Question

Leasing versus buying an asset?

Answer 1

Leasing versus buying an asset arises when we have decided to acquire an asste or in other words, it has been verified that Net Present Value of the asset is Positive. Then we will have two options

Lease the Asset or Buy the Asset

Lease is considered to be a rental arrangement. The Lessor is the owner of the asset and the person who has taken the asset on lease from the Lessor is known as Lesse. It means that Lessor will enjoy Tax Sheild on Depreciation and Salvage Value of the Asset. Lessor will receive Lease Rentals from Lesse. The Lessor will pay tax on the Lease Rentals.

Now if we think from the viewpoint of Lesse then Cost of Leasing would be

Present Value of Post Tax Lease Rentals

Lesse will pay only the lease rentals to the lessor and he will save tax on such lease payments.

However if the Lesse decides to buy the asset by taking a loan then Cost of Buying would be

Down payment (if any) + Present Value of interest and principal payments - Present Value of tax sheild on depreciation - Present Value of tax sheild on Interest - Present Value of Salvage Value

Since the lesse would take a loan to finance the asset he will have to pay Interest and Principal for the period of loan. Now as the Lesse will buy the asset he will save Tax sheild on Depreciation. Since he is paying the interest he will save Tax sheild on Interest Payments. Since he will own the asset he will also get the salvage value at the end of the life of Asset.

Therefore the outflows would be

• Down payment (if any)  
• Interest
• Principal

The inflows would be

• Tax sheild on Depreciation
• Tax sheild on Interest Payments
• Salvage value

Now for a Leasing decision to be viable we need to choose that alternative in which our cost is lowest. If Cost of Buying is lower than Cost of Leasing then we will borrow the amount and buy the asset.

If Cost of Buying is more than Cost of Leasing then we will take the asset on lease.