Case 18: Leasing Decisions| | Background: The Portland Cancer Center is a not-for-profit inpatient and outpatient facility dedicated to the prevention and treatment of cancer. Working to perfect noninvasive brain surgery techniques for the past ten years, the Center is considering options to replace its current model of the Gamma Knife. Radiosurgery is often referred to as the Gamma Knife. The Gamma Knife delivers 201 separate radiation sources to treat certain brain cancers without invasive surgery. For patients with deep lesions the Gamma Knife significantly reduces the risk associate with traditional surgical procedures.
Other clinical benefits to the Gamma Knife include: treating Parkinson’s, trigeminal neuralgia, arteriovenous malformations, certain types of benign tumors and small malignant lesions. The Center will open a new radiation therapy facility for several new radiosurgery procedures. Replacing the Gamma Knife at this point is viewed as a “bridge”. This is because the Center’s managers think that whether the equipment is purchased or leased it will be used for no more than four years before moving to the new facility.
A financial decision on whether to buy the Gamma knife or lease it is most significant to this case. Facts: * Expected physical life of the equipment is ten years * Possibility to writing a “cancellation clause” and “per-procedure clause” if leased * Possibility the Center will move to new facility sooner than expected * If equipment is to be purchased, “tax-exempt” financing could be obtained * GB Financing lease contract: * Annual payments of $675,000 * Includes service contract so equipment will be maintained in good working order (GBF will have to enter maintenece contract with manufacturer) GBF forecasts $1. 5 million residual value * If lease is not written, GBF could invest the funds in a four year term loan of similar risk that yields 8% before taxes * The Center’s risk is transferred back to lessor * Portland purchasing the Gamma Knife: * Invoice price is $3 million, including delivery and installation * Maintenance contract for $100,000/year * Financed by a four-year simple interest conventional bank note at 8% * May claim tax deduction for portion of loan payment * Bears all the risk of equipment * Residual value is risky. 5% probability after four years will be $500,000; 50% probability that it will be $1 million; and 25% probability that it will be $2 million. * This risk adds a 5% risk adjustment to the base discount rate used on the other lease-analysis flows Analysis: This decision is a complex one. Will it be better to use debt financing and purchase or make an investment decision to lease the piece of equipment? It is important to decipher is the lease can save money, eliminate the risk of technological obsolesce, and to share the mutual risk with the lessor.
The dollar cost analysis of the lessee’s cost of owning and leasing can be seen in Exhibit 1. A 10% discount rate (based on corporate cost of capital) was used to convert the cash flows to present values. The Lessee’s percentage cost analysis show the internal cost rate (IRR) at 6%. This shows leasing is lower than the corporate cost of capital at 10%. Looking at the lease in terms of per procedure (Exhibit 2), the annual expected 100 procedures would cost the Center $25,000 more. Furthermore, if fewer procedures were performed the per-procedure lease would be favored.
It could be useful to assess the clinic’s previous volume patterns to determine the risk of this decision. Exhibit 3 shows the Lessor’s point of view to own the Gamma Knife. Using an opportunity cost rate of 8% before taxes will yield 4. 8% after taxes. The 6. 2% after tax return exceeds the 4. 8% after tax return available on alternative investments of similar risk. This also confirms the NPV of the lease investment is expected to be better off by $99,368 if it writes the lease. Recommendations: The financial advantage is for Portland Cancer Center to lease the Gamma Knife rather than purchase the equipment.
The per procedure lease has a benefit to both parties, however reduces risk for the Center. It would only be advantageous is the volume of procedures was low, specifically below 100 procedures. Maintaining a state of the art healthcare facility is important and the lease will allow the Center to do so. The lessor is compensated for taking risk with tax deductions, however they will assume the risk with the technology. The NAL of $130,554 affirms that leasing creates more value than buying in this situation. The lessee’s IRR of 6% is well below the 10%, which also indicates a positive aspect to leasing versus buying.
The terms of the lease should be carefully considered, especially the cancellation clause in the contract. This is important to address because of concerns with the new facility being ready before four years time. Significant costs could be associated with unutilized equipment so GBF could consider adding a penalty to the cancellation clause. The decision is also weighed based upon the move to the new facility. If the Center moves early keeping the equipment and moving it to the new facility is always an option. The Center should also negotiate a lower yearly lease payment.
