Lease vs Buy and the WACC Calculation - Product Advisory

June 2020

Introduction

The following document provides additional information regarding the Lease vs. Buy (LvB) functionality and how the Weighted Average Cost of Capital (WACC) calculation is done by LeaseAccelerator.

The LvB is a comparative analysis between two different acquisition models: asset purchase or lease. The comparison between the two is done by discounting the corresponding net after-tax cash flows for each scenario resulting in present value (PV) amounts that can be easily compared to each other. The purchase scenario is further bifurcated into two components, one assuming the use of cash on hand and the other assuming that cash is borrowed. The split between cash on hand and borrowed funds is based on the debt weight assigned to the lessee in the system. Please note that the Debt Weight also has a function with regards to the WACC calculation.

Exhibits

Exhibit 1 shows an example of the LvB Analysis screen after the lease details have been entered in the appropriate tabs. Note that most fields are pre-populated based on data entered in Settings. Some of these data elements may be overridden by privileged users for an individual LvB Analysis, however best practice is that these are defined and entered at the corporate level and should not be changed by the individual user so that the analysis remains consistent.

Exhibit 1

The LvB Analysis generates an LvB Report (Exhibits 2-5). The report is structured in three main sections:

• Results (Exhibit 2) are on the top left of the PDF output. This area shows the Lease PV of Net After-Tax Cash Flows and the Finance/Buy PV of Net After-Tax Cash Flows. The result of the LvB analysis appears here indicating which acquisition method is the most economical based on the inputs. The method generating the lowest PV amount will be the recommended one. The analysis also shows by how much the recommended method is better and the asset cost used for the analysis. Users will also be able to see a preliminary lease classification in this section, based on the old ASC 840 rules. Under ASC 840, many companies take into consideration whether the lease will impact the balance sheet. With private companies still having until 2022 to adopt ASC 842, this analysis is still included in the LvB, despite all public companies having transitioned to ASC 842.

• Break-Even Analysis (Exhibit 2) is on the top right of the PDF output. This indicates the amount of the lease payment needed to make leasing the preferred acquisition method. This is a helpful tool that can help inexperienced or infrequent lessees assess the credibility of an unsolicited leasing offer from a vendor captive and be used as a negotiation tool for a better lease rate factor.

• Key Rates (Exhibit 3) are shown below the Results and the Break-Even Analysis and this area contains several factors involved in determining the outcome of the Lease vs. Buy analysis. The Key Rates section was recently expanded to show Debt Weight and the various Rate Types used for the different cash flows as part of the LvB analysis. The system is currently defaulting to the use of the WACC for all the various cashflows and if a customer wants to have that modified, please reach out to customer support.

• Lease Terms are displayed to the right of to the Key Rates, showing the Lease Start Date, End of Term option, and the lease payment and term used for the analysis.

• Cash Flow Reports (Exhibit 4): The PDF output for this section is broken up into Lease Net Cash Flows and Buy Net Cash Flows. Both flows are shown annually and monthly. The analysis is taking into consideration actual cash flows occurring as a result of the specific transaction being evaluated. The tax benefit is a result of an actual cash tax payment, which is typically made following a standard process of paying estimated tax expenses throughout the year. The timing of these payments will differ by country and the system can be configured to adjust for country differences, however, it is necessary to contact Support if an adjustment to the tax calendar is needed for a particular country.

  • Cash flows are presented in table form and the attributes in these tables include:

  • Columns for Lease: Year Ending, Asset Purchase, Lease Payments & Fees, State Tax (Benefit), Federal Tax (Benefit) to arrive at the Net After Tax Cash Flows. 

