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The standard advice about leasing is that if you put a high premium on driving a new car, it might make sense to lease. Purchasing and reselling involves transaction costs, as well as uncertainty about resell value. Yet, determining whether it is “cheaper” to lease, is generally impossible since it depends on the strength of the consumer’s preferences for driving a new car and avoiding resell risk. These preferences cannot be measured in dollar terms. In some special cases, however, it is possible to determine whether leasing is cheaper. Consider the case of a consumer who has no strong preference for driving a new car and who, in fact, has every intention of purchasing the leased vehicle at the end of the lease period. In this case, one would expect that it would be more economical to purchase the car from the outset. Leasing a car involves an embedded call option--the right, but not the obligation, to purchase the car at a predetermined price at the end of the lease period. If one intends to purchase it anyway, leasing implies paying for an option that one does not need. Yet despite the embedded call option, there are a number of lease deals on the market at any time which appear to make it cheaper to lease and purchase at the end of the lease period, than to purchase the vehicle at the outset. In this paper, I propose a methodology for evaluating the cost of a lease in such cases and apply it to show evidence of underpriced leases. In addition, I explore some economic reasons behind this apparent pricing anomaly. I begin with a brief overview of the mechanics of leasing and the terminology that is used. The most common type of lease and the one that is under consideration in this paper is the closed-end lease. This is the type lease which provides the lessee (i.e., person leasing the car) with the option to purchase the vehicle at the end of the lease period from the lessor. The price at which the vehicle can be purchased is known as the residual value. The lessor may also add a purchase option fee to that amount. The capital cost is price of the vehicle, for the purposes of the lease. This price is often negotiated before the other terms of the lease are calculated. A downpayment paid by the lessee is known as a capital cost reduction. The capital cost reduction might also include the value of a vehicle that is being traded in, and other rebates. The capital cost less the capital cost reduction is the net capital cost (NCC), sometimes called the adjusted capital cost. The net capital cost can be divided into two components: the residual value and the depreciation of the vehicle over the lease period. The monthly payment in a lease reflects the financing costs incurred by the lessor as well as the depreciation of the vehicle over the lease period. The financing component is equal to the outstanding capital cost multiplied by a fixed percentage. This fixed percentage is known as the lease rate or lease factor . The outstanding capital cost in the initial period is the NCC; each period thereafter it is equal to the NCC minus the accumulated depreciation. The accumulated financing component through the life of the lease is known as the rent charge. Federal law requires disclosure of the rent charge, but not of the lease rate. Given the usual government insistence on full disclosure this permissable evasion is worthy of consideration. One possible explanation relates to the fact that, in most states, the whole of the lease payment, including the financing component, is subject to sales tax. It could be reasoned that disclosing an "interest rate" would lead consumers to believe they are paying tax on interest. In fact, they are not paying tax on interest since they are not borrowing. The lease rate reflects financing costs borne by the lessor. The financing component
will get smaller over the lease period, and since the lease payment
is fixed, the depreciation component gets larger. The lease payment
is somewhat analogous to the payment in an amortized loan. One
can think of the depreciation paid over the lease period as
being like the principal in an amortized loan. The difference is that
the interest is being paid not just on the remaining depreciation,
but on the remaining capital cost of the vehicle.
