Case Study

On
BIOTECH SERVICES INC.

MBA-Finance Third Trimester

Submitted to: Submitted by:

Prof. Dr. Radhe Shyam Pradhan Binita Shah

Faculty, Corporate Finance Birendra Byahut

Daya Krishna Ghimire
Dipesh Chand
Dikshya Pandey

Harihar Sharma

Janardan Subedi
Khagendra Adhikari

May 22, 2019

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Contents
Introduction ................................................................................................................................ 4

Background of the Case ......................................................................................................... 4

Analysis Of Data ........................................................................................................................ 7

Issue 1 ..................................................................................................................................... 7

Issue 2 .................................................................................................................................... 8

Issue 3 ................................................................................................................................... 11

Issue 4 ................................................................................................................................... 12

Issue 5 ................................................................................................................................... 14

Issue 6 ................................................................................................................................... 15

Issue 7 ................................................................................................................................... 15

Issue 8 ................................................................................................................................... 17

Issue 9 ................................................................................................................................... 18

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 Chapter I
INTRODUCTION
Background of the Case
The State of Florida has been revealing itself to government officials a very serious problem
over the past few years, but only now are its implications for the future well-being of the
citizens starting to be appreciated. The problem is pollution of the ground water by toxic
chemicals, improperly disposed wastes, and malfunctioning septic systems There are no signs
that the main water source underlying the state, the Florida aquifer, has yet been
contaminated, However, there are many Indications that agricultural chemicals used in the
citrus groves, abandoned underground gasoline tanks, and unregulated landfills have caused
extensive but localized contamination of welts that tap shallower water-bearing strata. To
combat this growing problem, strict environmental regulations have been enacted and are
being implemented throughout Florida.
Biotech services, Inc. have been providing soil and water testing facilities for quite a long
time. Biotech services, Inc. has profited from this surge demand for water testing, but the
capabilities of the laboratory are strained to the limit. Hence, business has been turned away
in many cases because of an inability to perform the tests and provide analyses on a timely
basis. Elizabeth Jensen, the founder and president of Biotech Services has planned to
purchase new specialized testing equipment to handle the above challenge and has estimated
that this would allow company to service a large share of emerging market. In regard with
above acquisition proposal the following findings were made:
Project Highlight
Particular Result
IRR 25%
Required Rate of Return 13%

Cost of Capital for Low Risk Project 10%

Cost of Capital for above average risk 17%
Cost of Machine $1,000,000
Investment Tax Credit 10%
Depreciation Method MACRS-5 Year Class
Tax Rate 40%

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 In the formal capital budgeting analysis of the proposed acquisition, the internal rate of return
(IRR) of the project was found to be 26 percent versus a required return of 13 percent,
Biotech uses an after-tax cost of capital of 10 percent for relatively low-risk projects and 17
percent for projects with above-average risk, so this normal-risk project passed with flying
colors. The discounted payback of slightly more than two years also indicated that the project
was a good Investment.
The test equipment has an invoice price of $1000 000, including delivery and installation
charges. The net financing required for the system would be the purchase price less the
applicable Investment tax credit of 10 percent, (Assume that this 'tax credit is available at the
beginning of the year at the time of purchase of equipment). Biotech uses the method for
calculating depreciation specified by the modified accelerated cost recovery system
(MACRS) for a five-year asset, and its effective tax rate is 40 percent.
The maker of the equipment, Spectronics Engineering, has offered to lease the equipment to
Biotech Services for $270,000 per year for five years. This price includes a service contract
under which the equipment will be maintained in good working order. Actually, the expected
life of the testing equipment is eight years, at which time it should have a zero market value
At end of the fifth year, though the resale value should be substantially in excess of zero.
Jensen generally assumes a salvage value equal to the equipment's book value at any point in
time, but she is concerned that the difference between the eight-year economic life and the
five year MACRS life might invalidate this assumption.
Regardless, of whether the equipment is purchased or leased, Jensen does not intend to use it
for more than five years. In five years, Biotech's current lease will expire. Land has already
been acquired on which to construct a larger facility, which should be ready for occupancy at
the expiration of the present lease.. Hence, the project is being viewed as a 'bridge" to serve
only until the permanent equipment can become operational in the new laboratory in five
years.
Financing Options
i. To finance the above acquisition the company posses sufficient capital in form of temporary
investment in marketable securities.
ii. Bank can provide secured loan at 15%
iii. Offered to lease the equipment to biotech which will be maintained in working condition
As far as decision making is concerned Jensen has been a major role player in taking major
decisions as a tradition of the company. However, this time the decisions making took a heat
between Jensen and Beverly Brennon, the Biotech's treasurer, due to differences in
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 consideration of appropriate discount rate for determining the present value of cost of leasing
and of purchasing. Traditionally, Jensen's method of evaluating such a decision has been to
calculate the present value cost of lease payments versus the present value of total charges if
the equipment is purchased, however, in a recent decision concerning a matter similar to the
one presently being considered. The differences in views were between:
i. Taking average cost of capital as discount rate referred by Jensen as lease versus purchase
decision was a capital budgeting decision and such decisions should be evaluated at the
company’s cost of capital.
ii. Taking firm’s cost of secured debt as discount rate as cash flows was more certain and cost of
secured debt reflected lowest risk to Biotech.
Hence, to solve the above dispute Jensen and Brennon, they decided to refer to their
accountant. However, the accountant advice were even more confusing
i. Marion Boynton agreed to Jensen in taking average cost of capital as the discount rate
ii. Shirley Boynton suggested in the use of an after tax cost of secured debt.

