Residual value risk in the lease-or-buy analysis

Journal of the Academy of Business and Economics, Jan, 2003 by Wenyuh Tsay

ABSTRACT

Whether debt and lease are substitutes or complements is one of the major issues in leasing literature. Most of the academic literature on leasing focused on the tax deduction as one of the main motivations for the leasing alternative. Some of them discussed the issue of residual value in pricing the leasing contracts. However, no one carefully examined the impact of both taxes and residual value on the lease-or-buy decision. This study intends to incorporate both the tax liability and the residual value risk in the analysis of lease-or-buy decisions and the relation between debt and leases. This paper develops a simple model to illustrate the effects of tax liability and residual value risk on the lessee's lease-or-buy decision and whether debt and leases are substitutes. It is shown that when the earning and residual value processes are negatively correlated, the debt and leases are indeed substitutes and the firm is better off buying the assets rather than leasing. When the correlation of earnings and residual value is positive, debt and leases can be complements and it is better for the firm to lease in order to eliminate the redundancy of nondebt tax shields. The implications obtained in the analysis for the lessee and lessor can be further formulated as empirically testable hypotheses. Both the firm characteristics and asset attributes are determinants of the corporate leasing policy. The impact of the interaction between the asset attributes and the firm characteristics on a firm's financing decision can be readily tested.

1. INTRODUCTION

Many scholars have devoted their effort to examining the role of leasing as an alternative to corporate financing. Given the enormous growth of the leasing industry, it is not surprising that the topic of asset leasing continues to attract so much attention. In the last decade, leasing volume has significantly increased from $126 billions in 1993 to $216 billions in 2001. Over the past four decades, about one third of business equipment investment was arranged through leasing.

Most of the academic literature on leasing focused on the tax deduction as one of the main motivations for the leasing alternative. Some of them discussed the issue of residual value in pricing the leasing contracts. However, no one carefully examined the impact of both taxes and residual value on the lease-or-buy decision and on the pricing of lease payments. For example, the well-cited paper by McConnell and Schallheim (1983) used a compound option pricing framework to value a variety of asset leasing contracts. While they illustrate the effect of residual value risk on equilibrium lease payments, tax issues are not their concern in that paper. Another paper by Lewis and Schallheim (1992) proved that debt and leases can be complements, instead of substitutes. They discussed the effect of corporate tax liability on the choice of leases and debt level, but they avoid the issue of asset residual value.

This study intends to incorporate both the tax liability and the residual value risk in the analysis of lease-or-buy decisions and the relation between debt and leases. Residual value plays an important role in leasing arrangements, yet it is hard to estimate. Lease, McConnell, and Schallheim (1990) showed that the average actual residual value is 150% of the estimated residual values. In addition to the factors of accelerated depreciation and unexpected inflation, the difficulty in estimating the residual values contributes to conservative pricing of the residual value. A better understanding of the interaction between the residual value risk and the lessee/user firm's financing decision will help to identify potential lessees. Because pricing analyses of lease contracts are sensitive to the assumed lessee's firm characteristics, a more precise evaluation of the leasing contracts can be obtained.

Regarding the lessees, the following questions should be answered. First, what are the risk characteristics of an asset, in relation to the user's earnings flow, that determine the likelihood that the asset will be leased rather than bought by a specific firm? Second, in what circumstances (as far as the relation between earnings flow and residual value of assets is concerned) are debt and leases substitutes rather than complements for lessee firms? In section two of this paper, a simple model is presented to illustrate the effects of tax liability and residual value risk on the lessee's lease-or-buy decision and whether debt and leases are substitutes. It is shown that when the earning and residual value processes are negatively correlated, the debt and leases are indeed substitutes and the firm is better off buying the assets rather than leasing. When the correlation of earnings and residual value is positive, debt and leases can be complements and it is better for the firm to lease in order to eliminate the redundancy of nondebt tax shields.

The main factor that determines these results is that the residual value risk can be a natural hedging component against the cash flow risk from operation, depending on whether the correlation of these two risk components is positive or negative. This hedging phenomenon can affect a firm's financing decisions in two ways. First, when the residual value risk of the used asset works to stabilize the firm's cash flow, the firm's debt capacity can be increased. Second, due to the fact that the tax function is convex in taxable cash flow and the after-tax value of the firm is concave, any reduction in cash flow volatility can increase the expected after-tax value of the firm. This hedging explanation is more credible for lessee/user firms which have larger proportion of total cash flow related to the use of the leased assets.