where Li and tIi represent the loan payments and resultant interest tax
shields from Weston and Brigham's model.5 Substituting the right hand

side of (27) into Equation (17), Weston and Brigham's model becomes:6

 

l . . . . . .
For a discus51on of certa1nty-equ1valent coeff1c1ents, see, Van

Horne, 3rd ed., pp. 138-39, or Alexander A. Robichek and Stewart C.
Myers, Optimal Financing Decisions (Englewood Cliffs, NJ: Prentice-Hall,
1965), pp. 79-93.

2Findlay, p. 4. 3Ibid., p. 9.

4Previously it was demonstrated that Weston and Brigham's model
is formally equivalent to Bierman and Smidt's approach.

5This identity is a natural consequence of the fact that Weston
and Brigham assume the purchase is 100 percent debt financed.

6This is, in essence, an alternative method of showing the
equivalence of Equations (16) and (17).

 

123
n R. n tDi n tRi
NAL=Ao-.X ——1—-T-.X ———1_+.Z—_———1
1=1 (1+-rt) 1=1 (1+-rt) 1=1 (1+ rt)
n O.(1-t) V
+ z —J—————:r --————fl—-fi- (17')
1=1 (l-+rt) (1+-kt)
Since, by assumption, pi = 1.00 and
(1+ rt)" 11 (1+ kt)“ 11
Equation (26) may be written:
n Ri n tDi n tRi
NAL=AO—.2 —————i.--.>: ————T+.z ——-——-—1—
1=1 (1+-rt) 1=1 (1+-rt) 1=1 (1+-rt)
01(1-‘t) Vn

(26')

Thus, it is seen that when 01 is riskless and Vn is in the same "risk
class" as the firm,1 Findlay's model is identical to Weston and
Brigham's approach.

This may be demonstrated by the application of Equation (26') to
the Johnson and Lewellen example. The appropriate value for the
certainty equivalent coefficient is determined by solving the following
equation for A and substituting the Johnson and Lewellen numbers:

_L_____L_
(1+r " (1+kt)n

t)

 

1For a discussion of this concept, see, Mark E. Rubinstein,

"A Mean-Variance Synthesis of Corporate Financial Theory,“ Journal of
Finance 28 (March 1973), p. 174.

 

(1+rt)n
(”kt)"

A_1.045_ 69
_L_1_5-,
(1.12)

Thus, when 01 = 1.00 and A = .69, Equation (26') generates an NAL of

$429 for the Johnson and Lewellen problem:

$429 = $15,000 - $18,698 - $6,852 + $9,349 + $2,226 - $596

This is identical to the value calculated using Weston and Brigham's

Equation (17). Of course, only by chance would A/(l + rt)n equal

l/(l + kt)".1 Nevertheless, if A/(l + rt)n is in the vicinity of

(26')

1/(l + kt)n when 01 = 1.00 (that is, if Vn is in approximately the same

risk class as the firm when 0i is riskless), the two models will likely

generate the same accept-reject decision.

As in the case of Schall's method, there are practical

implementation problems associated with Findlay's approach.

Determining

a method of calculating 0i and A is a particularly troublesome problem.

In theory, 01 and A should be determined on the basis of the market's

perception of the risk of 01 and Vn'

that 01 = l + f(80) if the firm assumes a strong form of the capital

asset princing model.2

 

1Findlay, p. 9.
2

= Cov(Oi,Rm)
o Var Rm

 

B

For example, Findlay suggests

Similarly, the certainty equivalent coefficient

Here 80 is Sharpe's familiar beta coefficient and is defined as

125

A would be given by A = l - f(80). The difficulties involved in
operationalizing these measures, however, are clearly formidable.1
The situation is analogous to Schall's market determined discount rates,
the practitioner may only hope to attain general estimates of pi and A.
A second concern with Findlay's model is more conceptual in
nature. Findlay's NPV approach is designed to deal with situations in
which the lease is viewed as "a one-time bargain purchase rather than a
perpetual source of low-cost finance."2 Implicit in this approach is
the assumption that the alternative to leasing is purchase with cash.
This seems to be inconsistent with his model, however, since we have
shown that Equation (26) is formally equivalent to two approaches which
explicitly assume 100 percent debt financing of the purchase. In most
practical situations we should expect Findlay's model to generate
identical accept-reject decisions with Bierman and Smidt's model and
Weston and Brigham's model. As a result, the only important difference

between Equation (26) and the earlier lease-or-borrow approaches is

Findlay's use of risk-adjustment factors for 0i and Vn‘

 

the covariance of 0. and the return on the market
portfolio Rm, and

where Cov(Oi,Rm)

Var Rm the variance of the return on the market
portfolio.

See, Sharpe, pp. 425-42.

1See, for example, Richard S. Bower and Donald R. Lessard,
”An Operational Approach to Risk-Screening,“ Journal of Finance 28
(May 1973): 321-37; and Van Horne, 3rd ed., pp. 200-205.

 

2Findlay, p. 13.

126

Summary and conclusions: NPV
methodologies

 

 

It was noted in the Introduction to this chapter that the form of
a lease analysis model is largely a function of the author's conceptual
view of leasing. The review of the net present value models has
identified at least three conflicting viewpoints among financial
theorists. First, there are those writers who consider the lease versus
purchase problem to be a pure financing decision. At the other extreme
are those individuals, notably Johnson and Lewellen, who take a pure
investment approach to the decision. Finally, the middle ground is
occupied by theorists who feel that lease-purchase must involve
considerations of both investment and finance. In the following
paragraphs, the various NPV methodologies are classified according to
their conceptual orientation and the important differences among the

approaches are reviewed.

Leaseepurchase as a financing decision. Approaches which fall
into this category include the conventional methodologies,1 the Basic
Interest Rate approach, and the Bower, Herringer, and Williamson model.
These techniques are classified as pure financing approaches because
they separate the acquisition decision from the financing decision and
they view lease-purchase analysis as a lease-or-borrow problem.
Separation of the acquisition and financing decisions means that the
investment must first be justified on an ownership basis before

consideration is given to the question of leasing. As Cooper and

 

1The conventional methodologies include the Cohen model, the
Weston and Craig approach, and the subsequent Weston and Brigham
methods.

127

Strawser note, this approach "is a corollary of the notion that a
capital investment project should be evaluated without reference to

its method of financing."1 Thus, once the purchase option is shown to
be profitable, the analysis turns to the question of the lowest cost
method of financing the acquisition. The two alternatives considered by
these techniques are lease and 100 percent debt.

A major criticism of this approach is that an ex ante investment
analysis which assumes the asset will be purchased may cause the firm to
overlook particularly attractive leasing opportunities. In other words,
it is possible for a sufficiently low lease rate to reverse an original
negative purchase decision.

A second significant criticism of these techniques is their
assumption that 100 percent debt financing is the appropriate alternative
to leasing. This assumption has been questioned by Schall and will be

discussed in a later section.

Lease1purchase as an investment decision. The only theorists to
publish a pure investment approach to lease analysis are Johnson and
Lewellen. These authors view the lease as a long-term acquisition of
services contract which differs in timing but not in financing impact

from a purchase.2

As such, they apply the traditional capital budgeting
framework to the lease and purchase options. This results in their
Equation (21) which excludes an interest tax-shield term and employs kt

as the discount rate for t0, and Oi(l - t).

 

1Kerry Cooper and Robert H. Strawser, "Evaluation of Capital
Investment Projects Involving Asset Leases," Financial Management 4
(Spring 1975). p. 4.

 

2Johnson and Lewellen, "Lease-or-Buy," p. 816.

128

Johnson and Lewellen have been criticized both for the exclusion
of the interest term and for the use of kt to discount seemingly riskless
cash flows. They justify the exclusion of interest on the grounds that
"received doctrine" in capital budgeting calls for the elimination of
all financing charges from the analysis. Their justification for the
use of kt to discount low-risk flows is somewhat more complex. They
argue that the firm's chances of realizing the tax savings and salvage
value flows "is as uncertain as the prospect that the project involved

will work out as predicted."1

Thus, in their view, the highly uncertain
salvage value and the nearly certain depreciation and operating expense
flows average out to equal the risk of the overall investment project.
As a result, they consider it appropriate to apply the firm's after-tax
cost of capital to these flows.

The pure investment approach of Johnson and Lewellen has
attracted few adherents among financial theorists. The financial
community does not appear willing to accept their acquisition-of—services
approach to leasing. The consensus view appears to be that the lease
provides the firm with an alternative source of financing and that the
lease-purchase analysis must take this fact into account. Moreover,
few writers appear willing to accept their argument that the weighted
average cost of capital should be applied to flows which are nearly
risk-free.

It must be pointed out, however, that Johnson and Lewellen have
provided an important service by focusing attention on the investment

aspects of the lease versus purchase problem. They make it clear that

 

1Johnson and Lewellen, ”Reply," p. 1027.

129

a proper assessment of project profitability must consider both the
lease and purchase option. Indeed, their work has led to a recognition
by a number of writers that lease-purchase analysis must consider both

the financing and investment aspects of the alternatives.1

Lease-purchase as a financing and investment decision. Schall
has developed a model which allows for the simultaneous consideration
of the financing and investment aspects of the decision. Schall's
Equations (23) and (24) are set in the standard capital budgeting
framework for the lease and the purchase alternatives. Thus, positive
values for 5W(L) and 6W(P) indicate that both options are profitable
from an investment standpoint. The financing decision is made by
selecting the alternative with the largest positive 6W. Schall's
approach is unique in that the financing decision is not confined to a
choice between lease and 100 percent debt. Purchase financing may
include new equity or debt issues, reduction of dividends or the use of
cash which would otherwise be retained.

Schall's methodology recognizes that the lease is a hybrid and
that it is not possible to separate its financing and investment
implications. Moreover, the model applies discount rates which are
appropriate to the risk of the various flows. While there are a number
of practical implementation problems with the Schall model, it, never-
theless, represents an important step toward a resolution of the

conceptual differences in the area of lease versus purchase analysis.

 

1See, for example, Schall, "Lease-or-Buy," 1203-14; Robert C.
Carlson and Donald H. Wort, "A New Look at the Lease-y§,-Purchase
Decision," Journal of Economics and Business 26 (Spring 1974): 199-202,
and Cooper and Strawser, 44-49.

