FINC 0300 - America Coffee House: Evaluating Leasing and Purchasing

This case study provides a detailed financial analysis of whether America Coffee House should lease or purchase an asset, applying capital investment principles for evaluation. It discusses the advantages and disadvantages of leasing, including perspectives from both lessor and lessee. The analysis includes calculating the weighted average cost of capital (WACC) and performing a net advantage to leasing (NAL) analysis under various scenarios, such as changes in payment timing, salvage value, and security deposits. Ultimately, the report recommends leasing the asset, considering the reduced risks and potential cost savings compared to purchasing, based on the present value of lease payments versus the cost of purchasing the asset. The classification of lease payments is also examined under different conditions, reflecting the varying values of the lease contract.

Running head: ACCOUNTING AND FINANCIAL MANAGEMENT
Purchase versus Lease
Name of the Student:
Name of the University:
Author’s Note:

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Table of Contents
Introduction................................................................................................................................2
Discussion..................................................................................................................................2
Leasing Of Assets..................................................................................................................2
Weighted Average Cost of Capital........................................................................................3
Net Advantage to Leasing Analysis.......................................................................................4
Leasing or Purchase...............................................................................................................5
Classification of Lease Payments...........................................................................................6
Conclusion..................................................................................................................................7
References..................................................................................................................................8
Appendix..................................................................................................................................10
1) Weighted Average Cost of Capital...............................................................................10
2) Change in Payment at the beginning of each Period.....................................................10
3) Change in Payment at the End of Year.........................................................................11
4) Change in Salvage Value..............................................................................................11
5) Security Deposits..........................................................................................................12

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Introduction
Assets is an integral part of an organisation, which is used on a daily basis by the
organisation for their daily operational works. The principal of Capital Investment will be
applied for the purpose of evaluation and analysis of the financial viability of the project. The
Asset taken into consideration by the American Coffee house for including the same in
expanding the operations of the company 1.
Discussion
Leasing Of Assets
The process of financing the assets involves acquiring the necessary equipment’s and
assets for a business in order to operate where the company could not afford the assets.
American Coffee House could adopt various type of asset financing like
Leasing: the lessor lends Assets for a fixed period in exchange for a defined period of rental
payments by the lessee to lessor.
Hire Purchase Arrangements: The next best available option for financing the assets is in
the form of Hire Purchase where an initial deposit will be paid for the deposit of the asset and
the remaining balance of the asset will be paid in a fixed period. After making the full and
final payment of all the remaining balance of the asset, the ownership of the asset is
transferred from the lessor to the lessee (1).
The advantages of leasing or renting an equipment are:
 In the case of asset financing or leasing the lessor, do not have to pay the full amount
of acquiring the asset rather they have to pay a minimum amount for using the same.

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 Getting access to better and premium equipment can be well possible with the help of
leasing or asset financing where the initial investment in the asset would be
comparatively lower for the company.
 The rental amount that would be paid by the lessor to the lessee for the financing of
the asset is usually fixed which makes it easy for both the party to value the contract
in terms of present value.
 The lease payment that would be paid by the company or the lessor would be treated
as a taxable expense, which in turn reduces the effective tax rate of the lessor.
 Risk and maintenance of the asset would not be borne by the lessor, which reduces the
risk associated with an asset in terms of breakdown or replacement of the assets (2).
Disadvantages of leasing or renting and equipment are:
 The lessor would not be able to claim capital allowances on the leased assets if the
lease period under which the asset will be leased is less than for a sum of five
years of period or seven years in some cases.
 The leasing policies and the fixed amount payable by the company would not also
be in the best interest of the lessor.
 The option of buying the assets is not always applicable in the case of the leasing
where the lessor might actually want to purchase the same.
Weighted Average Cost of Capital
The weighted average cost of capital shows the minimum rate of return required by
the company for financing the operations and the various activities of the company. The
weighted average cost of capital is calculated with the help of the debt, equity and preference
share financing of the company and the various rates (2). The weighted average of each of
the sources of capital was done with the help of the following formula:

