Case 098Deal structuring and pricingCore

A shipping company can buy containers at Rs 2.5 lakh each with a 12-year life and Rs 30,000 residual, or lease them at Rs 40,000 a year. At a 10% cost of capital, which is cheaper, and what does the answer do to return on equity?

Warburg PincusNew York · 2012

The situation

Samudrika Container Lines, a sponsor-owned coastal shipping company, needs 10,000 more containers. It can buy them at Rs 2.5 lakh each; they last 12 years and sell for scrap at about Rs 30,000. Or it can lease them from a container lessor at Rs 40,000 a year each for 12 years, paid at the end of each year. The company's cost of capital is 10%. Ignore tax for the first pass.

Today the company earns Rs 60 crore on Rs 400 crore of equity, a 15% return on equity. If it buys, it would fund the Rs 250 crore 70% with debt at 9% and 30% with equity; the sponsor cares about return on equity and about covenants.

Your task

Compare the two on a present value basis, find the rate at which the answer flips, then show what buying does to return on equity and say what you would recommend.

Quick check

The lease costs Rs 40,000 a year; buying costs Rs 2.5 lakh once. At 10%, which is cheaper?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Buying is cheaper at 10%: about Rs 2.40 lakh in present value against Rs 2.73 lakh for the lease, a saving of about Rs 32,000 per container, and the answer flips only above a 12.5% cost of capital. But buying puts Rs 250 crore of assets and Rs 175 crore of debt on the balance sheet, and in year one return on equity falls from 15% to about 13.6%, because depreciation and interest replace the lease charge and the equity base grows. Recommend buying, and tell the sponsor the ROE dip is accounting, not value.

Step 1How do you compare a lump sum with a stream of payments?

Bring both to today at the company's cost of capital. Renting a flat at Rs 40,000 a month or buying it outright is the same question: a stream of rent against a price now, with the flat's resale value coming back at the end. Twelve payments of Rs 40,000 at 10% are worth 6.814 times one payment, Rs 2.73 lakh; buying is Rs 2.5 lakh now less Rs 30,000 in year 12, which is worth Rs 9.6,000 today, so Rs 2.40 lakh. Owning is cheaper by about Rs 32,000 a box, Rs 32 crore across the fleet. Said the other way, owning costs Rs 35.3,000 a year in equivalent annual costThe level yearly payment that has the same present value as a lump-sum purchase, so a purchase can be compared with a lease on a yearly basis. against Rs 40,000 for the lease.

At the company's 10% cost of capital the lease is worth Rs 2.73 lakh and buying Rs 2.40 lakh per container, so owning is cheaper by about Rs 32,000; the lines cross at 12.5%, above which the lessor's money is cheaper than the company's own.

The relationship

\text{PV}_{\text{lease}} = 40{,}000 \times \frac{1 - 1.10^{-12}}{0.10} = 272,548 \qquad \text{PV}_{\text{buy}} = 250{,}000 - \frac{30{,}000}{1.10^{12}} = 240,441

40,000	yearly lease payment, Rs, at the end of each year
1.10	one plus the 10% cost of capital
12	years of life and of lease
30,000	scrap value received in year 12

What it says in wordsDiscount the lease stream as a 12-year annuity and net the discounted scrap value off the purchase price; the lower present value is the cheaper way to get the container.

Step 2At what rate does the answer flip, and why does that matter?

The lease is a loan from the lessor at an implied rate. The present values are equal at about 12.5%, which is the interest rate embedded in the lease; a company whose cost of capital is above that should lease, because the lessor's money is cheaper than its own, and one below it should buy. That is why lease-or-buy is a financing decision, not an operating one: the container is the same either way. It also tells you what to negotiate: at Rs 35,000 a year the lease would be the cheaper route at 10%, and a lessor with a lower cost of funds than Samudrika may well get there.

Step 3What does buying do to return on equity?

It lowers it in year one, even though it creates value. Buying adds Rs 75 crore of equity and Rs 175 crore of debt; the Rs 40 crore lease charge disappears but Rs 18.3 crore of depreciation and Rs 15.75 crore of interest replace it, so profit before tax rises by about Rs 5.9 crore, net income by Rs 4.4 crore, and return on equity falls from 15% to about 13.6% because the equity base grew faster than the profit. The number improves as the fleet ages and the debt is repaid; the present value saving is real from day one. A sponsor that manages to ROE would lease; a sponsor that manages to value would buy and explain the ratio.

Rs crore	Lease	Buy
Assets added	none on balance sheet	250
Funding		175 debt, 75 equity
Yearly charge	40 lease	18.3 depreciation, 15.75 interest
Net income	60	64.4
Equity	400	475
Return on equity	15.0%	13.6%

Buying raises net income by about Rs 4.4 crore but adds Rs 75 crore of equity, so return on equity falls from 15% to 13.6% in year one even though the fleet is cheaper to own than to lease; the ratio and the value point in different directions and the memo must say which one the sponsor is managing.

Then add tax and covenants, the two things the first pass left out. Depreciation is deductible if you own and the whole lease payment is deductible if you lease, so tax usually narrows the gap; and Rs 175 crore of new debt moves leverage, so check the covenant before the sponsor signs. Buy if the company can carry the debt, lease if the covenant cannot, and never decide on the ROE line alone.

Where candidates lose it

The usual loss is adding up the lease payments, Rs 4.8 lakh, and comparing them with Rs 2.5 lakh. Money twelve years out is worth less than money now, and the question says 10% precisely so you will discount.

The second is stopping at the present value. The interviewer asked about return on equity because buying lowers it in the short run while creating value, and a candidate who cannot explain why has not connected the balance sheet to the decision.

What the interviewer asks next

The lessor offers Rs 34,000 a year. Which route now, and what is the implied rate?
With 25% tax and straight-line depreciation, redo the comparison.
The containers can be bought with a 100% secured loan at 8%. Does that change the lease-or-buy answer, or only the funding?

Asked at Warburg Pincus, Private Equity, New York, 2012 (Wall Street Oasis): A full case study on leasing verse buying. Walked through whether a trnasportation company should buy or lease containers.

Company names and figures are illustrative.