130

Other net present value approaches. It should be noted that

 

three of the approaches presented in this chapter do not fall neatly
into any of the above categories. These include the Eiteman and
Davisson method, the Bierman and Smidt approach, and Findlay's NPV
model.

The Eiteman and Davisson technique is intended more as an
illustrative example than a general lease versus purchase model.1 This
approach simply compares the purchase price of the asset with the
present value of the lease payments and foregone salvage value. There
is no attempt to approach the problem either from the standpoint of a
financing decision or an investment decision. The model simply compares
the "costs" of the two alternatives.

The Bierman and Smidt model, on the other hand, is clearly a
lease-or-borrow analysis. The choice is between financing the asset's
acquisition with a lease or with 100 percent debt. However, there is
an important difference between this approach and other lease versus
borrow methodologies. Bierman and Smidt recommend that the investment
analysis be performed after the lease versus debt choice has been made.
Thus, the investment analysis is not automatically performed under the
assumption of ownership as in the case of the other pure financing
approaches. If Bierman and Smidt's Equation (16) generates a positive
NAL, the capital budgeting computations will be made under the
assumption of lease rather than purchase. This ex post investment
analysis has the effect of bringing the investment element back into

the decision. As such, Bierman and Smidt's model is more closely

 

1Telephone interview with Dr. Wilford J. Eiteman, July 28, 1975.

131

related to Schall's technique than to the pure financing methods. The
major conceptual difference between the two approaches is that Bierman
and Smidt assume 100 percent debt financing of the purchase while
Schall allows for non-debt financing.

In contrast to other writers in the field of lease-purchase
analysis, Findlay holds the view that net present value methods should
only be applied when leasing does not constitute a regular source of
finance for the firm. Findlay's NPV model is designed for the company
which confronts lease opportunities on an infrequent basis as one-time
bargain opportunities. For firms which regularly employ leasing as a
continuous source of finance, Findlay recommends an internal rate of
return technique. IRR models are, by definition, pure financing
approaches, and Findlay believes that these methods are better able to
deal with financial risk considerations than net present value models.
In his view, NPV methodologies are more aptly suited to consider the
investment risk elements of the decision. Findlay's NPV method is
neither a pure financing nor a pure investment approach. In concept,
it is somewhat akin to Eiteman and Davisson's "cost" comparison
technique. However, from a practical standpoint, it has been
demonstrated that Findlay's model will generate results which are very
similar to Weston and Brigham's pure financing approach. The Findlay
IRR method will be considered, along with the other internal rate of

return methodologies, in the following section.

Internal Rate of Return Models

 

This section will cover the major lease-purchase models which

employ the internal rate of return criterion. IRR approaches generate

132

an interest cost of leasing which is usually compared with the interest
rate on an equivalent amount of debt financing. As such, IRR models may
be viewed as pure financing approaches.

The proponents of internal rate of return point to the fact that
this approach avoids the problem of selecting the appropriate rate of
discount. In addition, it is suggested that IRR models are more easily
interpreted by practitioners who are used to making financing decisions
on the basis of alternative interest costs.

There is much less disagreement among theorists concerning IRR
models than there is with NPV models. Indeed, the majority of published
methods are simply variations of a single approach known as the
traditional model. In the following section, the traditional model is

introduced and its many variations are contrasted and compared.

The traditional IRR model

 

The traditional internal rate of return model solves the

following equation for the after-tax cost of leasing pt:

 

n R1 n tDi n tRi
O = A0 - 2 -——-————T - 2 -——————-T-+ 2 -———————$
i=1 (1+pt) i=1 (1+pt) i=1 (1+pt)
n O.(l -t) V
1=1 (1+ pt) (1'tpt)
The decision rule is to lease the asset if pt < rt, where rt equals the

after-tax interest rate on a similar amount of intermediate-term debt.
In essence, Equation (29) calculates the discount rate which
equates the present value of the lease cash flows with the purchase cash

flows. The resulting internal rate of return in interpreted as the

133

interest cost of leasing--the implicit interest charge incurred by the
lessee. If this rate is below the firm's debt cost, it is less expensive
to lease than it is to purchase the asset with borrowed funds.

Findlay notes that Brigham's lessor return model is actually

1

the first published version of the traditional approach. Brigham's

model is designed to calculate the effective yield on a lease to the

lessor:2
n R. n tDi n tRi
0=-AO- Z 1 1+ 2 1... z 1
1=1 (l-trT) 1=1 (1+ rT) 1=1 (1+ rt)
V
+ n n (30)
(1+rT)

where rT equals the after-tax rate of return. If the signs on all of
the terms in Equation (30) are reversed, we have a lessee decision model
which is formally identical to Equation (29).3 The only difference is
the absence of 01(1 - t) from Brigham's equation.

The first published version of the traditional approach to be
specifically designated as a lease versus purchase model appears in
Quirin's 1967 work.4 Quirin presents the model, without comment, as the

solution to an example problem:

 

1Brigham, "Equipment Lease Financing," pp. 73-74. The first
application of the internal rate of return method to the leasing problem
is to be found in McEachron, pp. 213-19.

2Brigham's original model included a term for the investment tax
credit. This has been ignored here for the sake of consistency.

3Findlay, p. 11.

4G. David Quirin, The Capital Expenditure Decision (Homewood, IL:
Richard D. Irwin, 1967), p. 119.

134

n R1 n 'tDi n tRi ( )
0 = A _ Z .. Z + Z —-———-—r 31
0 i=1 (1 +pt)i i=1 (1+pt)I i=1 (1+pt)'

It should be noted that this model is very similar to the NPV
approach offered by Bierman and Smidt in Equation (16):

n Ri n tDi n tRi

”AL‘Ao‘éimn-LWHETW “6’

t t t
The only important difference between the models is their summary
measure. Equation (16) uses the after-tax debt rate to discount the
flows in order to calculate the net present value advantage of the
lease. Quirin's approach, on the other hand, solves for the internal
rate of return of the cash flows and compares this with the after-tax
cost of debt. As such, both models lead to the same accept-reject
decision.

A model which is formally identical to Quirin's was presented by
Mitchell in 1970.1 This is the first IRR model to be presented in
equation form:

R.

1
————————-- -———————r + ————————-
0 (1+ot1' i=0 (1+pti' i=0 (1+pt)'

tDi tRi

M3
M3

0 = A0 -

IIM:

(32)
i

The difference between this approach and that of Equation (31) is the
timing of the cash flows. Mitchell's model assumes that all flows occur

at the beginning of the period rather than at the end.

 

16. 8. Mitchell, "After-Tax Cost of Leasing,” Accounting Review

45 (April 1970): 308-14. A very similar model was developed indepen-
dently by Doenges in 1971. See, R. Conrad Doenges, "The Cost of
Leasing," Engineering Economist 17 (Fall 1971): 31-44.

 

135

The Mitchell approach was offered as an alternative to a
methodology pr0posed by Beechy.1 Beechy's method generates a pre-tax
internal rate of return. The corrected version of this model is shown

as Equation (33):2

n R. n tL? n t1;
0 = A0 - z -———l——3-+ 2 -———1——?-- 2 -——————-f
1=1 (1 + p) 1=1 (1 + o) 1=1 (1 + p)
n tD. n O.(l-t) V
- 2 1 + 2 _J______,._ ————11——- (33)

1 (1+ .0" i=1 (1+ of (1+ 9)"

where p equals the pre-tax cost of leasing. Beechy uses the Bower,
Herringer, and Williamson equivalent loan technique to construct the
tax shields given by the third and fourth terms of the equation. The

equivalent loan payments are generated by Equation (12):

L; = ramp/(a )1 (12)

0

where L; = BHW's equivalent loan payments, and

R.
1

J = -—-—--1r
1 (l + r)

0 1

"MD

The equivalent interest payments I; are calculated as shown in Table 4.
The form of the summary measure is the only important difference
between Equation (33) and the traditional IRR model of Equation (29).

Beechy's pre-tax rate is equal to the traditional model's after-tax rate

 

1Thomas H. Beechy, "Quasi-Debt Analysis of Financial Leases,”
Accounting Review 44 (April 1969): 375-81.

2Thomas H. Beechy, "The Cost of Leasing: Comment and Correction,"
Accouting Review 45 (October 1970): 769-73.

136

multiplied by l/(l - t). Thus, both models will lead to the same
accept-reject decision.

The equivalence of the Beechy and Mitchell models may be
demonstrated by applying both approaches to the Johnson and Lewellen
example. Substituting the appropriate figures into Equation (29)
generates an after-tax lease rate pt equal to 3.6 percent. Application
of Beechy's model to the Johnson and Lewellen problem yields a pre-tax
lease rate p of 7.2 percent. Thus, Beechy's IRR is exactly twice
Mitchell's rate based on a tax rate of 50 percent. Since r = 8 percent
and rt = 4 percent, both models indicate that leasing is less expensive
than purchasing.

The most recently developed version of the traditional approach
appears in Findlay's 1973 paper.1 Findlay's model is shown as

Equation (34):

 

 

n-l R1 n-l tR1._1 n-l tDi
O = A0 - Ro - 1+ 2 1'- Z l
1=1 (1+pt) 1=1 (1+pt) 1=1 (1+pt)
n-10.(1-t) tR -tD +0(l-t)-V
+ Z 1 i + n-l n n n n (34)
1:1 (1+-pt) (1l + pt)

The important practical difference between this methodology and
Equation (29) is that Findlay assumes prepayment of the lease rentals.
Otherwise, the models are formally equivalent.

From a conceptual standpoint, however, Findlay's version
represents a departure from previous presentations of the traditional

model. As noted earlier, Findlay divides potential leasing situations

 

1Findlay, p. 12.

137

into two cases: (1) the situation in which leases are available on a
wide variety of assets under roughly similar terms, and (2) the

situation in which leases are available on only a few assets under widely
varying terms.1 In the former case, leasing may be viewed as a
continuing source of finance which has an optimal proportion in the
capital structure. Leasing is, therefore, considered to be a debt—
surrogate, and Findlay recommends the use of Equation (34) to make the
lease-or-borrow decision. In the latter case, leasing is not viewed as

a regular source of finance but rather as a "one-time bargain purchase."2
As such, Findlay suggests the application of his net present value model
given by Equation (26).