  • Columns for Buy: Year Ending, Asset Purchase, Debt Repayment, Interest &

  • Fees, State Tax (Benefit), Federal Tax (Benefit) to arrive at the Net After Tax Cash Flows

• Tax Deductions Reports (Exhibit 5): The PDF output for this section is broken up into Lease Tax Deductions and Buy Tax Deductions. Both deductions are shown annually and monthly. Deductions are presented in table form and the attributes in these tables include:

  • Columns for Lease: Year Ending, Amortized Fees, Depreciation, Lease Payments, NOL Adjustment, Total Deductions to arrive at the Federal Tax Deductions

  • Columns for Buy: Year Ending, Amortized Fees, Depreciation, Interest and Fees Payments, NOL Adjustment, Total Deductions to arrive at the Federal Tax Deductions

Exhibit 2

Exhibit 3

Exhibit 4

Exhibit 5

Key Rates Defined

As mentioned above, the LvB Analysis is based on a number of factors largely defined at a corporate level. Below are highlights of the various factors which are specific to the LvB. Other factors are standard to the core Compliance Essentials applications (i.e. fiscal calendar, IBR) and are not addressed in this document.

Tax Rates

The tax rates entered in the system for the entity are applied to the specific transaction and the resulting tax benefit from any expense or income as a result of the transaction is reflected based on the applicable tax rates entered in the system. The resulting tax cash payment is then included in the cash flow section of the analysis. This is what produces the net after tax cash flows used for the comparison between the lease and the buy scenario once they are discounted to a present value amount. These are estimated tax rates to be used for analysis purposes only and LeaseAccelerator does not perform nor support tax accounting.

The result of the analysis is highlighted on the first page of the report.

Net Operating Loss

The LvB functionality allows for the use of Net Operating Losses (NOL). If additional granularity is required, please make sure to get advice from your tax department. If the company is in an NOL situation, then it will not generate an after-tax benefit until the NOLs are fully consumed. This is due to the fact that in an NOL situation the company is not paying any actual cash taxes and therefore there is no tax shield provided by an actual cash tax payment. The entry in the system is to specify the year when the NOLs are fully used up and then the cash-benefits from the proposed purchase are reflected from there on as the company once again pays cash taxes.

Rate Types

The system is flexible, and the customer may elect which rate to use for the discounting of the different cash flows that are part of the LvB Analysis. The choices are Debt, Equity, or WACC. As this functionality is a comparative analysis, it is highly advisable that the same rate is selected for every cash flow. The best practice suggestion is to use the WACC, as that is the typical rate companies use for capital allocation decisions. 

If a customer prefers to use an assumption that all funds used for the acquisition of new assets come from new borrowings, then the debt weight must be set at 100%. Be aware of this point as it will impact the WACC calculation as well (see The WACC Calculation below).

If a customer wants to use the 100% debt weight to assume that all purchases are funded with borrowed funds, then using the cost of debt as the preferred discount rate for the cash flows is probably the best methodology to keep everything consistent.

Please note that LeaseAccelerator is also adjusting the cost of debt to the after-tax number when doing the actual present value calculation. This applies to both the WACC and/or the cost of debt only if that is the rate used. The result is that the PV of the after-tax cash flows are calculated with the after-tax adjusted discount rate, which is the best practice corporate finance methodology. The WACC and cost of debt shown on the LvB report will be the pre-tax rates.

The WACC Calculation

LeaseAccelerator calculates the WACC when the cost of Equity and Debt plus the Debt weight (blue numbers) are provided.

In most companies, the WACC is a single number that is used for capital allocation decisions. Usually, it is updated on an annual or quarterly basis. It typically is not modified to match the term of whatever project is being evaluated.

However, in LeaseAccelerator all rates are configured by term to maximize flexibility. While technically, Equity rates are not related to the term, they can be configured using a single rate by specifying the same Equity rate for 1 month and 360 months (or whatever the longest lease term is), as LeaseAccelerator will automatically interpolate the rate for all terms in between. Customers have the flexibility to do the same method with the cost of Debt if it is preferred to have a static WACC over all the various terms. Customers can also enter the Cost of Debt with its proper yield curve and the resulting WACC will adjust based on the term selected for the deal being evaluated.

The debt weight is typically the "ideal" amount of debt that the customer is striving for. Most companies have a target debt to equity ratio that they are managing towards and that is what should be used, based on best practices.