Three Potential Pitfalls

There are three potential problems with the implicit rate that we calculated on the lease. First of all, we can interpret this rate as the internal rate of return, or IRR, on the decision to lease rather than buy, but doing so can be confusing. To see why, notice that the IRR from leasing is 5.317 percent, which is greater than Tasha's aftertax borrowing cost of 5 percent. Normally, the higher the IRR, the better, but we decided that leasing was a bad idea here. The reason is that the cash flows are not conventional; the first cash flow is positive and the rest are negative, which is just the opposite of the conventional case (see Chapter 9 for a discussion). With this cash flow pattern, the IRR represents the rate we pay, not the rate we get, so the lower the IRR, the better.

A second, and related, potential pitfall has to do with the fact that we calculated the advantage of leasing instead of buying. We could have done just the opposite and come up with the advantage of buying instead of leasing. If we did this, the cash flows would be the same, but the signs would be reversed. The IRR would be the same. Now, however, the cash flows would be conventional, so we could interpret the 5.317 percent IRR as saying that borrowing and buying is better.

The third potential problem is that our implicit rate is based on the net cash flows of leasing instead of buying. There is another rate that is sometimes calculated, which is based solely on the lease payments. If we wanted to, we could note that the lease provides $10,000 in financing and requires five payments of $2,500 each. It would be tempting to then determine an implicit rate based on these numbers, but the resulting rate would not be meaningful for making lease versus buy decisions, and it should not be confused with the implicit return on leasing instead of borrowing and buying.

Perhaps because of these potential sources of confusion, the IRR approach we have outlined thus far is not as widely used as the NPV-based approach that we describe next.

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