The reason for this dual approach to lease analysis is that
Findlay considers the important risk element to be different in the two
decision scenarios. In the first situation, financial risk is the main
concern since the decision involves a choice between two significant
components of the capital structure. As pointed out in the discussion
of his NPV model, Findlay suggests that the IRR summary measure is
better able to deal with financial risk differences than the NPV
approach. If investors consider lease and debt financing to be

equivalent, and business risk is constant may be compared directly

apt

with the after-tax debt rate rt. On the other hand, Findlay suggests

that if investors view leasing as having no impact on the risk of the

firm, pt may be compared with the after-tax cost of capital k Finally,

t‘
he notes that if the suppliers of capital view leasing as adding some

risk to the firm but not as much as debt, the equilibrium marginal pt

 

1Ibid., pp. 12-13. 2Ibid., p. 13.

138

would lie somewhere between rt and kt.1 In Findlay's opinion, it is
this last possibility that cannot be analyzed properly by NPV models.
As a result, he suggests the use of his NPV model for the second
decision scenario.

In this second decision situation, Findlay views the financial
risk element as a minor concern because leasing is not considered to be
an important component of the capital structure. Leasing is viewed as
an infrequent method of obtaining assets on favorable terms. As such,
investment or business risk is the major factor in the decision. The
adjustment for business risk is made through the use of certainty
equivalent and risk adjustment coefficients applied to the salvage
value and operating expense terms. The decision in this instance is one
of lease versus purchase rather than the lease versus borrow approach
of the IRR methods.

Findlay's dual analysis method represents a unique attempt to
deal with the different aspects of risk involved in a leasing decision.
Quite a different approach to the risk problem is represented by

Roenfeldt and Osteryoung's model.2

 

1Ibid., p. 12. Here, of course, Findlay is referring to the

incremental financial risk added to the firm by increasing the debt-to-
equity ratio (where lease commitments are included as debt). He notes
that if leasing does not add as much risk to the firm as debt, the
capital structure will be able to contain more total nonequity financing
than would otherwise be the case. Thus, pt will lie between rt and kt
in equilibrium.

2Rodney L. Roenfeldt and Jerome S. Osteryoung, ”Analysis of
Financial Leases," Financial Management 2 (Spring 1973): 74-87. It
should be noted that Wyman has suggested another unique approach to
risk analysis using computer simulation in an IRR framework. See,
Harold E. Wyman, "Financial Lease Evaluation Under Conditions of
Uncertainty," Accounting Review 48 (July 1973): 489-93.

 

 

139

The Roenfeldt and Osteryoung_model

 

This approach represents a departure from the traditional IRR
methodology. The internal rate of return models considered thus far all
represent variants of Equation (29). The Roenfeldt and Osteryoung
(R & 0) model, on the other hand, differs from the traditional approach
because of its use of risk-adjustment or certainty-equivalent
coefficients.1

The development of the model is based on three assumptions.
First, it is assumed that the firm's present capital structure is
optimal and that the firm will continue to pursue the policy of
maintaining an optimal structure. Second, financial risk is assumed to
be constant between the two alternatives of lease and debt financing.
Finally, noneconomic advantages or disadvantages of leasing versus
borrowing are ignored.2

The R & 0 model is given by Equation (35):

 

n R1 n tDi n tRi
O=AO- Z -——-—-1.—— Z -—.i-+ X ———-T
i=1 (1+pt) i=1 (1+pt) i=1 (1+pt)
n 0101(1-t) AnVn (35)
+ z . --—-—--
i=1 (1+pt)' (1+pt)"

where 01 and An have the same meaning as in Findlay's Equation (26).
The coefficient 01 is a risk-adjustment factor which takes on values
equal to or greater than 1.00 and varies directly with the risk of Oi‘
The certainty equivalent coefficient An varies between 0 and 1.00 and

is inversely related to the risk of V". Roenfeldt and Osteryoung employ

 

1Roenfeldt and Osteryoung, p. 79. 2Ibid., p. 78.

140

these coefficients to adjust for the investment risk associated with 0i
and Vn‘ In the special case in which 0i and Vn are riskless, 01 and An
would assume values of 1.00, and Equation (35) reduces to the
traditional model given by (29).

The absence of these coefficients from the previously discussed
versions of the traditional approach indicates that these models fail to
account for the investment risk component of the decision. The operating
savings and salvage value enter these equations unadjusted for risk. It
will be recalled that this failure to consider investment risk is
Findlay's major criticism of IRR models. However, Findlay also finds
fault with Roenfeldt and Osteryoung's treatment of financial risk.1 He
notes that the R & 0 model assumes an equivalence of financial risk
between lease and debt financing.2 As such, the pt generated by

Equation (35) is compared directly with r However, the model does not

t'
allow for the possibility that investors may perceive less risk with

lease financing than with debt. (In this instance, the equilibrium

marginal will lie somewhere between the after-tax debt rate and the

pt
cost of capital.) In essence, the R & 0 approach holds financial risk
constant while adjusting for business risk through the use of the
coefficients pi and An. Thus, in Findlay's view, the Roenfeldt and
Osteryoung method is analytically equivalent to his own net present

value model.3

 

1Findlay, p. 15.

2It should be pointed out that this assumption is implicit in all
models which compare the interest cost of leasing with the debt rate.

3This may be seen by comparing Equation (35) with Findlay's
Equation (26).

141

Findlay's criticism may be of little practical importance,
however, given the earlier discussion of the accounting treatment of
leases. The available evidence tends to support the position that
investors view lease and debt financing as equivalent. As a result,
the assumption of financial risk equivalence inherent in the R & 0
and traditional models does not appear unreasonable.

A second criticism may be leveled against the R & O methodology.
This concerns their use of an ex ante investment analysis which assumes
the asset will be purchased with cash. It has been pointed out
previously that this approach may lead a firm to reject a particularly
attractive lease. Indeed, this problem is endemic to all IRR models.
It results from the fact that IRR approaches deal only with the
financing aspect of the decision. As such, a separate analysis must be
performed to determine the investment worthiness of the asset.

The more appropriate approach would be to perform the investment
analysis after it has been determined whether leasing or borrowing is
the lowest cost method of finance. In this way, the cash flows
appropriate to the preferred financing method can be employed in the
discounted cash flow investment analysis. If it is determined, for
example, that a purchase with debt capital is preferred, Johnson and
Lewellen's Equation (19) may be employed for the investment decision.
Similarly, if the lease option is selected, Johnson and Lewellen's

Equation (20) would be appropriate.1

 

1Of course, Johnson and Lewellen's use of rt to discount R1 and
tRi in Equation (20) is a point of contention among financial theorists.
Many firms may wish to substitute kt as the discount rate for these
terms in order to maintain consistency with Equation (19). Johnson and
Lewellen's defense of this dual discount rate approach will be found in
their "Reply,” pp. 1026-27.

142

Summary and conclusions: IRR methodologies

 

It has been demonstrated that there is a good deal of similarity
among internal rate of return methodologies. Most published models
represent variations of the traditional approach. Indeed, even the
Roenfeldt and Osteryoung certainty—equivalent method reduces to
Equation (29) as a special case. Findlay's approach represents a
conceptual departure from the traditional model, but the practical
importance of this deviation may be minimal. In most instances,
Findlay's Equation (34) will lead a firm to the same decision as
Equation (29).

Perhaps the more important contribution of Findlay's paper is
that it focuses attention on the differential risk elements in leasing
analyses. The hybrid nature of lease versus purchase decisions requires
a consideration of both financial and business risk. Findlay's dual
analysis approach is an important step toward the development of a
procedure which deals effectively with both types of risk.

The important practical advantage of the internal rate of return
method appears to be its simplicity. IRR models avoid the problem of
selecting the appropriate discount rates, and they are easily
interpreted by business decision makers. The discount rate advantage
may be illusory, however, since some means of dealing with the investment
risk associated with 0i and Vn must be found. The use of Roenfeldt and
Osteryoung's adjustment factors still presents a firm with the practical
problem of estimating their values. Findlay's suggestion that 01 and An

may be viewed as functions of the appropriate beta coefficients provides

143

theoretical insight, but it begs the practical question of how the
proper functional forms may be estimated.1

A second concern with IRR methods is the assumption that
100 percent debt financing is the only alternative to leasing. As
Schall points out, full debt financing may not be optimal from the
standpoint of shareholder wealth maximization. It is possible for the
purchase to be financed with some mix of new debt or equity, the
reduction of current dividends, or the use of cash which would otherwise
be retained in the firm.2 Internal rate of return methods are simply
incapable of dealing with these other financing options.

A related issue is the use of an ex ante investment analysis
which assumes that the asset will be purchased. This problem arises
because IRR models deal only with the financing aspect of the lease-
purchase decision. As a result, a separate analysis must be performed
to determine the investment worthiness of the asset. If the analysis
is conducted under the assumption of a cash purchase, however, a
favorable leasing opportunity may be foregone. The more appr0priate
technique is to determine the lowest cost method of financing via the
internal rate of return method and then to determine the investment
worthiness of the selected alternative using either Equation (19) or (20).

One final concern with IRR approaches relates to the reinvestment
rate problem. Internal rate of return methods assume that intermediate
cash flows are reinvested at the internal rate of return. Net present
value models, on the other hand, assume that the intermediate flows are

reinvested at a rate equal to their respective discount factors.

 

1Findlay, p. 9n. 2Schall, ”Lease-or-Buy,” p. 1203n.

 

144

Generally, theorists tend to favor the use of NPV approaches.1 Net
present value has the virtue of consistency in that the same reinvestment
rate assumptions are applied to each decision situation. It is pointed
out that with IRR techniques the implied reinvestment rate varies
depending upon the interest cost of the lease. It is also noted that
only by chance will the internal rate of return equal the actual
reinvestment rate.2 However, this is also true of net present value
models. There is no guarantee that the discount rates applied to the
cash flows in a NPV leasing model will equal the appropriate reinvest-

ment rates.3

 

'Van Horne, 3rd ed., p. 81. 2Mitche11, p. 309.
3Beechy, I'Cost of Leasing,” p. 773.

