Question

Explain the analysis of deciding if you would lease versus purchase.

Answer 1

Lease or buy decision involves applying capital budgetingprinciples to determine if leasing as asset is a better option than buying it.

Leasing in a contractual arrangement in which a company (the lessee) obtains an asset from another company (the lessor) against periodic payments of lease rentals. It may typically also involve an option to transfer the ownership of the asset to the lessee at the end of the lease.

Buying the asset involves purchase of the asset with company’s own funds or arranging a loan to finance the purchase.

In finding out whether leasing is better than buying, we need to find out the periodic cash flows under both the options and discount them using the after-tax cost of debt to see where does the present value of the cost of leasing stands as compared to the present value of the cost of buying. The alternative with lower present value of cash outflows is selected.

After-tax cash flows of lease

Determining periodic cash flows in case of leasing is easy. Most leases involve periodic fixed payments and an optional one-time terminal payment. They may also involve payment of insurance, etc. associated with the asset which also need to be accounted for. These payments have associated tax shield, i.e. they are allowed as deduction from the company’s taxable income which results in a decrease in net tax liability of the company.

Periodic after-tax cash flows of lease = (maintenance costs + lease rentals) * (1 – tax rate)

Terminal after-tax cash flows = periodic after-tax cash flows + amount paid at purchase the asset

After-tax cash flows of purchase

The most significant component of cash outflows in case of purchase of asset is the payment for cost of the asset. If the company uses its own funds, the total cost is assumed to be paid at the time 0, however, if the company obtains a loan to finance the purchase, the loan repayment and associated tax shield on interest shall appear in all the periods of the lease analysis.

Other cash flows include the tax shield on depreciation, any potential savings, maintenances costs, insurance, etc. associated with the purchase and use of the asset.

Once we know the after-tax cash flows under both the alternatives, we just need to find present values for each option using the company’s after-tax cost of debt and choosing the option that has lower present value of cash outflows.

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