The automobile enables us to live, work, and play in ways that were unimaginable a century ago. Indeed, auto mobility is a key ingredient to our well being as a society. Whether it is commuting to work or traveling on vacation, automobiles connect us to each other like nothing else on earth. Autumn's Property Management (APM) has a dilemma of whether or not to buy or lease a new vehicle for the company. APM is a newly formed company that has been in business for about two years. The company currently manages six commercial properties and two industrial properties and would like to expand to investing in residential homes.
APM needs to have reliable transportation that is comfortable for clients to ride in. APM is looking to purchase a four door sedan with a price range of $30,000 to $55,000. There are many different factors to mull over when deciding whether to purchase or lease a new vehicle. The processes of each are very different, with leasing potentially being more confusing due to its vast terminology. APM would like to find the best possible way to make this purchase.
The advantage, disadvantages, and types of loans will be analyzed for both buying and leasing options. APM will then compare and analyze their findings; making a final decision in the best interest for the company. For APM, there are a number of advantages to buying a vehicle. First, while a standard warranty is not necessarily an advantage, an extended warranty is. Most automobile manufacturers now offer a 100,000-mile warranty on new and used vehicles. APM would purchase an extended warranty if they decided to buy a new vehicle.
Most extended warranties cost extra money, but can easily be haggled in with the purchase price of the car. Second, APM could put as many miles as necessary for day-to-day business operations. Unlike leasing, there are no mileage restrictions when a vehicle is purchased. Third, APM would not have a residual to pay at the end of the term.
For leases, this is the remaining value after the lease term expires. The higher the residual amount, the lower your lease payment will be. Finally, APM would be free to make any modifications to a purchased vehicle and would own it outright and the end of the term. At the end of a lease the vehicle has to be returned or a residual paid.
While there are a number of advantages to buying a car, there are also some disadvantages to consider. The biggest draw back is monthly payments on the purchase of a vehicle. Monthly loan payments are usually higher than monthly lease payments because you are paying for the entire purchase price of the vehicle, plus interest and other finance charges, taxes, and fees. The term of a loan is usually longer than the terms of a lease. Therefore, the payments are higher and last for a longer duration. How much money put on the car can affect the payment, but to get a payment as low as a lease payment APM would have a substantially larger up-front cost of getting into a new vehicle.
The second drawback is the cost of obsolescence on a new vehicle. When a car is leased, the lessor has the risk of future market value on the vehicle (Gitman et al. 243). If APM buys a new car then they will have the risk of future market value on the vehicle. For APM this means that the company will have the burden of a car that has depreciated considerably over the life of the loan. Third, APM has the burden of repairs on the vehicle after the warranty expires.
In a lease, the car would be covered for the duration of the term. If a car is bought, depending on the warranty, APM could be making payments on a car with an expired warranty. Loan terms are usually for three to six years depending on the price of the vehicle. The loan will usually cover only 80 percent of the purchase price, which could mean a sizable down payment. However, making a large down payment will reduce the total amount financed thus reducing the monthly payment. The interest rate will depend on APM credit rating.
APM has the option to find other financing besides using financing though the dealership. In some cases, better interest rate can be obtained thought credit unions if one is a member. Like buying a vehicle, leasing a vehicle has some advantages. If APM leased a car, they would be able to avoid the cost of obsolescence (Gitman et al. 243). APM would pay for only a portion of the vehicle's cost, which is the part that is used up during the time APM drives it.
The monthly lease payments would be lower and made up of two parts: a depreciation charge and a finance charge. The depreciation part of each monthly payment compensates the leasing company for the portion of the vehicle's value that is lost during your lease. The finance part is interest on the money the leasing company has tied up in the car while APM was driving it (web). With leasing, APM would have the option of not making a huge down payment and sales tax would only be paid on the monthly payments. Leasing allows for current flexible financing (Gitman et al. 243).
APM would not need to arrange for other financing until the end of the lease. Most car leases have built-in gap coverage, while car purchase loans almost always do not. Gap coverage, or gap insurance, pays the difference between what is owed on the lease, and what the car is actually worth if the car is stolen or destroyed. This is important because it is very common with car loans in these days to have low down payments and delayed payment deals to owe more than your car is worth for most of the life of the loan. This can mean APM could still owe hundreds or thousands of dollars to the loan company even after APM's insurance has paid off for a car that would no longer have any use (web).
This could turn out to be a shocking surprise for anyone caught in this unfortunate situation. There is a downside to leasing a car. At the end of the lease, APM will have no ownership or equity in the car. At the end of the lease (typically two to four years), APM would have a new payment either to finance the purchase of the existing car or to lease another car.
If APM was to purchase the car, the residuals would be very high. For example, on a $49,000 car the residual at the end of the lease would roughly be $27,000 (Khalil). This was based on a four year lease with a 4.9 percent money factor, $5000 down and other up-front fees calculated. However, the mileage was only for 12,000 miles.
If APM was to lease another vehicle the company would still have a car payment where as if they purchased the car the payments would cease at the end of the loan. When a vehicle is leased, the lessee is not able to make any alterations to the vehicle. One major disadvantage to leasing a car is that extra fees that may apply. Up-front costs may include the first month's payment, a refundable security deposit, a capitalized cost reduction (like a down payment), taxes, registration and fees, and other charges. Excess mileage, wear and tear, and disposition are common extra fees at the end of the lease. Most leases allow 12,000 to 15,000 mile a year; however if APM was to put on more miles, they could expect a charge of 10 to 25 cents for each additional mile (Khalil).