CHAPTER IV
SURVEY DESIGN AND METHODOLOGY

The Research Objective
The purpose of the survey is to determine what financial
analysis methodologies are currently employed by large industrial firms
to make lease versus purchase decisions. This information will then be
used to develop hypotheses concerning normative marketing strategies
for firms involved in industrial leasing. In this sense, the survey
may be classified as exploratory research, since its objective is the
generation and clarification of hypotheses.1 As Zaltman, Pinson, and
Angelmar point out,
the nature of the exploratory mission is to clarify existing
ideas about relations among concepts and perhaps discover new
hypotheses. This is useful when the state of available
evidence is internally contradictory or insufficient to permit
the statement of formal hypotheses or the detection of new
concepts.2
As discussed earlier, the dearth of research in this area makes
it difficult to construct highly specific hypotheses with regard to
lease marketing strategies. It is felt that a first step toward a

greater understanding of industrial leasing must include an analysis

of the current state of the art in lease analysis methodologies.

 

1Gerald Zaltman, Christian R. A. Pinson, and Reinhard Angelmar,
Metatheory and Consumer Research (New York: Holt, Rinehart, and
Winston, 1973), p. 17.

2

 

Ibid.

145

146

Hypotheses

 

The general research hypotheses which guided the design of the

survey are:

H]: The most widely used lease-purchase analysis methodologies

among large industrial firms are the conventional net
present value method and the traditional internal rate of
return method.

2: Sophisticated lease-purchase analysis methods are used by
relatively few large industrial concerns.

H3: The majority of large industrial firms view lease versus
purchase analysis as a financing decision.

The first two hypotheses reflect the persistence of the conventional

NPV and traditional IRR methods in contemporary textbooks, as well as
the modest adoption rate of managerial technology by American

industry. A second consideration is the difficulty in operationalizing
many of the more sophisticated analysis models which have been developed
in recent years. The conventional and traditional models represent
generalizations of widely used capital budgeting techniques. As such,
they are easily understood by top management and are also easily
justified by middle management technicians.

The third hypothesis follows directly from the first two. It
was pointed out in Chapter III that the choice of a lease analysis
model is largely a function of one's conceptual orientation. That is,
an analyst's view of the leasing problem should determine whether his
methodology is couched in terms of a financing decision, an investment
decision, or a combination of the two. The lease-as-debt approach
of contemporary financial texts, as well as the intuitive appeal of
the debt-surrogate argument leads to the assumption that most firms

view leasing as an alternative means of finance.

147

The Sample

 

The sample consisted of the 200 largest industrial firms in the
United States listed by Fortune magazine.1 The Fortune 200 was chosen
in order to obtain a cross-section of large industrial firms
representing various industries and varying degrees of leasing
activity.2 Given the exploratory nature of the study, it was felt that
a survey of the larger, more sophisticated industrial firms was the
most appropriate. Additionally, a major concern of this study was the
attainment of a reasonable response rate. It was believed that larger
firms would have the time, the willingness, and the capability to
respond to the survey. Underlying this belief is the assumption that
larger firms have more at stake in the area of leasing decisions and
would, therefore, show greater interest in the survey. Finally, the
Fortune 200 represents a major segment of the potential market for
industrial leases. With the possible exception of the larger firms in
the transportation industry, the sample includes most of the largest
lessees and potential lessees in American industry.

It was felt that a nonprobability sample was appropriate, given
the low anticipated response rate and the nature of the research
hypotheses. While a probability design would have benefits in terms of
external validity, it was believed that these advantages would largely

be negated by nonresponse bias. In addition, the hypotheses are such

 

1"The 500 Largest Industrial Corporations,” fpfigyfl§_89 (May
1974): 232-39.

2Research by Wehle indicates differences in the motivation for
leasing between lessees classified as intensive and nonintensive. See,
Wehle, Pp. VI-l to VI-57.

148

that sophisticated statistical analyses requiring probability samples
are not necessary.

One of the more difficult tasks facing the researcher in
industrial buyer behavior studies is the identification of the relevant
buying center and the specific members of that group.1 In the present
study, the task was to identify the appropriate analyst-influencer in
the lease buying group. This was accomplished by sending the research
instrument to the chief financial officer of the firm and asking him to
forward it to the person or department responsible for lease-purchase
analyses. It was also hoped that by obtaining top level cooperation

with the study a higher response rate would be achieved.

The Research Instrument

 

The research instrument consisted of a lease case problem and a
questionnaire. Also included in the packet was a cover letter and a
set of instructions. A copy of the research instrument has been
included as Appendix A.

The respondents were asked to analyze the case problem using
the methodology they would normally employ for financial leasing
decisions.2 The case itself is a modified version of the Johnson and
Lewellen problem introduced in Chapter III. The Johnson and Lewellen

figures were multiplied by a factor of 20 and a number of assumptions

 

1Webster and Wind, p. 35.

2A similar approach was employed by Vancil and Anthony in their
well-known 1959 survey. They sent case problems to financial
institutions in order to determine the methodologies used to evaluate
the lease commitments of firms from an investment standpoint. See,
Vancil and Anthony, pp. 31-41.

 

149

were changed so that the case could be analyzed using any of the
methodologies existing in the literature.

It was believed that the case approach provided the best vehicle
for obtaining the type of information required by the study. The use
of a hypothetical case problem offers the advantage of comparability
across respondents without the danger of compromising any proprietary
data of the firms. In addition, the use of a case problem allows for a
larger and more geographically dispersed sample than would be possible
through personal interviews. Every effort was made to insure that the
case was not biased in favor of any specific methodology. Respondents
were instructed to employ their normal lease analysis method and to
ignore any data which were not relevant to that method.

The accompanying questionnaire was designed to develop data for
a respondent profile and to obtain information relevant to the case
analysis. The profile questions focused on such things as the
respondent's position within the firm, the industry classification of
the company, its sales volume, and the dollar value of its annual
lease commitments. Two questions were included to assist in the
analysis of the returned case problems. The first required the
respondents to indicate the decision (lease, purchase, or indeter-
minate) generated by their methodology. The second asked them to cite
the source of their analysis model. Finally, the analysts were asked
if they considered the lease-purchase problem to be a financing
decision, an investment decision, or a combination of the two. This
question was designed to test the third research hypothesis and also

provided a check for consistency with the firm's analysis method.

150

The instrument was pretested by eliciting the comments of
experts in the field of leasing. These individuals included the
executive secretary of a large lessor trade association, the vice
president in charge of leasing for a major midwestern bank and the head
of financial analysis for a large public utility. In addition,
extensive discussions were held with various leasing executives at the
American Association of Equipment Lessors Annual Seminar at the
University of Notre Dame. As a result of these discussions, a number
of changes were made in the case problem before it was sent to the

respondents.

Methods Used to Increase the Response Rate

 

A low response rate was anticipated, given the nature of the
survey and the amount of time required to complete the case analysis
and questionnaire.1 As a result, various techniques were employed in
an effort to increase the number of returns. Some of these techniques
have already been mentioned. Other methods included the use of
preaddressed business reply envelopes for the return of the instrument,
an offer of the survey results to respondent firms, and assurances of
anonymity for all participants. In addition, every effort was made to
simplify the case and questionnaire in order to reduce the time
required to prepare a response. All correspondence with the firms was
nonpersonalized in the belief that this would have a favorable effect
on response rate. While the empirical research on personalization has

shown mixed results, it is clear that for some populations a

 

1For example, Vancil and Anthony achieved only a 10 percent
return in their survey. Ibid., p. 32.

151

nonpersonalized instrument improves the return rate.1 It was felt

that frequently surveyed groups, such as the Fortune 200, would be more
likely to respond to a nonpersonalized contact. Finally, a follow-up
reminder letter (Appendix B) was sent to the sample approximately one

month after the initial mailing.

 

1See, for example, Ramond Simon, "Response to Personal and Form

Letters in Mail Surveys," Journal of Advertising Research 7 (March
1967): 28—30; Alan Andreason, "Personalizing Mail Questionnaire
Correspondence," Public Opinion Quarterly 34 (Summer 1970): 273-77;
Eli P. Cox III, W. Thomas Anderson, Jr., and David D. Fulcher,
"Reappraising Mail Survey Response Rates," Journal of Marketing
Research 11 (November 1974): 413-17; and Michael J. Houston and
Robert W. Jefferson, "The Negative Effects of Personalization on
Response Patterns in Mail Surveys," Journal of Marketinngesearch 12
(February 1975): 114-17.

 

CHAPTER V

SURVEY RESULTS AND CONCLUSIONS

The Respondent Profile

 

Returns were received from 63 companies, a response rate of
31.5 percent. Tables 6 through 10 present a profile of the respondent
firms. As can be seen from Table 8, the dominant participants in the
study are the larger firms among the Fortune 200. The 57 corporations
which chose to identify themselves represent a combined 1974 sales
volume in excess of $215 billion. The median sales of these firms is

in the neighborhood of $2 billion.

TABLE 6

LEVEL OF RESPONDING DEPARTMENT
WITHIN THE COMPANY

 

 

 

Department Number of Firms
Corporate headquarters 61
Division 2
Subsidiary _9
TOTAL 63

 

152

153

 

 

 

 

TABLE 7
DISTRIBUTION OF RESPONDENTS BY INDUSTRY
CLASSIFICATION
Classification Number of Firms

Conglomerate 12
Agriculture, Forestry 2
Mining, Petroleum Refining 11
Manufacturing, Construction 23
Transportation, Communication 1
Other .1_
TOTAL 63

TABLE 8

CLASSIFICATION OF RESPONDENTS ACCORDING
TO FISCAL 1974 SALES VOLUME

 

 

 

Sales Volume Number of Firms
$2.5 billion and over 27
$1.5-$2.5 billion 24
$1.1-$1.5 billion 8
$800 million-$1.1 billion 4
Less than $800 million I_g

TOTAL 63

 

 

154

TABLE 9

NUMBER OF RESPONDENTS REPORTING
LEASING ACTIVITY

 

 

 

 

Status Number of Firms
Lease 59
Do Not Lease _;3
TOTAL 62
TABLE 10

DISTRIBUTION OF RESPONDENTS BY DOLLAR VALUE
OF 1974 LEASE PAYMENTS

 

 

 

Dollar Value Number of Firms
$100 million or over 4
$50-$1OO million 10
$25-$50 million 15
$10-$25 million 15
Less than $10 million _13
TOTAL 57

 

A total of 57 respondents indicated that they employ a formal
financial analysis methodology in making lease versus purchase
decisions. Four firms stated that they do not use a formal method, and
two firms did not respond to this question. The lease-purchase
analysis was considered to be a financing decision by 45 companies.
None of the responding firms viewed the analysis as a pure investment

decision; however, 14 companies considered it to be both a financing

155

and investment decision, and four respondents did not express an

opinion. These data are summarized in Tables 11 and 12.