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Weighted Average Cost of Capital = ((Weight of Equity* Cost of Equity) + (Weight of
Debt*Cost of Debt) + (Weight of Preference Share* Cost of Preference Shares)).
The return/rate on equity was calculated with the help of the dividend discount model
where the formula applied was:
Required Return of Equity: (D1/Po) + Growth Rate.
The required return on equity was calculated to be around 12% and the return on
preference share was calculated to be around 7.10%. The after tax cost of debt was calculated
to be around 6% taking the tax rate at 25%. The weighted average cost of capital was
calculated to be around 10.141% and the same has been calculated by using the relevant
weight of the capital and the relevant cost involved in the same (Appendix 1).
Net Advantage to Leasing Analysis
The leasing method will be analysed based on the annual payment of $2.15 million
that would be paid for a sum of six years of period. The payment was discounted with the
help of the weighted average cost of capital that was determined for the company, which was
around 10.141%, and the same was used for discounting the cash flows that would be paid by
the company for getting the actual sum of investment that is paid by the company for using
the assets (3).
Changes in Value when Payment is done at the End of Period: The net value determined
for the asset was around $7,661,654 million (4). The annual lease payment was taken into
consideration for a sum of six years of time and the same was taxed at the taxation rate of
25% for determining the actual value to be paid by the lessor (Appendix 2).
Changes in Value when Payment is done at the Beginning of Period: The net value
determined for the asset was around $6,939,275 million (5). The annual lease payment was

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taken into consideration for a sum of six years of time and the same was taxed at the taxation
rate of 25% for determining the actual value to be paid by the lessor. The value determined is
much lower than the above value reflecting the impact of time value of money (Appendix 3).
Change in Salvage Value: If the salvage value of the asset changes from 1.5 million dollar
to about 2.7 million dollar then the same would be affecting the cost involved in the purchase
of the assets (6). The net value of the assets that would be paid by the lessor would ultimately
be reduced for the company in the form of the higher salvage value of the assets. The net cost
that would be paid by the American Coffee house if the salvage value changes and after
accounting for all the tax shield the company would be getting would be around $6,936,553
million (Appendix 4).
Security Deposit: The value of the asset would change if there would be an initial
investment of $800,000 in the first year in the case of lease payment scenario (7). The lease
payment would be $2.15 million as it is in the six years of period. The after tax cash flows
were discounted at a rate of 10.141% where the value of the asset at today’s times was around
$6,861,654.
Breakeven Lease Payment: The breakeven lease payment for the company where the
payment requested on a lease agreement by a party to a potential agreement is indifferent in
regards to either entering or non-entering into the lease agreements (8). In the above various
case analysed for the company it was found that the American Coffee House would be paying
the lowest in the case of first scenario when the payment is made at the beginning of each
year when the company will be able to receive and utilize the asset in the lowest possible
value, which is around $6,939,275.

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Leasing or Purchase
The analysis from the perspective of the company would be based on the case that the
financial viability and the cost involved in the same would be the key factor that will be taken
into analysis for the purpose of evaluation (9). The assets of the company would be leased if
the present value of the asset were certainly less in the case of lease payment then the
purchase of assets. In the case of leasing an asset it would be certain that in the base case
where payment are made at the beginning of each year the total value of the asset would be
around $7,432,018 million. The salvage value of the asset was taken at 1.5 million in the
evaluation of the project. On the other hand, if the American Coffee House leased the asset
then the value of the asset or the total payment that the company needs to pay would be
around $6,939,275. The same was done by taking an assumption that the payment will be
done at the beginning of each year. However, it is recommended that the company goes for
leasing the asset as the company would be enjoying the benefits of leasing where the
company would not be having the risks associated with the asset such as wear and tear,
maintenance risk and various other problems (10).
Classification of Lease Payments
The classification of the lease payment would be done in accordance with the various
factors and scenarios taken into consideration for the analysis of the project. The sensitivity
analysis from the project could be taken into consideration when payment of the lease will be
at a different point of time if the payment is made at the beginning of each year the value of
the contract or the lease would be worth around $6,939,275. On the other hand, if the value of
the lease changes to payment made at the end of period then the value of the contract or lease
would be around $7,661,654. The same is higher due to payment, which will be made at the
end of the year. Leasing of the asset would differs in different condition reflecting the value