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 Chapter II
ANALYSIS OF DATA
Issue 1: The conventional format for analyzing lease versus purchase decisions assumes
that money to buy the equipment will be obtained by borrowing. In this case, though
Biotech has sufficient internally generated capital, held in the form of marketable
securities, to buy the equipment outright. Does this assumption cause any difficulties in
structuring the analysis? How can an analyst overcome such problems? Enumerate
some points that are important for resolving this issue.
Answer: The conventional format for analyzing lease versus purchase decisions assume that
money to buy the equipment will be obtained by borrowing. Here in the case, the Capital
budgeting analysis has already been made where and IRR shows 26 % while required rate of
return is 13% only. So, IRR is greater than required rate of return. Thus, the acquisition is
already viable. The decision to undertake the project has been already made. Acquisition of
new specialized testing equipment would give the Biotech service company the analytical
capability to service a large share of the emerging market. It also helps them to diversify their
profit and risk. For this company has conducted the formal capital budgeting analysis for the
proposed acquisition where it has found that internal rate of return of the project is 26
percent versus a required rate of return of 13 percent. Thus, the acquisition of the equipment
through internally generated capital is economically worthy. Biotech services, Inc. has
profited from this surge in demand for watering testing, but the capabilities of the laboratory
are strained to the limit. So, business has been turned away in many cases because of an
inability to perform the tests and provide analyses on a timely basis. Biotech services believe
that acquisition of new specialized testing equipment would give the company the analytical
capability to service a large share of the emerging market. The test equipment has an invoice
price of $1000, 000 including delivery and installation charges and investment tax credit of
10 percent. Biotech uses the method for calculating depreciation specified by the modified
accelerated cost recovery system (MACRS) for five- year asset, and its effective tax rate is 40
percent. But regardless of how the capital to purchase equipment is obtained, cost of leasing
should always be compared with other alternative source of financing i.e. cost of debt
financing. In other words source of capital used to purchase the assets is not relevant in
analyzing lease versus purchase decision.