TABLE 11

NUMBER OF RESPONDENTS REPORTING USE OF FORMAL
FINANCIAL ANALYSIS METHOD FOR EVALUATION
OF LEASING DECISIONS

 

 

 

 

Analysis Method Number of Firms
Dp_Employ Formal Method 57
Do Npt_Employ Formal Method ._4
TOTAL 61
TABLE 12

RESPONDENTS' VIEW OF THE LEASING DECISION

 

 

 

Type of Decision Number of Firms
Financing Decision 45
Investment Decision 0
Both Financing and Investment Decision _14

TOTAL 59

 

Approximately 57 percent of the individuals who completed the
questionnaire are members of a corporate financial analysis department.
Another 30 percent of the individuals are associated with the office of
the corporate treasurer or comptroller. The remainder of the
respondents are from various departments including accounting, facilities

management, and purchasing.

156

Results of the Case Analysis

 

Of the 63 respondents, 53 submitted analyses of the lease
versus purchase case problem. Two of the firms employed two different
analysis methods. Since these companies indicated that they regularly
applied both models to lease-purchase decisions, a total of 55 methods
were available for classification. Unfortunately, documentation
problems made it impossible to interpret seven of the analyses. The

48 remaining methodologies are classified in Table 13.

TABLE 13

CLASSIFICATION OF RESPONDENTS' LEASE VERSUS
PURCHASE ANALYSIS MODELS

 

 

 

Models Frequency of Methodology
Traditional IRR Model 24
Conventional NPV ll
Bierman and Smidt Model (1966) 5
Basic Interest Rate Model 4
Weston and Brigham Model (1972) 2
Bower, Herringer, and Williamson Model ._2
TOTAL 48

 

The traditional IRR and conventional NPV models are, by far,
the most popular approaches among the respondents. Over 70 percent of
the classified analyses fall into one of these two categories. The
Bierman and Smidt and the revised Weston and Brigham models are
employed by a total of seven firms. It will be recalled that these
models were shown to be mathematically equivalent in Chapter III.

Similarly, the Basic Interest Rate approach and the BHW method, which

157

were also demonstrated to be virtually identical, are used by a total
of six of the respondents.

The decision to lease or purchase based on the case analysis
was quite consistent across the methodologies. Unfortunately, various
computational errors made it impossible to compare the decisions of all
the respondents. Of the 38 comparable analyses, 36 firms chose to
purchase the asset, one firm chose to lease, and one company indicated
that the decision was indeterminate. Only in the case of the firm
which chose leasing was the decision inconsistent with the results
generated by the analysis model. The respondent who indicated that the
decision was indeterminate stated that a final decision would be
influenced by other qualitative factors. It should be noted that a
number of other companies qualified their lease-purchase choice by
pointing out that "other factors" would be taken into consideration in
a real-world setting. This is, of course, consistent with Wehle's
findings that various financial and nonfinancial concerns affect the
lease decision.1

The results of the case analysis appear to be in accord with
the general research hypotheses of Chapter IV. The first hypothesis
posited that the conventional NPV and traditional IRR models are the
most widely used lease-purchase analysis methods among large
industrial concerns. Given that over 70 percent of the classified
methodologies fall into one of these two categories, it would appear

that the evidence is quite consistent with this hypothesis.

 

'Weh1e, pp. v-1 to v-32.

158

The assumption of the second hypothesis is that sophisticated
analytical models are employed by relatively few major industrial
firms. Once again, the data are consistent with this conclusion. None
of the respondents attempted to apply the more recently developed models
of Johnson and Lewellen, Schall, Findlay, Wyman, or Roenfeldt and
Osteryoung. Indeed, only two of the respondents employed a model
developed later than 1966.

The data also tend to support the third hypothesis, which
postulated that the majority of large industrial corporations view
lease-purchase analysis as a financing decision. Over 76 percent of
the firms responding to this question indicated that they considered
lease versus purchase to be a financing decision (see Table 12). The
remaining firms view the analysis as both a financing and investment
decision.

The fact that a large majority of the respondents view the
leasing problem as a decision involving alternative means of finance
has important implications for lease marketing. The assumption that
lease-or-purchase is a pure financing decision implies that a separate
investment analysis must be performed to determine if the asset itself
is worth acquiring. As noted in Chapter III, however, an ex ante
investment analysis which assumes the asset will be purchased may cause
the firm to overlook a bargain leasing opportunity. Of the 53 firms
which submitted case analyses, 20 performed an ex ante investment
analysis (assuming purchase of the asset) and 5 firms simply assumed
that such an analysis had already been performed. These figures are
particularly significant, since the respondents were not required to

consider the investment aspects of the case. Undoubtedly, the number

159

of ex ante investment analyses would have been higher if specific
mention of the investment element had been made in the case
instructions.

An ex ante investment analysis which assumes that the asset will
be purchased results in a clear bias against leasing. If the purchase
option does not generate a profitable return, it is assumed, a priori,
that the lease will be unprofitable. However, Johnson and Lewellen
have demonstrated that this may not be the case.1 If the lease rate is
sufficiently low, acquisition of the asset may be a profitable
investment under the lease but may be unprofitable if the asset is
purchased. Thus, models which require a prior investment analysis
under the assumption of ownership tend to underestimate the economic
advantages of leasing. With the exception of the Bierman and Smidt
approach, all of the methodologies listed in Table 13 fall into this
category. There is, however, another type of bias which is endemic to
these approaches. In the following section, the source of this bias
will be examined and its implications for lease marketing will be

discussed.

Implications for Lease Marketing

 

In Chapter II, it was suggested that an important opportunity
may exist for lease marketers to educate industrial firms to lease-
purchase models which more accurately reflect the financial advantages
of leasing. The results of the survey tend to confirm the existence of
this market opportunity. Most of the respondent firms employ methods

of analysis which do not properly adjust for the risk element in the

 

1Johnson and Lewellen, ”Reply,” p. 1025.

160

decision. This failure to adjust correctly for risk tends to
underestimate the true economic advantages of leasing, thus biasing
these models in favor of the purchase option.

Net present value approaches which fail to make a proper
adjustment for risk include the conventional model, the Basic Interest
Rate model, and the Bower, Herringer, and Williamson model. Approxi-
mately one-third of the classified methodologies fall into one of
these three categories. As was pointed out in Chapter III, the basic
problem with these approaches is their use of the cost of capital to
discount relatively risk-free cash flows.

The reason that this factor tends to favor the purchase option
may be seen by comparing Weston's and Brigham's 1972 model (17) with

1 As mentioned

the adjusted version of their earlier approach (6").
previously, Equation (6") is probably the most widely known version of

the conventional methodology:

n L. n R. n tD. n tR.
NAL = 2 _____]_____{__ Z __1_—-T- Z ——1—i—+ Z —. 1 1
i=1 (1+kt) i=1 (1+kt) 1=1 (1+kt) i=1 (1+kt)
n tI. n O.(l -'t) V
_ ,__1_.+2_L___.-—-—"—— <6")

i=1 (1* k

t) i=1 (1+kt)' (1+kt)n

The only difference between this model and the 1972 revision is that
rather than k to discount the contractual and

t t
tax-shield cash flows:

the latter employs r

 

1Recall that in Chapter III Weston's and Brigham's 1966 model
was adjusted by the addition of Oi (1 - t) and V in order to compare
the various approaches. n

 

161
n L. n R. n tD. n tR
NAL: X 1 1- Z 1 I- Z —""—l"—"+ z 1
1:] (1+-rt) 1=1 (1+-rt) 1=1 (1+-rt) 1=1 (1+-rt)
n tI. n 0.(l-t) V
.. z 1 + E —1———----——D—'— (17)

._ i . 1 n
1—1 (1+-rt) 1 1 (1+ rt) (l-frt)

The higher discount rate applied to these terms by (6") favors
the purchase because the "costs" of a lease tend to outweigh its
"benefits" in the early years of the asset's life. These costs include
the lease payments, the foregone tax shields resulting from depreciation
and interest, and the sacrifice of the asset's salvage value. The
benefits include the loan payments and after-tax operating expenses
avoided by leasing, as well as the tax shield provided by the lease
rentals. Because of the use of accelerated depreciation and the
annuity method of calculating loan interest, the costs of leasing will
generally exceed the benefits in the earlier years; and a relatively
high discount rate such as kt will tend to give excessive weight to
these costs. Thus, Equation (6") frequently generates a negative net
present value advantage of leasing (see Table 5). Similarly, Vancil's
Basic Interest Rate method and the BHW model will tend to favor the
purchase option because of their use of kt as a discount rate.

On the other hand, the low rate of discount employed by
Equation (17) gives relatively more weight to the later years of the
asset's life when the benefits of leasing frequently outweigh its
costs. As a result, the revised Weston and Brigham model (and its
equivalent, the 1966 version of the Bierman and Smidt approach) are

more favorable toward leasing. This is demonstrated in Table 5, in

162

which Equation (17) is the only methodology which generates a positive
present value for the Johnson and Lewellen problem.

From a theoretical standpoint, the use of a discount rate in
the vicinity of rt more accurately reflects the true economic
advantages of leasing. It was pointed out in Chapter III that the
relative certainty of the contractual and tax-shield flows warrants a
rate of discount which is below the firm's cost of capital. For
practical purposes, the use of the firm's after-tax debt rate represents
a reasonable approximation of the appropriate rate.

Of course, the Weston and Brigham and Bierman and Smidt models
are not the only net present value approaches which adjust for the
differential risk element in the lease-purchase decision. Johnson and
Lewellen, Schall, and Findlay all attempt to account for risk
difference in their analyses. The advantages and disadvantages of
each of these approaches were discussed in Chapter III. The attempt
here is not to recommend an ideal methodology, but rather to suggest
that certain models are better able than others to reflect the
financial advantages of leasing. In this regard, the more recently
developed models of Weston and Brigham, Schall, and Findlay are
clearly superior to the conventional, BIR, and BHW approaches employed
by many of the respondents.