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of the contract. The lease payment would also change if the value of the asset changes from
one year to another when the payment of lease would change (11).
Conclusion
The evaluation and analysis of the asset were done in the case of American Coffee
house were the value of the asset would differ in different condition. The value of the asset
and lease analysis was done in different condition where the evaluation of the company was
done from the investor’s perspective. It was observed from the above case that the value of
the asset in the case of leasing and purchase was analysed reflecting the value of the contract
in the case of lease and the value of the asset in case of purchase.

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References
1. Saunders A, Brynjolfsson E. Valuing Information Technology Related Intangible
Assets. Mis Quarterly. 2016 Mar 1;40(1).
2. Cosci S, Guida R, Meliciani V. Leasing decisions and credit constraints: Empirical
analysis on a sample of Italian firms. European Financial Management. 2015
Mar;21(2):377-98.
3. Propheter G, Hatch ME. Evaluating lease-purchase financing for professional sports
facilities. Urban Affairs Review. 2015 Nov;51(6):905-25.
4. Gao SS. International leasing: strategy and decision. Routledge; 2018 Dec 20.
5. Fatima M. Differences and similarities between Ijara and conventional operating lease
contracts. Market Forces. 2016 Jun 26;1(4).
6. Li T, Karim R, Munir Q. The determinants of leasing decisions: an empirical analysis
from Chinese listed SMEs. Managerial Finance. 2016 Aug 8;42(8):763-80.
7. Nuryani N, Heng TT, Juliesta N. Capitalization of Operating Lease and Its Impact on
Firm's Financial Ratios. Procedia-Social and Behavioral Sciences. 2015 Nov
25;211:268-76.
8. André C, Boulet D, Rey-Valette H, Rulleau B. Protection by hard defence structures
or relocation of assets exposed to coastal risks: Contributions and drawbacks of cost-
benefit analysis for long-term adaptation choices to climate change. Ocean & coastal
management. 2016 Dec 1;134:173-82.
9. Bourjade S, Huc R, Muller-Vibes C. Leasing and profitability: Empirical evidence
from the airline industry. Transportation Research Part A: Policy and Practice. 2017
Mar 1;97:30-46.
10. Kolpak EP, Gorynya EV, Shaposhnikova AI, Khasenova KE, Zemlyakova NS.
Special aspects of leasing activities and its meaning in conditions of enterprise

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competitiveness. International Review of Management and Marketing. 2016 Aug
18;6(6S):126-33.
11. Rampini AA. Financing durable assets. American Economic Review. 2019
Feb;109(2):664-701.

