Final Case Study - Buy vs Lease

Angelo Rossi opened his little "upscale" Italian restaurant almost 25 years ago in the heart of New York City. His specialty was the freshly baked bread oozing with homemade garlic butter and of course, the delicious varieties of pasta and lasagna. The ambience and aroma were simply out of this world and kept bringing the customers back for more. An immigrant from Southern Italy, Angelo put all his saving into his business. With the help of this wife, Maria, and their son Paulo, Angelo kept the restaurant running smoothly and helped it gain tremendous popularity among many New Yorkers. Angelo was always proud of the fact that he owned everything in his restaurant, right from the property on which it stood down to the plates on which the food was served. Everything had been paid for with his own hard-earned cash. Being from the "old school," Angelo always believed that to be a debtor is to be a slave to the lender. He, therefore, chose to save up and pay cash for whatever was needed. Over the time the restaurant's client grew significantly and the wait times during peak periods became unbearably long. After careful consideration, Angelo relocated the restaurant to a much larger site with ample parking and tables. As always, the move was financed with cash. Then about three years ago, Angelo retired and turned over the business to Paulo. Having watched his dad nurture the business, Paulo kept up the family tradition of excellent service and personal attention to details. Along with the business, however, Paulo inherited some worn out equipment, which surely had "seen better days." Paulo was sick and tired of making frequent phone calls to the service company for equipment repairs and maintenance work. As a result, the restaurant service quality was beginning to deteriorate and profits were being hurt. In particular, three ovens, a dishwasher, and a pasta machine needed to be replaced. The total cost of the equipment including delivery and installation was estimated to be $100,000, 3-year Modified Accelerated Cost Recovery schedule rates could be used to depreciate the equipment. Now if were Papa Rossi at the helm, there would have been enough cash in the coffer to buy the equipment outright. However, under Paulo, the cash balance of the firm had shrunk miserable. The problem with Paulo was that unlike his father, he enjoyed a much more lavish lifestyle. The flashy sports car, penthouse, and boat were paid in full from business profits, leaving not much cash for business renovation and equipment replacement. On numerous occasions, Papa Rossi had tried to counsel his son on the benefits of being thrifty but to no avail. Young Paulo preferred to live for today. Thanks to Papa Rossi's conservative ways the credit rating of the restaurant had been exemplary. The money for the equipment could be easily borrowed from their bank at a rate of 10% per year over a 5-year term. However, Paulo had heard from his business colleague that in some cases it is better to lease than to buy. Many of his colleagues claimed that they were already enjoying significant benefits as a result of having leased business assets. After checking around and calling various leasing companies, Paulo found that he could lease the needed equipment and appliances from AAA Leasing Company for an annual lease payment of $25,000 over a 5- year term, payable at the end of each year. Maintenance costs would be covered by the annual lease payment. If purchased, maintenance costs on the new equipment were estimated to be $2,000 per year which are payable at the end of each year and fully tax-deductible. Paulo, being fully aware of his father's dislike for debt, was seriously thinking about leasing the equipment. However, not being fully conversant with all the pros and cons of leasing versus borrowing and buying, there were a number of questions that Paulo needed to answer for. Above all, he was curious about AAA Leasing Company's main slogan, which read "Why buy it if you can lease it?"

Questions:

1. What are the different kinds of leases available and which one would be the best suited for Paulo's restaurant? Explain why.

2. Calculate the net advantage to leasing (NAL) the restaurant equipment. It is assumed that old equipment would have a salvage value of $30,000 after 5 years. The restaurant's tax rate is estimated to be 40%.

3. What do you think typically happens to leased equipment after the term of the lease expires?

4. How should depreciation and taxes be accounted for in the calculations?

5. If the equipment were to be leased, would the lease payments be tax deductible? Explain.

6. How much of an impact does the forecast of the salvage value of the new machine have on the lease versus buy decision?

7. If Paulo leases the equipment, what impact would it have on the firm's debt capacity?

8. Does the size of the business play any role in lease versus buy decision of this type?

9. Does the type of asset under consideration have much effect on the lease versus buy decision?

10. Are there any other factors that need to be considered in a lease versus borrow and buy decision of this type? Explain.

11. All things considered, should Paulo lease or borrow and buy the equipment? Explain.