In a similar fashion, the internal rate of return model
developed by Roenfeldt and Osteryoung is more effective in dealing
with risk than the traditional IRR approach. If Oi and Vn are
considered to be relatively risky cash flows, the traditional model

given by Equation (29) will tend to overestimate the cost of leasing:

163

n R. n tD. n tRi
O=A0- 2 _’1—T z -——‘——-1.—+.z ————-1-
1=1 (1+pt) 1=1 (1+pt) 1=1 (1+pt)
n O.(l-t) V
+ z ._L_____r._.___Jl___ (29)

i=1 (1+-pt)1 (11'0t1n

This results because 0i and Vn enter the equation unadjusted for
investment risk. On the other hand, Roenfeldt and Osteryoung adjust

for the riskiness of these terms by applying the coefficients 0i

and An:
n R. n tDi n tR.
O = A0 - z ————l——7-- z _—____—T'+ z _—__l_—T'
i=1 (1+pt) i=1 (1+pt) i=1 (1+pt)
n 0.0.(1-t) A V
+2--————“ .-——-———-““ <35)

1=1 (1+pt1' (1+ot)"

where 01 z 1.00 and O 5 An 5 1.00.

In many practical situations, the effect of these adjustments
may be minimal. For example, if 01 consists of highly predictable
fixed costs and Vn is a small proportion of A0, the coefficient 01
will equal 1.00 and AnVn will be too small to have a major impact on pt.
However, there may be instances in which the magnitude and riskiness of

these variables will be sufficient to drive pt below r (This may be

t'
the case in high technology industries in which the expected salvage
value of the asset is purely a matter of conjecture.) In such
situations, the traditional model will clearly overstate the after-tax
cost of leasing. As a result, an important opportunity exists for

lease marketers to introduce potential customers to a risk-adjusted

form of the IRR approach. This appears to be a particularly attractive

164

opportunity in light of the fact that one-half of the survey

respondents employ the traditional rate of return methodology.

The marketing financial analyst

 

The results of the survey and the review of the lease analysis P
literature make it clear that there is potential in pursuing a lease
marketing strategy which focuses on the buying technologies employed
by lessees. A properly presented financial analysis model which
accurately portrays the economic benefits of leasing may have a major
impact on a firm's lease-or-purchase decision. The most significant
problem faced by lessors in implementing this strategy appears to be
one of selecting and training the appropriate sales Personnel.

Manufacturer lessors may have difficulty in this regard because
their present sales force may not have the background, training, and
expertise to make effective financial presentations. The sales
representative required for this task must be able to interface with
controllers, accountants, tax specialists, and financial analysts. He
must possess strong communications skills and have a solid background
in corporate finance, accounting, and financial analysis. In short, a
new type of marketing specialist is required: the marketing
financial analyst.

The marketing financial analyst would operate as part of a sales
team and would have the responsibility of “selling” the economic
benefits of leasing. The team concept is not new. Many industries
employ sales teams which consist of both account managers and technical
specialists. The computer industry, for example, uses applications

specialists who make presentations on the problem-solving capability

165

of various systems. Oftentimes these specialists work directly with
a customer's systems group in order to ensure a smooth transition to
the new hardware and software.

In a similar manner, the marketing financial analyst would make
presentations to relevant members of the buying center. He would also
work directly with the firm's financial organization in determining the
economic impact of the lease-purchase decision. By working with the
financial group, he would be able to analyze the firm's current buying
technology and suggest alternative methodologies which accurately
reflect the costs and benefits of the lease and purchase options.

For optimal efficiency, it would be desirable for the marketing
financial analyst to have the capability of adapting to the specifics
of the situation. For example, if the lessor is faced with stiff price
competition on a particular order, the analyst may be given limited
authority to adjust the lease rate or the terms of the contract in
order to obtain the account.1 This flexibility may allow the lessor to
gain a competitive advantage over finns which require corporate or
division level approval of similar changes. Having a financial analyst
in the field would enable the firm to adapt more rapidly to changing
circumstances which may arise during the negotiation stage of the
industrial purchasing process.

As the degree of autonomy of the marketing financial analyst
increases, however, the question of control becomes more significant.

For example, if the analyst reports directly to field sales management,

 

1Of course, guidelines must be developed to insure that such
changes do not violate the Robinson-Patman Act.

166

he may deve10p a tendency to adjust the terms of the lease contracts
to maximize sales at the expense of profit. This is particularly true
if, as is so often the case, the sales organization's performance is
measured in terms of orders and revenue. One possible solution to this
problem is to maintain the marketing analysts under the direct control
of the chief financial officer. They would then advise field sales
management in a staff capacity. This organizational arrangement would
allow the corporate or division level financial group to exert an
influence on the activities of the field analysts. Periodic rotation
for home office assignments may also be helpful in minimizing the
sales orientation of the analysts. A subsidiary benefit of this
approach may be to improve the working relationship between the sales
and financial organizations.

Many non-manufacturer lessors may also find the marketing
financial analyst approach to be highly relevant to their sphere of
operations. Expansion of this segment of the industry will increasingly
depend on the active promotion of the economics of leasing. Tradition-
ally, independent and bank lessors have been less than aggressive in
their marketing of leases. For example, many banks operate their
leasing departments strictly on a referral basis from commercial loan
officers. In addition, much of the promotional literature of
non-manufacturer leasing firms suggests a lack of appreciation for the
relevant economic benefits of leases. Many of their brochures feature
highly questionable advantages and present analytical models which
violate the fundamentals of financial theory. It appears that these
firms would have much to gain by adopting the marketing financial

analyst approach.

167

As the survey results suggest, the opportunity exists to raise
the awareness levels of industrial consumers vis-a-vis the financial
advantages of leasing.1 The use of highly trained marketing financial
analysts would allow lessors to introduce potential customers to more
advanced lease analysis models. To the extent that a given lease
contract results in an economic advantage to the lessee, both parties
to the transaction gain. Indeed, in the absence of any significant
market imperfections, a more efficient allocation of resources should
result.

The impact of leasing on the marketipg
mix of manufacturers

 

 

Manufacturers who offer their products for both sale and lease
will find that leasing has a major impact on their marketing mix
strategies. For example, the firm's promotional program must be
redirected to communicate, not only the technical advantages of the
product, but also the economic advantages of leasing. This has a
significant effect upon the objectives of the promotional campaign,
the message strategy, and the promotional media employed. The firm may
find it necessary to reallocate a portion of its promotional resources
from its traditional targets, such as purchasing agents and engineers,
to other participants in the lease-purchase decision process. In
particular, the firm will have to identify and reach the relevant
analyst—influencers in the financial organization. In addition to

communicating the economics of leasing, the firm's message strategy

 

1As noted in Chapter II, Wehle's survey also suggests that
industrial firms may be unaware of many of the potential economic
advantages of leasing. See, Wehle, pp. VI-l to VI-57.

 

168

must attempt to dispel negative attitudes that buying center members may
have concerning leases. In large part, this will require an informa-
tional campaign which confronts these issues directly.

Pricing presents a unique problem for the manufacturer-lessor
because both a sales price and a lease rate must be determined for the
same product. One approach, which is used in a number of industries,
is to set the lease rate and purchase price such that they generate the
same rate of return over the product's life cycle. Alternatively, the
rates may be set so as to encourage either leasing or purchasing.
Depending upon the nature of the product and the industry, a manufacturer
may feel that a high lease-purchase ratio generates certain marketing
advantages. For example, leasing may encourage closer contact between
the lessee and the manufacturer's sales force. Such contact may lead to
lease renewal business or increased sales of other products in the
company's line. In addition, the use of incentives such as lease
credits may encourage the lessee to "trade-up" as his capacity or needs
require. This technique is used by many computer firms who allow their
customers to apply part of the payments on presently leased systems to
the purchase or lease of larger systems.

On the other hand, some manufacturers may wish to set relatively
high lease rates in order to encourage purchase. Leasing can place a
heavy financial strain on a firm. Fruhan estimates that in the
computer industry it requires $1.20 in firm capital to support $1.00 in
annual shipments.1 Indeed, it has been suggested that the inability to

meet the heavy capital requirements of the industry was one of the major

 

1William E. Fruhan, "Pyrrhic Victories in Fights for Market

Share,” Harvard Business Review 50 (September—October 1972), p. 102.

169

factors in the decision to abandon the RCA and General Electric computer
ventures.1 Thus, some firms may wish to maintain a low lease-purchase
ratio because they feel that they do not have the financial strength to
support an expanding lease base.

For a firm with an established lease base, however, the capital
drain is not as severe since revenue from outstanding contracts helps to
support new lease business. Indeed, a high lease-purchase ratio is said
to be an advantage during periods of economic slowdown. This is because
the lease base continues to generate revenue even as new orders dr0p
off. The argument may be somewhat overstated, however, since the drop
in new orders will tend to reduce the firm's revenue base for the
future years.

In addition to affecting the firm's lease base, the business
cycle has important implications for lease pricing. During periods of
tight money, for example, firms may find it attractive to lease equipment
rather than to finance its purchase with costly debt capital. The
manufacturer lessor may be able to encourage this tendency by maintaining
the effective yield on its leases below the rate on comparable bank term
loans. The extent to which a firm will be able to implement such a
strategy will depend, in large part, on the price it must pay for
capital funds. As such, the larger and more financially sound firms
would tend to be at an advantage in this process. In effect, these

firms would be acting as wholesalers of capital by issuing securities

 

'Ihid.

170

at relatively low rates,1 and using the funds to support leases at
rates which are competitive with bank debt.
During periods of recovery, lessors may be able to take
advantage of changes in the investment tax credit. Changes in this
statute are generally made during these periods in order to encourage
additional capital investment.2 As was pointed out in Chapter II,
firms with low or heavily sheltered earnings may be unable to use the
full amount of the credit. This presents lessors with an opportunity
to utilize the credit and pass on a portion of the savings via a lower
lease rate. Thus, astute lease pricing may allow a manufacturer to take
advantage of economic conditions at both extremes of the business cycle.
Manufacturers may find that leasing also impacts the service and
product quality elements of the marketing mix. Wehle found that many
firms expect better maintenance and installation service on leased
equipment.3 If these expectations are not fulfilled, the lessor may lose
the opportunity for lease renewal business and new orders. In addition,
lessees often feel no obligation to make rental payments, and lessors

are reluctant to require payment, until the equipment is operating

 

1This might include equity issues, bonds, or long-term bank
notes.

