California State Polytechnic University, Pomona

GBA 645 Financial Decision Making

Professor: Paul Sarmas, Ph.D.

Case Report
Real Estate and Capital Structure
Decisions: Lease-versus-Buy Analysis
Team of Analysts:
Gustavo Castaneda
Jonathan D. Francis
Leo Li
Kan Wang

Fall 2009
GBA 645 Financial Decision Making November 25, 2009

Table of Contents

I. Introduction........................................................................................................................................3
Overview.................................................................................................................................................3
The Company...........................................................................................................................................3
Situational Analysis..................................................................................................................................3
II. Case Analysis....................................................................................................................................3
Considerations.........................................................................................................................................3
Purchasing...............................................................................................................................................4
Recommendation....................................................................................................................................5
III. Summary & Conclusions..................................................................................................................5
IV. References.........................................................................................................................................5
V. Appendix............................................................................................................................................6

Gustavo Castaneda, Jonathan Francis, Leo Li, and Kan Wang analyzed this case under the
supervision of Professor Paul Sarmas, PhD. solely as the basis for class discussion rather
than to illustrate effective or ineffective handling of decision or business processes. The
purpose of this case is to introduce the class Lease-versus-buy Analysis.

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I. Introduction

Overview
This case provides real estate market data for the analysis of an office lease-or-buy decision.
The case demonstrates what is known as the “leasing puzzle” – the answer simply being that
the two forms of financing are not cost equivalent in the presence of capital market
imperfections, despite both being credit forms. The case presents two opposing anecdotes: one
about a trading company that bought its office and profited hugely from this decision as the
market and capital values move upwards, but then faced huge losses as the market declined;
and another from a comparable trading company leasing office space, and applying its capital to
grow the trading business without diversion.

The Company
Sunny Trading Company Limited is a Hong Kong based company dealing in toy trading. It
rented “Grade A” office space in the Wanchai district. The office space was a gross floor area of
250 m2 with a conference room, reception area, an open space with partitions for staff, a
computer server room, and a kitchen area. In 2002, the company’s lease was up for renewal.
The rent was set to increase by 10 percent. An attempt to negotiate a lower rent failed, thereby,
making Sunny Trading Co. consider the option of buying office space. Which option would
benefit Sunny Trading Co: continue the lease or buy office space?

Situational Analysis
The anecdote presented in this case illustrates why trading companies should not take the
opportunity to capitalize on a buoyant real estate market. The argument is that shareholders do
not need trading companies to invest in properties for them since they can do this through their
own investment portfolio activities. In principle, there is no simple answer, but the analysis
provides ample materials for debate. It is possible for illustration purposes to a least-cost
calculation of the buy-versus-lease decision. Nevertheless, we will determine the answer
entirely by assumptions about interest rates and rental market dynamics.

II. Case Analysis

Please answer all the case questions in the case (if any) and the following aspects.

Considerations
1. What factors should Jonathan consider when making a buy or lease decision?

There are benefits and risks involved in both buying and leasing. The decision would have
different effects on the company. However, we will decide based on a comparison between the
net present value of both borrowing-to-buy alternative and the cash flows associated with the

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leasing alternative. Factors that Mr. Young needs to consider in the lease-versus-buy decision
are the effects on the company’s growth opportunities in addition to the cost and the risks
involved in each alternative.

Buy Decision

The risks in buying include the fluctuation of the value of the property depending on the
economic situation. In a financial crisis, currency value could depreciate, making investors pull
out of property investment, thus, decreasing property prices. The benefits of owning include the
potential for price appreciation, the ability to stay in the same location and conduct business
over the long run, and the tax benefits of buying.

Buying office space would have to be financed either by debt or by equity. Financing the
purchase through debt would increase the company’s debt ratio and may decrease the
company’s ability to obtain more credit for future business projects and growth. Using cash to
purchase property would decrease the company’s liquidity and lessen capital available for near
year-end project such as satisfying the Christmas season demand with a sound plan and growth
to diversified types of toys.

Lease Decision

On the other hand, leasing office space would allow the company to use credit and cash for
possible job requirements and unexpected orders. Leasing gives the ability to expand / reduce
operation by extending lease or canceling it, in the event of increasing or decreasing growth.
Leasing risks include increase in rent renewal, if Sunny Trading Co. did not manage to close a
good agreement with the property owner.

Purchasing
2. How will the purchase decision affect the financial position of STL?

The 30% down payment (HK $2,580,000) required to invest in the property, which is a fixed
asset and not easily converted to cash, will affect the financial position of Sunny Trading Co.
The effects on buying in the financial statements are the following.

On the Income Statement

 Increase in interest expense

 Increase in depreciation
 Decrease in taxable income

On the Balance Sheet

 Decrease in cash and cash equivalents – down payment

 Increase in fixed assets
 Increase in liabilities

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Another effect on the financial position of Sunny Trading Co. is that the purchase decision will
be a drain on profits because the down payment funds will not be available to, otherwise,
expand the toy trading business. Furthermore, the opportunity costs will mean missed business
opportunities, less profits, and less growth.

We will show the effect on some of the financial ratios before and after the purchase.

Recommendation
3. Would you recommend that Jonathan buy or lease an office? Why or why not

Some of the assumptions we will make in our analysis are the purchase will be financed with a
15-year mortgage. The best lending rate, 5.13%, will not change through a fifteen-year loan,
there will be no residual value, and land is not depreciable.

III. Summary & Conclusions

In conclusion, the team of analysts recommends Mr. Young to pursue the purchase of the office
because it is cheaper to own the office space than to lease it, if cost is the decision driver. In
terms of risk, buying property would mean having to finance the purchase through either debt or
equity, leading to increased liabilities or equity in detriment of current assets. The property
investment would also be subject to fluctuating valuation depending on the economic situation.

With leasing, Sunny Trading Co. would risk increased rent renewal and / or possible loss of the
lease, and would need to look for new office space. In terms of the effects on the company,
buying office space would decrease the capital for projects and growth of the company. The
decision to buy or lease must take into account all the factors above. After our analysis of the
relevant ones we conclude that if Sunny Trading Co. is able to obtain an interest rate of less
than or equal to ???%, they would be better off buying. If not, the company should prefer to
lease.

IV. References

Pretorious, Frederick and Ho, Mary. Real Estate and Capital Structure Decisions – Lease-
versus-Buy Analysis. The University of Hong Kong: Centre for Asian Business Cases,
HKU253, 2003.

Ross, Stephen. Westerfield, Randolph. And Jordan, Bradford. Essentials of Corporate Finance.
Eighth Edition Irwin, 1996

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V. Appendix

For calculations, please refer to the Microsoft Excel spreadsheet and tables in the following
pages.

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Real Estate and Capital Structure Decisions – Lease vs. Buy Analysis