In Practice Leasing versus Borrowing

If borrowing money to buy an asset and leasing the asset are both variations on debt, why might a firm choose one over the other? We can think of several factors that may sway firms in this choice:

1. Service Reasons: In some cases, the lessor of an asset will bundle service agreements with the lease agreement and offer to provide the lessee with service support during the life of the lease. If this service is unique, either because of the lessor's reputation or because the lessor is also the manufacturer of the asset, and if the cost of obtaining this service separately is high, the firm may choose to lease rather than buy the asset. IBM, for instance, has traditionally leased computers to users, with an offer to service them when needed.

2. Flexibility: Some lease agreements provide the lessee with the option to exchange the asset for a different or upgraded version during the life of the lease. This flexibility is particularly valuable when the firm is unsure of its needs and when technology changes rapidly. Flexibility is also useful when the asset is required for a period much shorter than the life of the asset, since buying the asset and selling it again is expensive in terms of transactions time and cost.

3. Tax Reasons: The classic reason provided for leasing is that different entities face different tax rates. An entity with a high tax rate buys an asset and leases it to one with no or a low tax rate. By doing so, the lessor obtains the tax benefits, which are greater because of its higher tax rate. The lessee, in turn, gets the use of the asset and also gains by sharing in some of the tax benefits.

In addition, if a lease qualifies as an operating lease, it essentially operates as off-balance sheet debt and may make firms that use it look safer to the careless analyst. If firms consider leasing as an alternative to borrowing, the choice becomes primarily a financial one. Operating leases create lease obligations to the firm and these obligations are tax deductible. The present value of these after-tax lease obligations has to be weighed against the present value of the after-tax cash flows that would have been generated if the firm had borrowed the money and bought the asset instead. The after-tax cash flows from borrowing and buying the asset have to include not only the interest and principal payments on the debt, but also the tax benefits accruing from depreciation from owning the asset and the expected value of the asset at the end of operations.

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