How Risky are Your Lease vs. Buy Decisions

Present value analysis and Monte Carlo simulation make it possible to add risk analysis to your lease vs. buy decisions. Because of the strength of Monte Carlo simulation to model different outcomes, it has the ability to make the risk in a lease vs. buy decision explicit. The results are an effective way for management accountants to add value to the decision process and manage constituents' expectations. The lease vs. buy decision is a financing decision with an effort to manage an asset's cost volatility (that is, risk) and still support the company's strategic focus. (1) The routine task of a lease vs. buy present value analysis does indeed prescribe a decision. That is, select the lowest present value cost alternative along with other strategic considerations. Strategic considerations may include brand image, how fast technology is changing, or the asset's appearance over time. A challenge surfaces when trying to estimate the risk associated with a lease vs. buy decision. While the discount rate captures risk in a traditional present value analysis, is it reasonable to assume one discount rate captures the risk of the many different cash flows? Are your lease analytics and your buy analytics comparable? Do you see the risk of leasing over buying from routine present value analysis? And how variable is the range in cost of leasing over buying? For better lease vs. buy decisions, create a comparable analysis, and estimate the risk in the decision. By incorporating risk into the analytics, you may find a wide disparity between the cost of leasing over owning or vice versa. With a few additional steps in the present value analysis, you can develop comparable information and capture the risk of one option over another. If you understand how to run Excel, you can use add-in software that captures the risk. Nonquantifiable and Quantifiable Risk Because of its very nature, some risk is quantifiable and some is not. Risk varies among lease vs. buy options, and it is unreasonable to assign a value to all the risks that come into play in a lease vs. buy decision. Table 1 shows an illustrative list of nonquantifiable risk factors. Estimating quantifiable risk means providing management with a range of possible present value cost outcomes along with the likelihood of one cost outcome over another. (2) A routine present value analysis provides a single present value estimate regarding the cost of leasing compared to buying. A routine present value analysis extended with Monte Carlo simulation provides a more comprehensive range of possible present value cost outcomes, thus managing expectations and communicating the risk of one option over another. Monte Carlo simulation weaved into the lease vs. buy decision offers real benefits. Management accountants can readily comprehend and communicate the risk associated with the lease vs. buy decision. They may find that the lease option in support of a particular strategic objective is very expensive compared to a buy option. Or they may find that the cost of leasing--and not carrying the risk of ownership--is very similar to owning the asset itself. With Monte Carlo simulation, the analytics provide an estimate of the risk to support the decision to lease vs. buy, thus managing expectation well beyond selecting the lowest-cost present value amount (a single cost estimate) alternative. We will now briefly examine how to interpret the output of a Monte Carlo simulation used in a lease vs. buy decision. Interpreting Monte Carlo Simulation Output Distribution theory directs the interpretation of Monte Carlo simulation output. The height of the distribution in Figure 1 represents a frequency count (histogram). The value with the greatest frequency is the most likely outcome in Figure 1. This value, $130, represents the single estimated cost from a traditional present value analysis. [FIGURE 1 OMITTED] Think of the space under the curve in Figure 1 as an area. …