2The investment tax credit was first established in 1962. It was
revised in 1964 and subsequently suspended in 1966. In 1967, the ITC
was reinstated only to be repealed again in 1969. The present statute
was reenacted in 1971 and revised in 1975. See: Ray M. Sommerfield,
Federal Taxes and Manpgement Decisions (Homewood, IL: Richard D. Irwin,
1974), p. 165; and P-H FederaT'Tax Course 1976, par. 2050. Given the
checkered history of the tax credit, it appears reasonable to assume
that Congress will continue to use it to accelerate recovery during
periods of economic slowdown.

3Weh1e, p. VI-45.

 

171

properly at the customer's location. As such, proper installation and
basic product quality become important factors in determining the
profitability of leased equipment. Indeed, it is not unusual for newly
developed computer systems to generate little or no lease revenue
during the first months after introduction because of the inevitable
problems associated with bringing the systems up to full working
capacity.

From the standpoint of long-term profitability, the lessor has a
vested interest in maintaining high standards of quality and service.

As the product moves through its life cycle, the lease renewal revenue

it generates will be in proportion to its expected useful life. Clearly,
high quality standards and expert maintenance will allow the manufacturer
to stretch the period of useful service. Proper maintenance will also
facilitate the sale or lease of the product as second-hand equipment

once its original lease has expired. As such, the product may be able

to generate a reasonable return through the maturity and decline stages
of its life cycle. The sale or lease of reconditioned equipment which
has been fully depreciated can result in substantial profits if initial
product quality is high and demand is of sufficient magnitude.

In the final analysis, however, the long-term profitability of a
manufacturer's leasing program depends upon how well the firm can market
the economics of leasing. The theme of this research has been that the
lease is essentially a financial device, and that it provides the
industrial consumer with a set of benefits which are primarily economic
in nature. It has been pointed out that the financial analysis
methodologies employed by industrial firms to make lease versus purchase

decisions tend to be biased against the lease alternative. As a result,

172

the overall marketing strategy of the lessor must focus upon
communicating the relevant economic benefits to potential lessees. This
includes the need to educate these firms to more advanced models of
lease analysis. The marketing financial analyst concept is a proposed
organizational arrangement which will facilitate this communication
process. As suggested earlier, the marketing financial analyst will
require the support of the firm's other promotional elements. Informa-
tional campaigns employing selective mass media vehicles and direct mail
appear to be particularly appropriate for this task. Institutional
campaigns in broader distribution print media will also provide support
for the firm's lease marketing activities. Finally, the lessor's
promotional program must be coordinated with the other segments of the
marketing mix. The pricing, product quality, and service elements must
ensure that the consumer will realize an economic advantage by entering

into the lease contract.

Recommendations for Future Research

 

The present study has revealed at least three areas for future
inquiry. First, there is a clear need for further research on the
evaluative criteria employed by industrial firms in making lease versus
purchase decisions. More specifically, research should determine which
of the alleged advantages of leasing are considered to be true benefits
and which are viewed as being illusory. In addition, the relative
salience of perceived benefits should be investigated. To date,
research in this area has simply catalogued various proposed benefits
without actually determining the factors which are truly significant

in the leasing decision. The research problem appears to be

173

particularly well-suited to the application of expectancy-value models.
Moreover, the information generated by research of this type would be of
great value to lessors in planning their lease marketing strategies.

Lease marketers should also profit from further research on the
lease versus purchase decision process portrayed in Figure 1. A
majority of the hypotheses which are implicit in the model have not
been tested empirically. For example, research could shed additional
light on the nature and significance of the analyst-influencer's role
in the lease-purchase decision procedure. There is also a need to
examine the impact of individual factors such as background, education,
and experience on the decision orientation of buying center members.
Empirical inquiry would also be useful in determining the external
sources of information used in making the decision. Further research
on these and the many other issues raised by the lease-purchase decision
model will allow lessors to better meet the needs of their industrial
customers.

Finally, further theoretical work is required in the development
of normative lease versus purchase analysis models. As was illustrated
in Chapter III, a good deal of disagreement exists concerning the
appropriate analysis procedures. Future work in this area should focus
on resolving some of the major points of contention among the more
recently developed models. The differences in these approaches are
largely a function of the varying conceptual orientations of their
authors. Schall's recognition of the lease as a financial hybrid is an
important step toward a more precise and rational definition. Hope-
fully, other researchers will build upon this foundation in an attempt

to forge a synthesis in the area of lease analysis methodologies.

APPENDICES

174

MICHIGAN STATE UNIVERSITY

 

GRADUATE SCHOOL OF BUSINESS ADMINISTRATION EAST LANSING ' MICHIGAN ° 48824
DEPARTMENT OF MARKETING AND
TRANSPORTATION ADMINISTRATION

Dear Sir:

As you know, there is a great deal of disagreement among practitioners
and academicians concerning the appropriate methods of analyzing lease
versus purchase decisions. The Graduate School of Business Administration
at Michigan State University is conducting a survey to determine current
corporate practice in this area of decision making. We would greatly
appreciate your firm's participation in this survey. In return, we would
be willing to send you a copy of the research results.

Enclosed is a hypothetical lease versus purchase case situation and
a brief questionnaire. We would like you to forward this material to the
person or department responsible for the financial analysis of lease-
purchase decisions for the corporation. If your firm decentralizes such
decisions at the division level, please forward the case and questionnaire
to the domestic division which is most heavily involved in the leasing of
capital assets. In the event that your firm does not undertake lease
commitments, please have a member of your corporate financial staff fill
out the applicable sections of the questionnaire only.

Neither the case nor the questionnaire requires disclosure of any
proprietary information concerning your corporation. Nevertheless, you
have our assurance that your responses will be kept strictly confidential,
and that your firm's name will not appear in any tabulation of results of
this research project. If you wish, however, you may return the materials
anonymously.

The usefulness of this survey's results to you, as a decision maker,
will be directly proportional to the corporate participation we are able

to obtain. We, therefore, request your cooperation in this matter.

Sincerely, //l,
\i 1' ... . /
'1' ’1‘ I q; 1. -| , m
LL) 1.11-1.11. .11 1 mg .‘-- 11.. M
William Lazer . Paul Anderson

Professor of Marketing Graduate Assistant

175

MICHIGAN STATE UNIVERSITY
GRADUATE SCHOOL OF BUSINESS ADMINISTRATION
LEASING SURVEY

INSTRUCTIONS for CASE ANALYSIS and QUESTIONNAIRE

 

The purpose of the case and questionnaire is to determine current
corporate practice regarding the financial analysis of lease versus
purchase decisions. We feel that the best way to accomplish this is
to ask you to analyze the enclosed case situation by employing the
methodology you would normally use for such situations. (If your firm
does not lease capital assets, or if you do not employ a formal analysis
methodology for these types of decisions, simply fill out those portions
of the questionnaire which apply and return it in the enclosed envelope.)

Please note that neither the case nor the questionnaire requires you
to reveal any proprietary information concerning your firm. Nevertheless,
we assure you that your responses will be kept strictly confidential, and
that your firm's name will not appear in any tabulation of the results of
this survey. You may, of course, return the case analysis and
questionnaire anonymously if you wish.

Please perform the calculations for the case analysis on your own
forms or worksheets, and carefully document each step of your methodology.
The case problem has no right or wrong answers and is not intended to be
a "typical" lease versus purchase situation. Indeed, many simplifying
assumptions have been made in order to make the calculations easier.

(For example, all cash flows, with the exception of the purchase price
outflow, are assumed to occur at the end of each year.) The numbers are
purely hypothetical and do not necessarily represent current economic
conditions. In addition, it is not intended that you use all of the data
given in the case. Use only that data which you would employ in your
normal lease-purchase analyses. If you use a computer program for these
types of decisions, please enclose a copy of the output from the program
along with an explanation of the program's methodology. Should you have
any questions or problems, please call Mr. Paul Anderson at 517-355-4619.
The most convenient time would be on Wednesdays or Fridays between

12:30 p.m. and 2:00 p.m. Eastern Time.

After you have completed the case, please fill out the brief
questionnaire and return it and the case analysis worksheets in the
enclosed self-addressed envelope. You may keep all of the other
materials for your files. It would be greatly appreciated if you
could return the case analysis and questionnaire as soon as possible.
If we can obtain your cooperation in this matter, we will be able to
send you the results much more quickly.

176

MICHIGAN STATE UNIVERSITY
GRADUATE SCHOOL OF BUSINESS ADMINISTRATION
LEASING SURVEY

CASE: FINANCIAL ANALYSIS OF A LEASE VERSUS PURCHASE DECISION

Assume that your firm has the option of acquiring a piece of
capital equipment for the cash purchase price of $300,000. This repre-
sents a cash outflow at the beginning of the equipment's useful economic
life of five years. The fire-tax residual or fair market value of the
equipment at the end of t e fifth year is expected to total $45,000.*
If the equipment is purchased, it will be 95% depreciated over its
useful life using the sum-of—years digits method (see Schedule 1 below).
Pre-tax operating costs of the equipment under the purchase option are
expected to be $40,000 per year.* Operating costs include such things
as labor, materials, maintenance, insurance, etc., and are assumed to
be cash outflows at the end of each year (see Schedule 2 below).

Alternatively, the firm may obtain the use of the equipment by
entering into a non-cancelable financial lease with a term of five years.
The annual lease rate is $84,000 payable at the end of each of the five
years. The lease contract does not provide for a purchase option at the
termination of the lease. However, the lessor has agreed to assume a
portion of the operating costs of the equipment. These costs, which
include such things as maintenance and insurance, are expected to total
$20,000 per year.* As a result, the firm will incur $20,000 in annual
operating costs with the lease compared to $40,000 if it purchases the
equipment (see Schedule 2 below).

Assume that your company expects the equipment to generate new
cash revenues of $175,000 per year as shown in Schedule 3* (considered
to be cash receipts at the end of each year). Further assume that dis-
cussions with the firm's bank reveal that it may obtain a five-year term
loan in the principal amount of $300,000 at an interest rate of 8% per
annum. A repayment schedule for such a loan is shown in Schedule 4
(it is assumed that installment payments are due at the end of each year).