The lease answers the clinic’s requirement of a short-term commitment with the least risk associated due to a new facility that is on the way. There are also perks to a short- term lease agreement because this is not recorded on the lessee’s balance sheet. Exhibit 1: Lessee's Analysis| | | | | | | | | | | | | | Cost of Owning| | | | | | | | | | | | | | | | Year 0| Year 1| Year 2| Year 3| Year 4| Net purchase price| | $3,000,000 | | | | | Maintenance cost| | 100,000 | $100,000 | $100,000 | $100,000 | | Maintenence tax savings| | 0 | 0 | 0 | 0 | | Depreciation tax savings| | | 0 | 0 | 0 | $0 |
Residual value| | | | | | 1,125,000 | Residual value tax| | | | | | 0 | Net cash flow| | $3,100,000 | $100,000 | $100,000 | $100,000 | $1,125,000 | | | | | | | | PV cost of owning:| | $2,223,685 | | | | | | | | | | | | Cost of Leasing| | | | | | | | | | | | | | Lease payment| | $675,000 | $675,000 | $675,000 | $675,000 | | Tax savings| | 0 | 0 | 0 | 0 | | Net cash flow| | $675,000 | $675,000 | $675,000 | $675,000 | $0 | | | | | | | | PV cost leasing:| | $2,354,239 | | | | | | | | | | | | Cost Comparison| | | | | | | Net advantage to leasing (NAL)=| $130,554 | | | | | | | | | | | | |
Lessee's Percentage Cost Analysis| | | | | | | | | | | | | Leasing-versus-owning CF| | $2,425,000 | $575,000 | $575,000 | $575,000 | $1,125,000 | | | | | | | | Lessee's IRR=| 6%| | | | | | Exhibit 2: Per-procedure Lease | | | | | | | | | | | | | | | | | Per Procedure Lease| | | Annual Lease| | Procedures| Annual| Annual| | Annual| Annual| | | | Lease| Net | Annual| Lease| Net| Annual| Profit| | Payment| Revenue| Profit| Payment| Revenue| Profit| Difference| 70 | $490,000 | $700,000 | $210,000 | $675,000 | $700,000 | $25,000 | 185,000 | 80 | $560,000 | $800,000 | $240,000 | $675,000 | $800,000 | $125,000 | $115,000 | 90 | $630,000 | $900,000 | $270,000 | $675,000 | $900,000 | $225,000 | $45,000 | 100 | $700,000 | $1,000,000 | $300,000 | $675,000 | $1,000,000 | $325,000 | ($25,000)| 110 | $770,000 | $1,100,000 | $330,000 | $675,000 | $1,100,000 | $425,000 | ($95,000)| 120 | $840,000 | $1,200,000 | $360,000 | $675,000 | $1,200,000 | $525,000 | ($165,000)| 130 | $910,000 | $1,300,000 | $390,000 | $675,000 | $1,300,000 | $625,000 | ($235,000)| | | | | | | | | GBF quoted per procedure lease rate of $7,000| | | | | *expected annual volume of 100 procedures| | | | | *expected net revenue per procedure of $10,000| | | | | Exhibit 3: Lessor's Analysis| | | | | | | | | | | | | | Cost of Owning| | | | | | | | | | | | | | | | Year 0| Year 1| Year 2| Year 3| Year 4| Equipment cost| | $3,000,000 | | | | |
Maintenance| | (100,000)| ($100,000)| ($100,000)| ($100,000)| | Maint tax savings| | 40,000 | 40,000 | 40,000 | 40,000 | | Depreciation shield| | | 240,000 | 384,000 | 228,000 | $144,000 | Lease payment| | 675,000 | 675,000 | 675,000 | 675,000 | | Tax on payment| | (270,000)| (270,000)| (270,000)| (270,000)| | Residual value| | | | | | 1,500,000 | Residual value tax| | | | | | (396,000)| Net cash flow| | $2,655,000 | $585,000 | $729,000 | $573,000 | $1,248,000 | | | | | | | | NPV| $99,368 | | | | | | IRR| 6. 20%| | | | | | | | | | | | |