There could be possible penalties for an early return. Another part of the lease that needs to be analyzed along with the advantages and disadvantage are the terms of the lease. All terms need to be negotiate, even the price of the vehicle. By lowering the lease price it will help to reduce the monthly payments. All negotiated terms needs to be in writing. If APM decided to lease, they would need to inquire if the lease is closed-ended or open-ended.
A closed-end lease is a lease where the car is returned at the end of the lease and the lessee walks away. However, APM would still be responsible for certain end-of-lease charges. In an open-end lease, APM would be responsible to pay the difference between the value stated in the contract and the lessor's appraised value at the end of the lease (web). This option seems a risky because APM might be faced with unrealistic prices.
Next, APM will need to determine the length of the lease that they want. Typically, the lease would be two to four years. The length of the lease will determine how large the residual will be at the end of the lease and may have a baring on the money factor. Mileage restrictions might be a problem for APM and would need to discuss with the lessor, because APM drives a lot of miles in a year.
APM will need to analyze the costs of the lease versus purchase problem through discounted cash flow analysis. This analysis compares the cost of each alternative by considering: the timing of the payments, tax benefits, interest rate on a loan, lease rate (money factor), and other financial arrangements. To make this analysis, APM must first make certain assumptions about the economic life of the vehicle, salvage value, and depreciation. To evaluate a lease, APM must first find the net cash outlay (not cash flow) in each year of the lease term. These amounts are found by subtracting the tax savings from the lease payment.
This calculation gives APM the net cash outlay for each year of the lease. Each year's net cash outlay must next be discounted to take into account the time value of money (Gitman et al. 103). This discounting will give APM the present value of each of the amounts.
The present value of an amount of money is the sum APM would have to invest today at a stated rate of interest to have that amount of money at a specified future date (Gitman et al. 104). For example, Jack offered to give Jill $100 five years from now. How much could Jill take today and be as well off? Jill could take less than $100, because Jill would have the use of the money for the five year period. Naturally, how much less Jill could take depends on the interest rate Jill thought she could get if she invested the lesser amount.
To have $100 five years from now at six percent compounded annually, Jill would have to invest $74.70 today. At 10 percent, she could take $62.10 now and have the $100 at the end of five years. Fortunately, there are tables which provide the discount factors for present value calculations. There is also relatively inexpensive special purpose financial pocket calculators programmed to make these calculations (Gitman et al.
105). And better yet, most spreadsheets such as Excel have present value calculations built in and even have templates to use for analyzing a lease versus purchase. So why would APM bother with making these present value calculations? APM needs these calculations compare the actual cash flows over the time periods. APM simply would not be able to realistically compare methods of financing without taking into account the time value of money.
The sum of the discounted cash flows is called the net present value of the cost of leasing. It is this figure that will be compared with the final sum of the discounted cash flows for the loan and purchase alternative. The interest portion of each loan payment is found by multiplying the loan interest rate by the outstanding loan balance for the preceding period. As noted earlier, the salvage value is one of the advantages of ownership. It must be considered in making the comparison; however, it is discounted at a higher rate (the company's assumed average cost of capital, nine percent). This rate is used because the salvage value is not known with any certainty, as are the loan payment, depreciation, and interest payments.
The major difference in cost, of course, comes from the salvage value. If APM ignores that value (a highly conservative approach), the alternatives are very close in their net present vale of costs. Naturally, it would be possible that salvage costs for the vehicle could be very high or be next to nothing. Salvage value assumptions need to be made carefully.
Thus, while this sort of analysis is useful, APM cannot make a purchase versus lease decision solely on cost analysis figures. The advantages and disadvantages, while tough to quantify, may outweigh differences in cost especially if costs are reasonably close. It is very difficult to decide whether to buy or lease the next purchase of a vehicle because there are so many variables to consider. It would be easy to believe that leasing is a better deal, because the monthly payments and down payment typically are lower than they are for loans. The biggest difference is that the buyer owns a vehicle of some value at the end of a loan, while the lessor does not.
In addition, APM would spend more in the long run to lease a car than to finance and own it. APM does not mind driving the same car for many years as long as it is reliable and comfortable. APM would be able to purchase or haggle for an extended warranty to ensure that repairs to the vehicle are not costly. In conclusion, after comparing and analyzing the lease versus buy option APM has decided to purchase a new vehicle instead of leasing. While leasing a vehicle will have lower monthly payments, APM would surely be penalized for excess mileage at the end of the term as well as having to pay the residual if they decided to keep the car.
Both options have similar costs over the entire terms when the residual is factored in, and the tax benefits are also comparable but the freedoms that come with ownership is far more valuable to APM. There are advantages and disadvantages to both leasing and buying a vehicle. There is no right answer when the question of lease versus buy is raised, the decision must be made based on the needs of the business or individual.
Gitman, L.J., et al. Financial analysis for managers. (Vol. II). Boston: Pearson Custom Publishing, 2003.
Hathaway Capital. 17 Oct. 2003.
Khalil, Kelly. Personal interview. 10 Sept. 2003 Lease Guide.
17 Oct. 2003.