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 However, cost of leasing should always be compared with other alternative source of
financing i.e. cost of debt financing. In other words source of capital used to purchase the
assets is not relevant in analyzing lease versus purchase decision. Though the company uses
marketable securities to purchase the equipment, whether to lease or not should be decided by
comparing leasing with other financing sources. The most appropriate alternative source of
financing here could be borrowing because leasing and borrowing expose the firm to the
same amount of risk. Furthermore, with leasing and borrowing company will creates liability
similar in characteristic and will be exposed to intermediate term financing.
Thus, the conventional format for analyzing lease versus purchase decisions assumes that
money to buy the equipment will be obtained by borrowing doesn’t cause any difficulties in
structuring the analysis. So, Biotech services should borrow.
Some difficulties that may rise if the Biotech Services Inc. buys the equipment by borrowing
the money are as follows:
 If the companies borrow money by the transaction of marketable securities, the company may
make a purchase decision. This may avoid least cost compared alternative. It is so because in
this case lease arrangement is least cost compared to purchase of the equipment.
 It would be uneasy to find the rates through which the cash flows in the purchase decision are
to be discounted; in such a case analysis becomes more difficult.
 It would be difficult to substitute the tax shield in the equipment which is bought with
internal capital.
 The company may decide to purchase the equipment although leasing is cheaper since
company has enough internally generated capital.
With the problem explained above, here are some points to overcome such difficulties in
making decision are as follows:
a. Using the after tax cost of secured debt or bank loan rate is most appropriate, even
though the equipment is purchased with internally generated capital.
b. The appropriate source of financing here could be borrowing because leasing and
borrowing expose the firm to the same amount of risk.
c. The entire possible and available alternative should be analyzed before taking any
decision in the company.

Issue 2: Set up the worksheet and calculate the comparative cost of leasing versus
buying the new testing equipment. (Note: the equipment must be depreciated over five

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years by the MACRS provisions. The following are the depreciation rates specified:
year 1, 20 percent; year 2, 32 percent; year 3: 19.2 percent; year 4: 11.52 percent; year
5: 11.52 percent; year 6: 5.76 percent.)
Answer:
Given that,
Invoice Price = $ 1,000,000
Investment Tax Credit = 10%
Net invoice price = $ 1,000,000 - 10 % of 1,000,000
= $ 900,000
Tax Rate = 40%
Cost of Secured Debt (Kb) = 15%
Lease Rental Rate (annually) = $ 230,000
Maximum Lease Term = 5 years
Now calculation of:
After Tax Cost of Debt (Kd) = Kb (1 – T)
= 0.15 (1 – 0.40)
= 0.09
= 9%
Cost of Asset
Yearly Installment Payment =
PVIFA (15%, 5 Yrs)
$900,000
= = $ 268480
3.3522

Loan Repayment Schedule

Year Installment Payment Interest Principal Remaining Balance
1. 268480 1,35,000 1,33,480 7,66,520
2. 268480 1,14978 153502 613018
3. 268480 91953 176527 436491
4. 268480 65474 2,03006 233485
5. 268480 34995 233485 0

Depreciation Schedule
Year Depreciation Rate(MACRS) Depreciation Value ($)

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 1 0.20 180,000
2 0.32 2,88000
3 0.192 172800
4 0.1152 103680
5 0.1152 103680
6 0.0576 51840

Cost of Owning Schedule

Yea Payme Interest Depn (4) Tax Shield CFAT PVIF@ PV of Costs
r (1) nt (2) (3) (5=(3+4)T (6=2-5) 9% (7) (8=6×7)

1 268480 1,35,00 180,000 1,26000 142480 0.9174 1,30711

0
2 268480 1,14978 2,88000 1,61191 1,07289 0.8417 90305

3 268480 91953 172800 1,05901 1,62579 0.7722 1,25544

4 268480 65474 103680 67662

103680 2,00818 0.7084 1,42260

5 268480 34995 103680 55470 2,13010 0.6499 1,38435

Salvage Value (51840) 0.6499 (33691)

Cost of Owning $593564

Therefore, the cost of owning (purchase) of the new equipment for the Biotech is $ 593564

Cost of Leasing
Year Lease Rental Rate (Lt) Lt (1 – T) PVIFA (9%, 5 yrs) Present Value
1–5 2,30000 138,000 3.8897 536779
Cost of Leasing $536779

And the cost of leasing of new equipment is $536779.

Then for the decision whether to own or lease,

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Net Advantage of Leasing = Cost of Owning – Cost of Leasing
= $ (593564-536779)
= $ 56785
Since Net Advantage of Leasing is positive, Biotech Services, Inc. can go for leasing of
equipment because it can save $ 56785.

