When the firm decided to acquire a particular building or equipment, the next question arises how to finance it. Some businesses do not have excess cash, so capital to finance new assets must be obtained from other sources. Funds to purchase asset could be obtained from internally generated cash, by borrowing or by selling new equity. Alternatively the asset could be leased. Business owners and managers are often concerned with the question whether to lease or purchase an asset. (Eugene F. et al. (2008).
"A lease is a comparable to a loan in a sense that the firm is required to make and failure to meet these payments will result in bankruptcy". (Eugene F et al. p.722).
Since most expenses such as lease payments occur in the future a good way to evaluate the lease and purchase options is compare net costs of both alternatives in terms of present values".
This report will be based on three real estate options that a firm is considering to conduct its business. There will be provided the calculation of the PV of cash flows and NPV calculation of the three real estate options. The first option is that the firm can purchase the property with its own cash at a cost of $11.4 million, and save the annual rental costs. In the second option the firm can purchase the facility with part financing.The third option is lease with renting the property at the annual amounts. Discount rate that will be used is 10 per cent cost of capital.After all calculations and analysis there will be conclusion describing what the most effective option is.
Calculation of the PV of the cash flows for each of the three options
In evaluation Purchase or Lease Decisions, NPV technique will be very helpful. This approach is similar to the capital-budgeting problem. However there is a major difference exists between capital budgeting and lease problems. In capital budgeting, the project with higher NPV is preferred one, whereas in lease versus purchase, the option with lower present value of expenditure should be selected. (Angelico A. Et.al 2006)
PV (Purchase without financing) = 70,949/ (1+0, 10)+ 80,300/(1+0,10) + 80,300/(1+0,10)+ 80,300/(1+0,10)+80,300/(1+0,10)+ 80,300/(1+0,10) +80,300/(1+0,10) + 80,300/(1+0,10)+ (80300+11,870,074)/ (1+0, 10) = 64, 499 + 66,364 + 60,331 + 54,846 + 49,860 + 45,327 + 41,207 + 37,461+ 5,068 125 = 5, 488, 018.82
PV (Purchase with financing) = 503,617/ (1+0, 10)+505,025/(1+0,10) + 510,180/ (1+0,10) +515,763 / (1+0,10) +521,809 / (1+0,10) + 528,357/ (1+0,10) + 535, 449 / (1+0, 10) + 543,129 / (1+0, 10) + (551,446+ 5,727, 858) / (1+0, 10)= (457834) + (417376) + (383306) + (352273) + (324002) + (298244) + (274770) + (253374) + 2 195 304 = (565, 874.30)
PV (Lease) = 660,000/ (1+0, 10)+ 660,000/(1+0,10) + 660,000/(1+0,10) + 660,000/ (1+0, 10) +660,000/ (1+0, 10) +726,000/ (1+0, 10) + 726,000/ (1+0, 10) 726,000/ (1+0, 10) +726,000/ (1+0, 10) = (3 930 859)
Calculation of the NPV for each option
"The difference between the present value of expected returns and the initial investment required to generate these returns is Net Present Value (NPV). The formula of NPV:
Where r - is the required rate of return." (Van Horne J., Machowicz J. 2001, p 323)
- NPV (Purchase without financing) = 5, 488, 018.82+11,400,000= ($5 911 981, 18)
- NPV (Purchase with financing) = (565, 874.30) + 3,579, 000 = ($4 144 874, 30)
- NPV (Lease) = (3 930859)
In making the final decision whether to lease or to purchase, managers pick up the less expensive alternative, as the aim to select the financing method that produces the lowest present value cost. In present assignment, this is the option number three, which is leasing, as it generates minimal negative cash outflow (3 930859) comparing with two other alternatives: purchase without financing ($5 911 981, 18) and purchase with financing (4 144 874, 30).
A growing tendency to favour leasing supports the fact, that it carries specific advantages. The first advantage is that it helps to conserve working capital. This is because leasing does not require a lump sum outflow of funds in the form of the purchase price of the asset. Cash is thus retained in the business, and can be used for other important purposes. The second advantage is that lease financing is highly flexible and convenient. The third is that leasing allows firm to avoid risk of obsolescence and finally the lease does not carry restrictive covenants that are found in the case of term loans. (Van Horne J., Machowicz J.(2001)
- Angelico A. Groppelli, Ehsan Nikbakht (2006) Finance, 5th Edition, Barron's Educational Series P.347
- Van Horne J., Machowicz J.(2001), Fundamentals of Financial Management, Prentice Hall, 12th edition, Pp 293-330
- Eugene F. Brigham, Michael C. Ehrhardt (2008), Financial management: theory and practice,12th Edition, Thomson South-Western, p.722
- Angelico A. Groppelli, Ehsan Nikbakht (2006) Finance, 5th Edition, Barron's Educational Series
- Van Horne J., Machowicz J.(2001), Fundamentals of Financial Management, Prentice Hall, 12th edition
- Brealey-Meyers (2003), Principles of Corporate Finance, The McGraw-Hill, 7th Edition
- Ross. S.A, Westerfied R.W, Jaffer J(2007) Corporate Finance, International Edition , 8th Edition, McGraw-Hill
- Brigham E.F, Gapenski L.C (2003), Intermediate Financial Management, Dryden
- McLaney E (2005) Business Finance, 7th Edition, McGraw-Hill
- Eugene F. Brigham, Michael C. Ehrhardt (2008), Financial management: theory and practice,12th Edition, Thomson South-Western