It is always possible to compute the lease rate from the information that must be disclosed by law, but the computation is somewhat complex . To further confuse matters, car dealers, if they volunteer to disclose the rate, will often do so by reciting the money factor . The money factor is monthly lease rate divided by two and, sometimes, multipled by 1000. Thus if the monthly lease rate is 0.0072, then the money factor could be expressed as 0.0036, or as 3.6. The reason for the money factor is not just to bamboozle the consumer. The money factor enters into a simple formula that approximates a lease payment. If the car dealer is working with this formula, it would be natural to think in terms of a money factor. Technical Note: 2.1 Computing a Lease Payment 3 Methodology for Valuing a Lease We are considering the case of a consumer who has no special preference for driving a new car. Such a consumer would be prepared to buy now and hold for longer than the lease period, or alternatively, lease and then buy at the residual value. What drives the choice between an outright purchase and the lease/purchase strategy will be the cost. Comparing the cost is a matter of comparing two streams of cashflows. If the outright purchase is done in cash, then there is a single cash flow at time 0. If the vehicle is financed, then there will be a stream of monthly payments, in addition to the downpayment. The lease/purchase strategy involves some upfront payments, a stream of monthly payments, and then a stream of cash flows representing the purchase at the residual value--this last stream could be single payment, or a stream of cash flows if the off- lease car is financed. IntelliChoice , a Web based information service, provides data on leases that we shall use to find evidence of underpriced leases. IntelliChoice identifies low price leases, the best of which they give their Gold Star rating. Their method of evaluating leases is to calculate an ad hoc measure that they call the “net interest rate” on the lease. This is the interest rate used by the lessor to determine the lease payments, augmented by various factors. In this paper we look at the Gold Star Leases available on 6/25/1998 to find evidence of cheap leases. At that time, there were nine leases that had the Gold Star Rating: three Acuras, three Cadillacs, two Saturns and a Saab. Our method will be to evaluate leases from a discounted cash flow perspective. Cash flows in the lease/purchase strategy will be discounted and then compared with the discounted cash flows in the outright purchase strategy. Two measures can be computed. The net advantage of leasing (NAL) is the discounted cash flows of outright purchase less the discounted cash flows of the lease/purchase strategy. A positive NAL implies it is cheaper to lease. This measure, however, presupposes a rate of discount. The break-even rate of discount (BERD) is a more general measure for evaluating leases. The BERD is the rate of discount at which the NAL is zero. If the BERD on a lease is lower than one’s opportunity cost of funds, then it is cheaper to lease. Since it is generally more economical to buy a car with cash than to finance it with a loan, we take as the basis of comparison, an outright purchase made by drawing down on the consumer’s savings. If the analysis shows that the lease/purchase strategy is cheaper than buying the car outright with cash, then a fortiori, it will be cheaper to lease than to finance with an autoloan. An exception to this conclusion is found special financing deals in which the manufacturer offers a loan at a rate even below what the consumer could earn in a risk-free investment. If such an offer exists, the appropriate comparison to the lease/purchase strategy would be an outright purchase using the special financing. For the sake of consistency, we shall assume that if the consumer adopts the lease/purchase strategy, he will pay cash for the car at the residual value. Used car loans carry higher interest rates than new car loans, so if the consumer were to finance at the end of the lease term, the lease/purchase strategy would be more costly. The assumption is not unrealistic, however, given that we are considering a consumer with the financial means for an outright purchase. In the case of the lease/purchase
strategy there is a series of 37 or 40 cash flows. At time 0, the initial
cash flow includes:
The payment of sales tax varies from state to state. The most common practice, and the one we assume, is to tax the monthly lease payment as it is paid. We assume a sales tax rate of 6%. We shall ignore the cost of license and registration since it enters into both strategies and hence washes out. The cash flow in the outright purchase is simply the price of the car plus sales tax. For the price of the car in the outright purchase strategy, we use the “target purchase price” provided by IntelliChoice: “This is the price that you can reasonably expect to negotiate for the vehicle as configured; however, it is not necessarily the lowest price. It includes an average acceptable markup for the dealer and reflects recent market conditions." Of the cars we looked at, excluding the Saturns, the target purchase price averaged 94% of the manufacturer’s suggested retail price (MSRP). The results of the analysis are sensitive to the target purchase price. The only vehicle that earned a Gold Star rating that does not appear “cheaper to lease” under our discounted cash flow method is the Cadillac Catera. The difference can be attributed to the fact that the target purchase price as a percentage of MSRP at 88%, is lower for the Catera than for the other vehicles listed. Using data provided by IntelliChoice, we were able to compute the BERD on nine leases. We found that it ranged from a low of 2.12% to a high of 7.94%. Seven of the nine leases had BERD’s of under 5%. Thus a consumer who considers his opportunity cost of funds to be 5% would classify seven of the nine leases as “cheap.” The results are summarized in the table below with hyperlinks to the calculations. As a basis of comparison, we also list the “net interest rate” the ad hoc measure computed by IntelliChoice, hyperlinked to Intellichoice’s data and calculations. [
Sorry, hyperlinks are not operative at this time. Calculations are left
as an exercise for the reader ...]