Figure: Cost of leasing and Cost of owning

600000
590000
580000
570000
560000
550000
540000
530000
520000
510000
500000
cost of owning cost of leasing

The above figure also shows the difference between cost of leasing and cost of owning. So,
cost of leasing is less than cost of owning i.e. $536779 <$593564. Thus, leasing is preferred
here.

Issue 3: Justify the discount rate or rates that you use in the calculation process.
Given,
From the capital budgeting analysis of the proposed acquisition,
IRR= 26% vs Return = 13%
Kd=10% for low-risk projects and 17% for high-risk projects
If she takes Bank Loan to finance the machine:
Interest = 15%
Thus, after tax cost of loan (debt), Kd = 9%
The proper discount rate depends on (1) the riskiness of the cash flow stream and (2) the
general level of interest rates. The loan payments and the maintenance costs are fixed by

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contract hence are not at all risky. The depreciation deductions are also “locked in,” but the
tax rate could change. Thus, depreciation cash flows (tax savings) are not totally certain, but
they are relatively certain. Only the residual value is highly uncertain. On balance, and in
relation to cash flows associated with such activities as capital budgeting, we conclude that
the cash flows in the time line are relatively safe, so they should be discounted at a relatively
low rate. In fact, they have about the same degree of riskiness as the firm’s debt cash flows
(which also have some tax rate risk, and which are also contractual in nature). Therefore, we
conclude that leasing has about the same impact on the firm’s financial risk as debt financing,
so the appropriate discount rate is Lewis’s cost of debt. (Note: the larger the residual value
in relation to the other flows, the less justifiable is this statement.) Further, since the cash
flows are stated on an after-tax basis, the rate should be the after-tax cost of debt. Biotech’s
before-tax debt cost is 15 percent, and since the firm is in the 40 percent tax bracket, its after-
tax cost is 15.0% (1 - 0.40) = 9.0%. Therefore, we use 9 percent as the discount rate. Further,
following rationale shows the intent behind the use of after-tax-cost-of-debt in decision
making:
1. The firm does not own the equipment
2. In case of non-payment of lease payments, the firm loses control of the equipment
3. Legal contracts are binding

Issue 4: Based on the information given in the case, do you classify this lease as financial
(capital) lease or as an operating lease? Why?
Answer:
We know that there are several factors which differentiate between operating lease or
financial lease. We can differentiate on behalf of different factors. An operating lease has the
short period of time and used to buy equipment on a relatively short-term basis. The lease
term is just for 5 years which work as a bridge till the larger facility is established
permanently. So, the lease can be considered as the operating lease.
Costs related to that asset like operating lease is a lease whose term is short compared to the
useful life of the asset being leased. The term of operating lease is always shorter than the
economic life of that asset. In the case of Biotech, the economic life of the equipment is 8
years however lease period of the equipment is 5 years. So from this point of view, the lease
is operating lease.
Similarly the condition of the lease in the above case mentioned that the leasing price
includes the repair and maintenance cost that are required to make machine in working
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 condition is to be included in the lease rent. Which also make us clear that the lease is a
operating lease because in operating lease repair and maintenance is bared by the lessee
Criteria of lease to be Financial (Capital) leases
 A lease is a capital lease if it meets any one of the following conditions:
 Lease transfers title to the asset to the lessee by the end of the lease period.
 Lease contains an option to purchase the asset.
 Lease period is equal to or greater than, 75 percent of the estimated economic life of the
asset.
 At the beginning of the lease, PV of the minimum lease payments equals or exceeds 90
percent of the fair value of the leased property to the lesser.
In the case of Biotech Services Inc., the company is not going to use the assets beyond 5
years no matter whether it is purchased or leased. Also in the case it has not been clearly
mentioned about the transfer of ownership of the assets at the end of the lease period. so we
cannot consider it as a financial lease, rather it is the operating lease. To support our
viewpoint the following calculation are made to check whether the remaining criteria is met
to claim the lease as a operating lease.
Calculation
1. Lease period is less than, 75 percent of the estimated economic life of the asset.
5
= 8 × 100