Additional assumptions concerning interest rates, capital costs,
and taxes are given below:

CAPITAL COSTS, INTEREST RATES, AND THE REINVESTMENT RATE

 

l. The firm's cut-off rate for capital investment decisions
(i.e., the corporation's after-tax weighted average cost
of capital) = 12%

2. The firm's cost of intermediate term debt capital (i.e.,
the rate of interest on a bank term loan available to the
corporation) = 8% (pre-tax) and 4% (after-tax)

177 2

The current "riskless" rate of interest (approximated by the

pre-tax rate of return the firm could earn by investing in
U.S. Government securities) = 6%

The company's average after-tax reinvestment rate (i.e., the
average rate of return on new investments which the firm
eXpects to earn over the next five years) = 12%

TAX RATES AND TAX ASSUMPTIONS

 

1.
2.

The firm's average and marginal income tax rate = 50%

The tax rate applicable to gains and losses on the disposal
of fixed assets = 30%

The applicable effective rate under the investment tax credit
is 4.667% or $14,000 (4.667% of $300,000)

a. Assume that sufficient income from other sources exists
such that the full amount is taken as a credit against
taxes in the first year of the equipment's life under
the purchase option
b. Assume that the lessor will not allow the firm to claim
the ITC (as allowed by Section 48(d) of the Internal Revenue
Code) if the equipment is leased

Assume that all taxes represent cash outflows at the end of each
year

Ignore all state and local taxes as well as all federal excise
taxes

Assume the lease is recognized by the I.R.S. as a true lease as
specified in Section 162(a)(3) of the Internal Revenue Code and
Revenue Ruling 55-540 so that the full amount of the lease
payments qualifies as a tax deduction

SCHEDULES

Schedule 1: Five-year Depreciation Schedule Applicable for the Purchase

 

Note:

Option (based on the sum of years digits method)
Depreciation

Ex ense
$ 95,000
76,000
57,000
38,000

19,000
$285,000

 

-<
m
an
1

weak...)

The above schedule represents the depreciation which is deductible
for tax purposes.

178 3

Schedule 2: Expected Annual Pre-Tax Operating Costs of the Equipment
(cash outflows at the end of each year)

 

 

 

 

 

 

 

Operatin Costs Operating Costs Additional Costs
1gp: if Purchased if Leased** of Purchase

1 $ 40,000 $ 20,000 $ 20,000
2 40,000 20,000 20,000
3 40,000 20,000 20,000
4 40,000 20,000 20,000
5 40,000 20,000 20,000

$200,000 $100,000 $100,000

**These costs are in addition to the annual lease rate.

Schedule 3: New Cash Revenues Expected to be Generated by the Equipment
(cash inflows at the end of each year)

Year Cash Revenue

$175,000
175,000
175,000
175,000
175,000
$875TOOO

UW-PWN—I

Schedule 4: Repayment schedule for a five-year 8% bank term loan avail-
able to the firm in the principal amount of $300,000
(installment payments due at the end of each year)

 

 

Installment Principal Remaining
_ggr Payment Interest Repayment Balance
1 $ 75,137 $24,000 $ 51,137 $248,863
2 75,137 19,909 55,228 193,635
3 75,137 15,491 59,646 133,989
4 75,137 10,719 64,418 69,571
5 75,137 5,566 69,571 ---
$375,685 $75,685 $300,000

*The numbers given for salvage value, operating costs, and cash
revenues may be considered to be "expected values" or best estimates of
the future values of these cash flows and are assumed to be as certain
as the average investment cash flows of the firm.

 

 

179

MICHIGAN STATE UNIVERSITY

LEASING SURVEY

ANALYST'SAQUESTIONNAIRE

GENERAL INFORMATION

 

N .4

co

O-OCJ'D)

p

5. Fiscal year 1974 sales volume of your corporation:

I‘D QOU'QJ

"thQOU‘Q-l

Your position in the company

GRADUATE SCHOOL OF BUSINESS ADMINISTRATION

 

Your department

 

Your department's level within the corporation:

Corporate headquarters
Division

Subsidiary

Other (please specify)

 

Industry classification of your firm:

Conglomerate

Agriculture, Forestry

Mining, Petroleum Refining
Manufacturing, Construction
Transportation, Communication
Other (please specify)

 

$2.5 billion and over
$1.5-$2.5 bi11ion
$1.1-$l.5 billion

$800 million-$1.1 bi11ion
Less than $800 million

DDDDDD DUDE

DDDDD

180

6. Does your firm lease capital assets?

Yes [:]
No [:j

_Lf your answer to Number 6 is "No," please go to Question 12.

7. Dollar value of annual lease payments made in 1974 as shown in
the corporation's annual report or on S.E.C. Form lO-K:

$100 million and over
$50-$1OO million
$25-$50 million
$10-$25 mil1ion
Less than $10 million

(DD—00"”

DECIDE

LEASE VERSUS PURCHASE ANALYSIS

8. Does your firm employ a formal financial analysis methodology for
lease versus purchase decisions? (i.e., are the financial aspects
of the lease-purchase decision analyzed using standard techniques
such as net present value, internal rate of return, payback, etc.)

Yes [Z]

No [Z] (please explain)

 

 

 

 

If your answer to Number 8 is "No," please go to Question 12.

9. Do you consider the lease versus purchase decision to be:

a. A financing decision (i.e., a decision
concerning alternative means of obtaining
capital resources) . . . . . ...... . . [:J

b. An investment decision (i.e., a decision
concerning the allocation of resources to
obtain the use of capital assets) . . . . . [Z]

c. Both a financing and investment decision .

181

LEASE CASE PROBLEM

10. Based on your analysis of the lease case problem, and from a
financial standpoint alone:

a. The purchase is preferred [:1
b. The lease is preferred [:1
c. The solution is indeterminate [Z]

(Please explain)

 

 

 

Be sure to enclose a copy of your lease—purchase analysis worksheets
with the questionnaire.

11. If possible, please specify the exact source(s) of the methodology
you used to solve the case (e.g., company manual, textbook, academic
article, etc.):

Title:

 

Journal or Magazine (if applicable)

 

Author(s)

 

Date of Publication

 

SPECIFIC IDENTIFICATION (OPTIONAL)

12. If you would like a copy of the results of this survey, please fill
out the following:

Name

 

Company
Address

 

 

 

 

NOTE: IF YOU WISH TO RETURN THIS FORM ANONYMOUSLY AND WOULD
LIKE A COPY OF THE RESULTS, PLEASE SEND A POST CARD
WITH YOUR NAME AND ADDRESS TO MR. PAUL ANDERSON AT
THE ADDRESS SHOWN ON THE ENCLOSED BUSINESS REPLY
ENVELOPE.

 

 

 

APPENDIX B

182
MICHIGAN STATE UNIVERSITY

 

GRADUATE SCHOOL OF BUSINESS ADMINISTRATION EAST LANSING ° MICHIGAN ° 48824
DEPARTMENT OF MARKETING AND
TRANSPORTATION ADMINISTRATION

Dear Sir:

Recently we sent you a letter requesting your firm's participation
in the Michigan State University Leasing Survey. To date, we have
received responses from approximately 20 percent of the companies in
our sample. While we are gratified by this response rate, we believe
that a somewhat larger return would greatly improve the usefulness of
the survey's results to the participants and to interested scholars.

We would be very appreciative, therefore, if your staff could find
the time to complete our case analysis and questionnaire.

The early returns which we have received are quite interesting,
and if we are able to improve our response rate, we believe that you
will find our summary of the survey results to be very useful.

In the event that your response is in the mail, or if you have
returned the research instrument anonymously, we would like to thank
you for your cooperation. Shortly, a letter will be sent to all of
the participating firms who have requested a copy of our results.
The letter will indicate the anticipated nature of the research
report and its expected completion date.

Sincerely,

e4~/7/::;57213;;:Ec_,,eew-
‘¢§:::TT:I’Anderson ////:>

Graduate Assistant ’/

BIBLIOGRAPHY

 

 

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Uncertainty." Accounting Review 48 (July 1973): 489-93.

 

Legal References

 

Black‘s Law Dictionary. Revised 4th ed. 1968.

 

P-H Federal Tax Course 1975.
P-H Federal Tax Course 1976.
Rev. Proc. 75-21, IBR 1975-18.
Rev. Rul. 55-540, 1955 CB 41.
2 P—H 1975 Federal Taxes.

U.S. Department of the Treasury. Annual Report of the Comptroller of
the Currency, 1963.

 

 

Miscellaneous

 

AAEL News Bulletin. 16 June 1975.

 

AAEL News Bulletin. 18 July 1975.

 

"Accounting for Leases.” Executive News Briefs 3 (September 1975): 1-2.

 

Babione, Francis A. "Marketing Equipment by Leasing.” Ph.D. disserta-
tion, Ohio State University, 1949.

Bytwork, Alvin J. "The Effectiveness of Alternatives to Purchase in the
Marketing of Construction Equipment through Distributors.” Ph.D.
dissertation, Michigan State University, 1961.

190

Cohen, Albert H. "Long-Term Net Leasing Practice: Problems of Taxation,
Finance and Accounting." Ph.D. dissertation, University of
Michigan, 1953.

Eiteman, Wilford J. Telephone interview. 28 July 1975.

Findlay, M. Chapman, III. "Financial Lease Evaluation: Survey and
Synthesis." Paper presented at the Eastern Finance Association
meetings, Storrs, CN, 12 April 1973.

Kares, Peter. "Some Economic Implications of Equipment Lease Financing.”
Ph.D. dissertation, Purdue University, 1968.

MacNab, Bruce E. ”The Lease as a Device to Market Equipment.” M.B.A.
thesis, Ohio State University, 1959.

Nantell, Timothy J. "Lessor's Pricing Decision, An Indifference Theorem,
and the Evaluation of Lease yp, Buy Algorithms." Ann Arbor,
1975. (Typewritten.)

Nelson, Andrew T. "The Impact of Leases on Financial Analysis.” Ph.D.
dissertation, Michigan State University, 1962.

Treynor, Jack L. "Toward a Theory of Market Value of Risky Assets."
1961 (Typewritten.)

Wehle, Mary M. ”Lessee Decision Criteria and Accounting Implications.”
Ph.D. dissertation, Harvard University, 1972.

 

 

 

 

 

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