Lease Vs Buying, Borrowing

SOME IMPORTANT POINTS ON LEASE VS BUYING/ BORROWING • • •

Lease vs. buying/ borrowing is a blend of investing and financing decision. Tax shield on depreciation is allowed only for lessor Lease rental is an expense for the lessee but and income for the lessor

First Approach i. ii. iii. iv.

Investing decision is evaluated separately based on NPV. Identify all relevant operating Cash Flows including taxes and capital allowances. Discount rates always based on WACC or COC. If NPV is positive, proceed to the financing decision other wise Reject the proposal.

Second Approach i.

Evaluate financing Decision: Only Cash Flows, which are relevant to the source of finance, are considered. (Operating Cash Flows are ignored, because they are same throughout the period).

1. LEASE Following Cash Flows are considered only 1. Lease Rental 2. Tax Shield on lease rental

Note: Tax authorities consider all leases as operating leases and allow full lease rental as deductible allowance

2. BUYING/ BORROWING 1. Cost of purchase 2. Tax Shield on Capital Allowance 3. Interest expense and its tax shield are considered only if annual interest payments are made 4. Do not considered interest expense and its shield if lump sum amount of loan is paid at the end of the period

After tax-borrowing rate is taken as a yardstick, cost of capital (WAAC) is not considered. Less costly option is adopted.

WAAC/COC is always higher than cost of debt after tax because Ke is always > Kd And Ke is included in WACC

LEASE VS BUYING/ BORROWING Method 1

Investment Decision at Cost of Capital (Relevant Cash Flows)    

Cost of Equipment Operating Savings Tax Effect on Savings Capital Allowance

Negative NPV (Reject)

Positive NPV

Lease related Cash Flows At after tax borrowing rate

Borrowing related Cash Flows At after tax borrowing rate

1. Lease Rental 2. Tax effect on lease rental

1- Loan Principal at Zero Year 2- Tax Effect on Depreciation

LEASE VS BUYING/ BORROWING Method 2 ( Investing + Financing Decision ) (Combined)

Acquiring with borrowing

 Cost of purchase/ Loan Principal  Operating savings  Tax effect on operating savings  Capital Allowance

(Discounted at after tax borrowing rate)

Acquiring with leasing

   

Operating Savings Tax effect on saving Lease rental Tax effect on lease rental

(Discounted at after tax borrowing rate)