= 62.5%
Since to be financial lease, the lease period must be equal or greater to 75% of the estimated
life of the assets. But in the given case the lease period is only 62.5% of the estimated
economic life. Hence the lease is the operating lease.
2. The present value of the lease payments is less than 90% of the current fair market value
of the assets.
𝑃𝑉 𝑜𝑓 𝑙𝑒𝑎𝑠𝑒 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 = 𝑃𝑉𝐼𝐹𝐴 (9%, 5𝑦𝑟𝑠) × 𝐿𝑡 × (1 − 𝑡)
= 230000 × 3.8897 (1 − 0.40)
𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 = $536779 , which is less than current market value of assets.
To illustrate:
(536779÷900000) ×100 = 59.64% or Rs 630131 which is less than 90% of 1000000
a. Equipment is not fully amortized for its entire economic life. However lease contract is
written off for the less than expected life of lease equipment.

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b. In order to be capital lease PV of the minimum lease payments equals or exceeds 90 percent
of the fair value of the leased property to the lesser but here in the case the PV of the lease
payments is less than 90% of the current fair market value of the assets. So it is operating
lease.
Hence this is not the case of financial (capital) lease due to the above reason. Most of the
features are similar to operating lease and it does not match with any features of financial
lease. Thus it is an operating lease.

Issue 5: Determine the internal rate of return for making lease versus purchase
decision.
Answer: The lease versus purchase decision can be evaluated through internal rate of return
analysis. The internal rate of return (IRR) or economic rate of return (ERR) is a rate of return
used in capital budgeting to measure and compare the profitability of investments. It is also
called the discounted cash flow rate of return. In the context of savings and loans the IRR is
also called the effective interest rate. This approach avoids the problem of having to choose a
rate of discount. The managers feel more comfortable with percentage rate of return that
straight NPV value. The internal rate of return or the cost of leasing is the rate of discount
that equates the cost of the asset with the present value of lease payments, net of their tax
shields, together with the present value of expected residual value after taxes. If there is no
ITC (Investment tax credit) or expected residual value, the ITC or RV (Residual Value) term
would not appear in the formula. The IRR approach makes it possible to make such decision
without having to choose the discount rate. The decision rule for IRR approach is specified as
follows:
If IRR > Kd: Choose Owning and
If IRR < Kd: Choose Leasing
Calculation of internal rate of return
Y Io and PMT Dep Tax Cash PVIF PV PVIF PV
r Zn shield Flow @6% @7%
0 900000 900000 1.0000 900000 1.0000 900000.
1 230000 180000 20000 -210000 0.9434 - 0.9346 -196261.6
198113.2
2 230000 288000 -23200 -253200 0.8900 - 0.8734 -221154.6
225347.1
3 230000 172800 22880 -207120 0.8396 - 0.8163 -169071.6
173901.9
4 230000 103680 50528 -179472 0.7921 - 0.7629 -

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 142158.6 136918.33
5 51840 230000 103680 50528 -231312 0.7473 - 0.7130 -164922.3
172849.8
-12370.7 11671.4
IRR 6.5092%

𝑃𝑉 𝑜𝑓 𝐿𝑅 – 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐼𝑅𝑅 = 𝐿𝑅 + × (𝐻𝑅 – 𝐿𝑅)
𝑃𝑉 𝑜𝑓 𝐿𝑅 – 𝑃𝑉 𝑜𝑓 𝐻𝑅
−12370.7 − 900000
= 6% + × (7% − 6%)
−12370.7 − 11671.4
= 6.5092%
Since, IRR < Kd i.e. 6.5092% < 9%
Leasing is preferable for Biotech as per our decision rule.

