Preliminary Analysis

Suppose Tasha were to borrow $10,000 today and promise to make aftertax payments of $2,330 per year for the next five years. This is essentially what Tasha will be doing if it leases instead of buying. What interest rate would Tasha be paying on this "loan"? Going back to Chapter 6, note that we need to find the unknown rate for a five-year annuity with payments of $2,330 per year and a present value of $10,000. It is easy to verify that the rate is 5.317 percent.

The cash flows for our hypothetical loan are identical to the cash flows from leasing instead of buying, and what we have illustrated is that when Tasha leases the machine, it effectively arranges financing at an aftertax rate of 5.317 percent. Whether this is a good deal or not depends on what rate Tasha would pay if it simply borrowed the money. For example, suppose Tasha can arrange a five-year loan with its bank at a rate of 7.57575 percent. Should Tasha sign the lease or should it go with the bank?

Because Tasha is in a 34 percent tax bracket, the aftertax interest rate would be 7.57575 X (1 - .34) = 5 percent. This is less than the 5.317 percent implicit aftertax rate on the lease. In this particular case, Tasha would be better off borrowing the money because it would get a better rate.

We have seen that Tasha should buy rather than lease. The steps in our analysis can be summarized as follows:

1. Calculate the incremental aftertax cash flows from leasing instead of buying.

2. Use these cash flows to calculate the implicit aftertax interest rate on the lease.

3. Compare this rate to the company's aftertax borrowing cost and choose the cheaper source of financing.

There's an online lease versus buy calculator at (where else?): www.lease-vs-buy.com.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VIII. Topics in Corporate Finance

26. Leasing

© The McGraw-Hill Companies, 2002

PART EIGHT Topics in Corporate Finance

The most important thing to note from our discussion thus far is that in evaluating a lease, the relevant rate for the comparison is the company's aftertax borrowing rate. The fundamental reason is that the alternative to leasing is long-term borrowing, so the aftertax interest rate on such borrowing is the relevant benchmark.

net advantage to leasing (NAL)

The NPV that is calculated when deciding whether to lease an asset or to buy it.

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