Simulation: Lease Vs. Buy Decision
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SCENARIO 1:
Bonnesante Research is a start up business in Irvine, California focusing on biotech, and is based on 30 employees. As it grows, companys asset acquisition needs to be focused. Bonnesante needs to submit its first drug to Food and Drug Administration within six months. In order to run advanced analytical software for the preparation of the drug, it needs to acquire mainframe computer. Now the decision needs to be taken to either lease or buy the mainframe computer.
SOLUTION 1:
As a CFO of Bonnesante Research company, by taking my colleagues opinion into consideration, I have decided to lease the mainframe computer for 18 months instead of buying it.. The reason being is that the loan options were proposing significantly higher outflows and the leasing option of 18 month with no money down proposed the lowest present value of the cash outflows of the duration. Since Bonnesante is not a profitable company due to this reason the expenses for buying an asset will not be tax deductible, and loaning option will also require to record the transaction and corresponding liability on the balance sheet. But through the operating lease option, an asset will not need to be reported on balance sheet. Moreover, the technology can be outdated in the future and there could be a need of upgrading it. Due to all those reason, operating lease is the best option that a company has at this moment.
SCENARIO 2:
Another scenario is that the Bonnesante requires an advanced spectrometer for its Research and Development program. The cost of this spectrometer is $2,000,000 but Bonnesante is now operating as a profitable firm. The options are to do a short term operating lease, a long term capital lease or to buy the spectrometer.
SOLUTION 2:
Since Bonnesante is running as a profitable company now, and the need of spectrometer is a great asset for a company to have in Research and Development field and will not be obsolete in the long run and can be utilized through its entire economic life which is in this case is five years, this is why buying spectrometer on a 40 year loan with the down payment of $113,608 seems to me a good decision over all. By buying this asset, Bonnesante will also have a benefit of claiming it as an asset depreciation whereas it will not be an option in operating lease since in the leasing option lessor has the benefit of claiming for depreciation, not lessee.
SCENARIO 3:
It is the sixth year of Bonnesante Company, and now it wants to convert into a fully integrated pharmaceutical company. It has also identified a plant but it needs to be upgraded. Also it is facing some cash flow crises that need to be solved also. At this time, the decision needs to be made whether to buy, lease or capital lease the plant. Moreover, cash flow crises need to be settled.
SOLUTION 3:
The best option Bonnesante has is to buy the plant on a nine year loan and upgrade it. This will give Bonnesante to then sell and leaseback option. Both of the options that are upgrading the plant, and selling and leaseback is only available to Bonnesante if it buys the plant. Sale and leaseback is an option for businesses who are facing short of cash. If incase Bonnesante would chose to lease the plant then it would have no option of upgrading it or selling and leasing it back. In addition, in order to solve the short cash flow crises Bonnesante would have no option but to take the bridge loan, which is though short term in nature but carries higher interest rate, which would have been much costly than buying the plant eventually.
RISKS NEED TO BE CONSIDERED WHILE DECIDING TO LEASE OR BUY:
There are various risks that need to be considered while making a decision for either to lease or buy. Although, purchasing an asset is the first thing that comes in the mind because this way company would have an option of owning it and selling it whenever it wants. But the factors that also need to be taken into consideration are that purchasing assets may not be a right decision for a company. It may ultimately have an adverse effect on a companys ability to adopt new technology. Also, it is even hard to replace a fully depreciated asset or the lack of capital budget may occur. Sometimes leasing provide several benefits to company such as reducing its cost, provide flexibility to company to avail the opportunity of new technology if needed rather than waiting for getting rid of an old asset in order to buy the new one. Also buying an asset makes companies to be held to a depreciation schedule or the approval of a capital budget for new equipments.
ADVANTAGES OF COMPUTING PRESENT VALUE:
The lease or purchase problem is analyzed using capital