Issue 6: Should Biotech Services, Inc. lease or purchase the equipment? Do you think
that salvage value is realistic? Why or why not?
Answer:
The company, Biotech Services should lease or purchase the equipment can be determined by
looking at following table.
Comparison of Present value and internal rate of return (IRR)
Present Value Internal Rate of Return
Cost of Owning $593585.516 IRR 6.5092%
Cost of Leasing $536779 After Tax Cost of Debt 9%
Decision: Choose leasing alternative
From Table, it is clear that Biotech should go for leasing of the equipment as shown by
calculations from both approaches. Under the present value approach, the cost of purchasing
is higher than the cost of leasing. So, and Biotech could save $56806 if it opts for the leasing
option.
The salvage value of the equipment is not realistic as the life time is assumed as fifth year but
expected life of the asset is eight year. Hence the asset is not fully utilized till completion of 8
years and the value of asset is underestimated. Also, the salvage value itself is risky cash flow
as compared to other cash flow which again suggests that the salvage could be higher or
lower as compared to its book value at the end of fifth year.

Issue 7: If Biotech decides to buy the equipment, the manufacturer of the equipment
will provide a service contract for maintenance and service for $ 25,000 per year,

15
payable at the end of each year. Revisit the calculations to determine the cost of leasing
and cost of owning. How will this affect your decision? What could be its effect on IRR?
Answer:
Cost of Owning
Year PMT Maint Total Outflow Int Dep Maint Tax Shield
1 268484 25000 293484 135000 180000 25000 136000
2 268484 25000 293484 114977.4 288000 25000 171191
3 268484 25000 293484 91951.41 172800 25000 115901
4 268484 25000 293484 65471.52 103680 25000 77661
5 268484 25000 293484 35019.65 103680 25000 65480

CFAT PVIF @ 9% PV
157484 0.9174 144480.73
122293 0.8417 102931.60
177583 0.7722 137126.99
215823 0.7084 152894.72
228004 0.6499 148187.04
(Salvage Value) -51840 0.6499 -33692.44
Cost of Owning 651928.65

Cost of Leasing
Year Lease Rental Rate (Lt) Lt (1 – T) PVIFA (9%, 5 yrs) Present Value
1–5 2,30000 138,000 3.8897 536779
Cost of Leasing $536779

And the cost of leasing of new equipment is $536779.

Then for the decision whether to own or lease,
Net Advantage of Leasing = Cost of Owning – Cost of Leasing
= $ (651928.65-536779)
= $ 115149.65
Since Net Advantage of Leasing is positive, Biotech Services, Inc. can go for leasing of
equipment because it can save $ 115149.65.

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Calculation of IRR
Yr Io PMT Dep Maint Tax shield Zn Cash Flow
0 900000 900000
1 230000 180000 25000 10000 -195000
2 230000 288000 25000 -33200 -238200
3 230000 172800 25000 12880 -192120
4 230000 103680 25000 40528 -164472
5 230000 103680 25000 40528 51840 -216312

Cash Flow PVIF @3% PV PVIF PV

@4%
900000 1.0000 900000 1.0000 900000.00
-195000 0.9709 -189320.3883 0.9615 -187500.00
-238200 0.9426 -224526.3456 0.9246 -220229.29
-192120 0.9151 -175817.0156 0.8890 -170793.98
-164472 0.8885 -146131.2417 0.8548 -140591.35
-216312 0.8626 -186592.6314 0.8219 -177792.70
-22387.62261 3092.68
𝑃𝑉 𝑜𝑓 𝐿𝑅 – 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐼𝑅𝑅 = 𝐿𝑅 + × (𝐻𝑅 – 𝐿𝑅)
𝑃𝑉 𝑜𝑓 𝐿𝑅 – 𝑃𝑉 𝑜𝑓 𝐻𝑅
−22387.62 − 900000
= 3% + × (4% − 3%)
−22387.62 − 3092.68
= 3.88%
Since, IRR < Kd i.e.3.88% < 9%
So IRR decreases from 6.5092% to 3.88% when maintenance expenses of $25000 per year is
available which is payable at the end of each year.
Leasing is preferable for Biotech as per our decision rule.

