GF599 Unit 4 Lease Versus Borrow Method Defense Example

One Method and Four Rivals: A Unit 4 Methodology Defense for the Tollbrook Financing Decision

[Student Name]

Purdue University Global

GF599: Graduate Capstone in Finance

Unit 4 Methodology Defense

[Instructor Name]

[Date]

Tollbrook Tire and Service and all figures are composite and illustrative, computed in the project's own model; the sources cited are real.

The Claim

The project treats the sale-leaseback as a loan. Selling gives Tollbrook cash today; in return the chain pays rent for fifteen years, gives up the depreciation deductions on the buildings and gives up the buildings themselves at the end of the term. The method computes those after-tax cash flows relative to keeping the buildings, finds the discount rate that makes their present value zero, and compares that implied cost with the after-tax cost of a secured mortgage the chain could actually obtain.

The inputs are:

1. Net proceeds after tax: $11,200,000 less a $280,000 selling cost and $655,000 of tax on the gain, or $10,265,000.

2. After-tax rent: 75 percent of the rent each year, from $567,000 in year one to about $748,000 in year fifteen, at the 25 percent blended rate.

3. Lost depreciation shield: $200,000 of annual depreciation at 25 percent, or $50,000 a year.

4. Buildings at the end of the term: if kept, the chain would own buildings estimated at $15,070,000 in year fifteen, assuming value grows at the 2 percent rent escalator so that the cap rate is unchanged. After tax on a sale at that point, they are worth about $12,630,000 to the chain.

5. The comparison rate: the bank's indication of 6.90 percent fixed, or about 5.18 percent after tax.

The rate that equates these flows is 7.57 percent after tax. Selling and leasing back costs more than borrowing.

Treated as a loan, the sale-leaseback costs Tollbrook 7.57 percent after tax against 5.18 percent for a mortgage, and that gap is the whole decision.

Why After-Tax Flows at the Borrowing Rate

A lease commits the lessee to fixed payments much as debt does, so the right comparison is with the borrowing the lease displaces. Under that view the lease's cash flows belong at the after-tax rate the lessee would pay a secured lender, because they carry roughly the risk of debt rather than the risk of the business (Myers et al., 1976). The same logic shows that leasing creates value only when the lessor and lessee face different tax rates or borrowing costs; in a competitive market with equal access, the advantages largely cancel (Lewellen et al., 1976). Standard texts present the lease-or-buy decision in exactly this form (Brealey et al., 2023).

Objection 1: Simply Compare the Cap Rate with the Mortgage Rate

The investor's cap rate is 6.75 percent, below the mortgage rate of 6.90 percent, so a quick reading says the lease is cheaper money. That comparison is wrong in four ways. It ignores the $655,000 of tax due on selling. It ignores the $50,000 a year of depreciation deductions Tollbrook would lose. It ignores the 2 percent annual rent increase, which raises the cost of the lease each year while mortgage payments stay fixed. And it leaves out the seven properties themselves in year fifteen, which the chain keeps if it borrows and loses if it sells. A cap rate is the investor's first-year yield, not the chain's cost of funds.

Objection 2: Discount at the Chain's Cost of Capital

Tollbrook's blended cost of debt and equity runs near 11.4 percent, reflecting the risk of the tire business. Discounting the sale-leaseback flows at that rate makes selling look $2,990,000 better than keeping, the opposite of the project's answer.

The reason is mechanical. A high discount rate shrinks the present value of every later payment, including the rent and, above all, the buildings' value fifteen years out. At 11.4 percent the after-tax end value is worth about $2,500,000 today; at the borrowing rate it is worth about $5,930,000. But the rent is a contractual obligation the chain must pay whatever happens to the business, and the end value is tied to real estate, not to tire sales. Discounting them as if they carried the business's risk understates both. The method keeps the borrowing rate.

Objection 3: Use Simulation

A Monte Carlo model could draw building values, interest rates and tax rates from distributions and report a probability that selling wins. The project considered this and set it aside for the base analysis. The decision depends on a few inputs, and the owner can understand a break-even value more easily than a probability distribution. The sensitivity work in Unit 8 will report break-even points for each major input instead. Simulation would add precision only if the input distributions were well grounded, and for one company's seven buildings they would be largely assumptions.

Objection 4: Survey Peer Chains

Asking other tire chains whether they sold their buildings, and whether they regret it, would describe what others did, not whether this offer is good for Tollbrook. Firms that sell their buildings differ in their reasons, their credit and their plans for the cash, so their experience does not transfer cleanly. The industry review in Unit 3 used published evidence on sale-leasebacks for context; the decision itself needs Tollbrook's own numbers.

What the Method Does Not Capture

The cash-flow comparison does not price flexibility. Owning lets Tollbrook sell a store building, redevelop a site or relocate when it chooses; a fifteen-year lease limits that. The lease's renewal options give the chain some flexibility the model does not value. Both effects are noted qualitatively and revisited in the limitations statement. The method also assumes the chain can borrow at the indicated rate; the feasibility memo identified fallback lenders if the bank's terms change.

Ignoring the End Value

One more check shows why the buildings' value in year fifteen must stay in the model. If it is dropped, selling looks $3,170,000 better than borrowing, because the chain would seem to receive $10,265,000 today for payments with a present value near $7,100,000. That is the same error as Objection 1 in another form, and it is the one an owner is most likely to make when reading the investor's letter.

Conclusion

The project will report the implied rate on the investor's route beside the after-tax mortgage rate, the present-value difference between the two routes, and the break-even decline in building value that would reverse the answer. Each rejected method is listed in the final report with the reason it was rejected and, where computable, how it would have changed the result.

References

Brealey, R. A., Myers, S. C., & Allen, F. (2023). Principles of corporate finance (14th ed.). McGraw Hill.

Lewellen, W. G., Long, M. S., & McConnell, J. J. (1976). Asset leasing in competitive capital markets. The Journal of Finance, 31(3), 787-798. https://doi.org/10.1111/j.1540-6261.1976.tb01923.x

Myers, S. C., Dill, D. A., & Bautista, A. J. (1976). Valuation of financial lease contracts. The Journal of Finance, 31(3), 799-819. https://doi.org/10.1111/j.1540-6261.1976.tb01924.x