5 Explaining the Pricing Anomaly If the lease/purchase strategy is cheaper than the outright purchase, the implication is that the lessee is getting an option with a price less than zero. Similarly, the lessor is writing an option but not receiving any compensation for doing so. Several explanations
are possible. One is that these special lease deals may simply be loss-leaders.
They are advertised with the intent of getting the customer in the showroom
and possibly steering him to something pricier. Another hypothesis is that
they are a form of price discrimination. They allow the manufacturer
to sell more cars without lowering the MSRP for everyone. The fact
that the underpriced leases are, in all the cases we examined,
manufacturer leases, supports this hypothesis. A bank or independent
finance company has no incentive to offer these leases since they will
not reap the profit of another car sale. Both of these explanations, however, fail to explain why manufacturers elect to use lease offers instead of low interest rate financing. Unlike with financing, issuing a lease involves assuming a residual risk. If used car prices drop, lessees will be less likely to exercise their option to purchase the vehicle at the residual value and the manufacturer will be stuck trying to sell a large number of used cars in a weak market. Unlike with interest rate risk, there are no derivatives that can be used to hedge this risk. A plausible reason for the preference on the part of manufacturers for leases is that they involve much lower monthly payments than one would find in the three to four year autoloans that manufacturers offer. The expectation is that consumers will be swayed by a low monthly payment to enter into the agreement. Even at close to zero percent financing, a typical three year autoloan can have payments almost double those in a three year lease. Leasing as opposed to financing has another advantage for the manufacturer. After three years, the consumer is back at the dealer, where the chances are high that they will lease another car. Only about 30% of consumers purchase their leased vehicle (Koropecki, 1998 ). Contrast this situation with that when they finance the car. After three or four years the consumer owns the car and is less likely to purchase a new one. Even with underpriced leases, the manufacturer has more to gain by moving another car, than not. We have shown in this paper that it can be more economical to adopt a lease/purchase strategy, rather than an outright purchase. What appears to be driving this pricing anomaly are the efforts of manufacturers to increase sales. Leases involve low monthly payments which allow wealth-constrained consumers to be driving pricier vehicles. Furthermore, the feature of a lease that brings the consumer back to the dealer after three years, has its marketing advantages. We should note, however, that we have not drawn any conclusions about the economical feasibility of rolling over from one lease to another. Whether that strategy is economical depends on how much value a consumer attaches to driving a new vehicle, as well as considerations such as mileage and wear and tear. Driving an older car is almost always cheaper than driving a new car so if one does not have a strong reason to be driving a new car, rolling over leases will not usuallly be economical for the consumer-- though it will be for the manufacturer. The price break for the consumer who adopts the lease/purchase strategy is analogous to the price break for the holder of a no-fee credit card who pays off his balance in full. The no-fee feature is to attract the more profligate spender. If everyone were fiscally conservative, there would be a fee. Similarily the cheap leases serve to rope in the profligate who will be more prone to roll over their leases. If everyone were capable of a present value calculation and an honest assessment of how important it is to drive a new car, there might be no cheap leases. References Koropecki, Sophia,."Leasing Exerting Downward Pressure on Car Prices." Dismal Scientist, <http://www.dismal.com/thoughts/car_prices.stm> . Aug 13, 1998. Kranitz, Michael Scott. Look Before You Lease: Secrets to Smart Vehicle Leasing, 2nd ed. Concord, MA: Buy-Rite Holdings, 1997. |