Issue 8: Can you suggest any other way to find a salvage value for the equipment at the
end of the year 5 that might be more realistic that merely assuming that it equals that
the book value? What would happen to the decision indicated by your analysis?
Depreciation is the measure of determination of the salvage value. There are different
methods of depreciation beside MACRS methods such as straight-line method (SLM), double
declining method (DDM), and sum of year’s digits (SYD) to find salvage value of the
equipment that might be more realistic than merely assuming. So, different methods have
different salvage values. But here are some of the useful methods that can be used to
calculate depreciation is straight line depreciation method (SLM) or double declining method

17
(DDM) which might change lease versus purchase decision. In straight line depreciation
method (SLM) of depreciation amount is fixed over a period and depreciation amount is tax
deductible which will influence the cost of the equipment. In double declining method
(DDM) of depreciation amount for initial starting period is higher than that of later ending
period as the depreciation amounts change the tax shield amount also changes because
depreciation is tax deductible as we have already discussed which will ultimately change the
cost of the equipment which is explained as follows:
Straight Line Depreciation Method (SLM):
In straight line depreciation method (SLM) of depreciation amount is fixed over a period and
depreciation amount is tax deductible which will basically change the cost of owning
equipment. It can be calculated by using the formula. I.e. Depreciation Expense = (Cost –
Salvage value) / Useful life.
Double Declining Method (DDM):
The double-declining method (DDM) is a type of accelerated depreciation method that
calculates a higher depreciation charge in the first year of an asset's life and gradually
decreases depreciation expense in subsequent years. It can be calculated by using the formula
i.e. Periodic Depreciation Expense = Beginning book value x Rate of depreciation.

Issue 9: What other qualitative factors are important to be considered?

Various factors are responsible to determine leasing versus owning decision. Mainly,
required rate of returns, maintenance cost, expected salvage values, obsolescence cost, and
methods depreciation etc. affects the decision. Thus, there are some qualitative factors are
important to be consider before making leasing versus owning decision. They are as follows.
1. Different required rate of lessee and lessor
If the lessor has a lower required rate of return than the lessee, leasing will be cheaper to
lessee than owning. Whether as if the lessee has lower required rate of return than the lessor’s
required rate, it would seem more profitable to buy than to lease.
2. Duration of the Project
Biotech is considering the present expansion in new equipment just as a bridge or temporary
till the larger and permanent facility is built. It shows that the company does not intend to use
it beyond 5 years. Thus, it would be the unreasonable decision to buy the equipment for such
short term and temporary kind of project if the cost of owning was found to be feasible.
3. Maintenance cost

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In case of operating lease contract lessor is responsible to bear maintenance cost. In such case
maintenance cost is normally included in lease rent. If maintenance cost can be performed
more cheaply by lessor leasing alternative may be preferable.
4. Expected salvage value
Since, the lessor owns the property at the expiration of the lease, it reduces cost of owning. If
expected salvage value is higher, owning alternative may be preferable otherwise leasing
alternative may be preferable.
5. Availability of Space and Market
If a property offered for lease meets other required criteria, it must be available at a
reasonable cost. Usually this is determined by having two appraisals prepared and negotiating
for lease at or below appraised value. Thus, if a property offered for lease meets other
required criteria, it must be available at a reasonable cost. Usually this is determined by
having two appraisals prepared and negotiating for lease at or below appraised value.
6. Obsolescence cost
Lease costs are frequently assumed to be lower due to higher obsolescence costs. But risk of
obsolescence may increase lease rent. Some people believe if the risk of obsolescence is high,
leasing should be preferable otherwise owning should be preferable.

7. Tax rate
Another important factor that affects lease versus owning decision is different in lessor’s and
lessee’s marginal tax rate. If the lessor’s tax rate is lower than the user’s tax rate or if there
are tax subsidies available are the lessor who is not for user, there will be an advantage to
leasing over owning. Thus, if the lessor is in a high tax bracket, the cost of leasing is
preferable otherwise cost of owning is preferable.
8. Urgency of Need
The relative urgency of the space requirements may drive the decision to lease. Immediate
needs may require a lease. If there is less urgency, a longer lead time may allow renovation,
purchase, or construction. In some circumstances, a combination of these options may be best
- with an initial lease while a facility is renovated, purchased, or constructed.
9. Methods of depreciation
Amount of tax saving on depreciation reduces the amount of lease rent. If lessor usages
accelerated depreciation and lessee usages straight line deprecation (when purchase), at that
time leasing alternative will be desirable over purchasing.

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