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Appendix
1) Weighted Average Cost of Capital
2) Change in Payment at the beginning of each Period
Particulars 0 1 2 3 4 5 6
Lease Payments (End of Each Year) 2,150,000 2,150,000 2,150,000 2,150,000 2,150,000 2,150,000
Tax Rate @ 25% 537500 537500 537500 537500 537500 537500
After Tax Cash Flows 1,612,500 1,612,500 1,612,500 1,612,500 1,612,500 1,612,500
Present Value of Cash Flows @ 10.41% 1,460,466 1,322,766 1,198,049 1,085,091 982,783 890,121
Total Amount to be Paid 6,939,275
Leasing of the Asset (Payment at the Beginning of Each Year)
Before Tax Cost 8%
Po= (D1/(Re-g)) Po= (D1/(Re-g)) Tax Rate 25%
Re=( (D1/Po)+g) Re=( (D1/Po)+g) After Tax Cost 6.00%
Where; Where;
Current Dividend Paid (Do) 3 Current Dividend Paid (Do) 1
Current Price (Po) 30 Growth Rate (g) 2%
Growth Rate (g) 2% Next Year Dividend (D1) 1.02
Current Price (Po) 20
Required Return= 12%
Required Rate of Return 7.10%
Number of Shares 10,000,000 Market Value of Debt 120,000,000
Market Value of Shares 30 Number of Shares 1,000,000
Equity Value 300,000,000 Market Value of Shares 20
Equity Value 20,000,000
Total Capital = Value of Equity+ Value of Preference Shares+ Value of Debt
Total Capital = 440,000,000
Percentage of Equity 68%
Percentage of Debt 27% WACC 10.141%
Percentage of Preference Shares 5%
Total 100%
Total Value of Equity
Total Value of Preference Shares
Total Value of Debt
Weighted Average Cost of Capital = ((Weight of Equity* Cost of Equity)+(Weight of
Debt*Cost of Debt)+(Weight of Prefference Share* Cost of Prefference Shares))
Required Return on Equity
Dividend Discount Model Dividend Discount Model
Required Return on Preference Shares
Cost of Debt

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3) Change in Payment at the End of Year
Particulars 0 1 2 3 4 5 6
Lease Payments (Begining of Each Year) 2,150,000 2,150,000 2,150,000 2,150,000 2,150,000 2,150,000
Tax Rate @ 25% 537500 537500 537500 537500 537500 537500
After Tax Cash Flows 1,612,500 1,612,500 1,612,500 1,612,500 1,612,500 1,612,500
Present Value of Cash Flows @ 10.41% 1,612,500 1,460,466 1,322,766 1,198,049 1,085,091 982,783
Total Amount to be Paid 7,661,654
Leasing of the Asset (Payment at End of Each Period)
4) Change in Salvage Value
Asset Price 10,000,000
Capital Cost Allowances 35%
Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Initial Investment 10,000,000 0 0 0 0 0 0
Opening Asset Value 10,000,000 6500000 4225000 2746250 1785063 1160291
Depreciation according to CCA 3500000 2275000 1478750 961188 624772 406102
Closing Asset Value 6500000 4225000 2746250 1785063 1160291 754189
Particulars Year 0 1 2 3 4 5 6
Initial Investment -10,000,000
Depreciation -3500000 -2275000 -1478750 -961188 -624772 -406102
Salvage Value (Cash Inflow) 2,700,000
Gross Cash Flows -10,000,000 -3500000 -2275000 -1478750 -961188 -624772 2,293,898
Taxation @ 25% -875000 -568750 -369688 -240297 -156193 384927
After Tax Cash Flows -10,000,000 2625000 1706250 1109063 720891 468579 1908971
Depreciation 3500000 2275000 1478750 961188 624772 406102
Final Cash Flows 875000 568750 369688 240297 156193 2315073
Present Value 792142 466135 274296 161409 94981 1274484
Final Value of the Asset -6936553
Asset Purchase
Cash Flows from Project

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5) Security Deposits
Particulars 0 1 2 3 4 5 6
Initial Investment 800,000 800,000
Lease Payments (Begining of Each Year) 2,150,000 2,150,000 2,150,000 2,150,000 2,150,000 2,150,000
Tax Rate @ 25% 537500 537500 537500 537500 537500 537500
After Tax Cash Flows 1,612,500 1,612,500 1,612,500 1,612,500 1,612,500 1,612,500
Present Value of Cash Flows @ 10.41% 1,612,500 1,460,466 1,322,766 1,198,049 1,085,091 1,470,365
Total Amount to be Paid 7,349,236
Leasing of the Asset (Payment at End of Each Period along with a Initial Investment of 800k)