Lease or Buy

Decisions
Lease or Buy Decisions

Lease or buy decision involves applying capital

budgeting principles 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.
Lease or Buy Decisions

Buying the asset involves purchase of the asset with

companys 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
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 companys
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.
After-tax cash flows of purchase
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 companys after-tax cost of debt and
choosing the option that has lower present value of cash
outflows.
 Example
B-Tel, Inc. is a telecommunication services provider looking to expand to
a new territory Z; it is analyzing whether it should install its own telecom
towers or lease them out from a prominent tower-sharing company T-
share, Inc.
Leasing out 100 towers would involve payment of $5,000,000 per year for
5 years.
Erecting 100 news towers would cost $18,000,000 including the cost of
equipment and installation, etc. The company has to obtain a long-term
secured loan of $18 million at 5% per annum.
Owning a tower has some associated maintenance costs such as
security, power and fueling, which amounts to $10,000 per annum per
tower.
The companys tax rate is 40% while its long-term weighted average cost
of debt is 6%. The tax laws allow straight-line depreciation for 5 years.
Determine whether the company should erect its own towers or lease
them out.
Solution

Annual cash out flows of leasing (Year 1 to Year 5) =

$5,000,000 X (1 40%) = $3,000,000
Annual cash flows of purchasing have three components:
the loan amount to be repaid in each period, the
maintenance costs to be borne each year, the tax shields
associated with maintenance costs, depreciation expense
and interest expense. The following table summarizes the
calculation of cash flows under this alternative.
 Period 1 2 3 4 5
Loan repayment A 4,157,546 4,157,546 4,157,546 4,157,546 4,157,546

Maintenance B 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000

costs

Depreciation D 3,600,000 3,600,000 3,600,000 3,600,000 3,600,000

Interest expense I 900,000 737,123 566,101 386,529 197,978

Total tax T = B+D+I 5,500,000 5,337,123 5,166,101 4,986,529 4,797,978

deductions

Tax shield @ 40% t = 0.4T 2,200,000 2,134,849 2,066,441 1,994,612 1,919,191

Net cash flows N = A+Bt 2,957,546 3,022,697 3,091,106 3,162,935 3,238,355

Solution

Annual loan repayment is based on present

value calculation; it is the amount paid at the
end of each year for 5 years that would write off
the loan completely. It is calculated as:
0.05
18,000,000 = 4,157,546
1(1+0.05)5

Interest expense are calculated in the following

debt amortization table:
 Total
Opening Principal Closing
Period Repayme Interest
Principal Repayment Principal
nt

0 18,000,000 - - - 18,000,000

1 18,000,000 4,157,546 900,000 3,257,546 14,742,454

2 14,742,454 4,157,546 737,123 3,420,424 11,322,030

3 11,322,030 4,157,546 566,101 3,591,445 7,730,585

4 7,730,585 4,157,546 386,529 3,771,017 3,959,568

5 3,959,568 4,157,546 197,978 3,959,568 -

 It is necessary to prepare amortization table
because tax laws do not allow deduction of total
loan amount, instead only interest expense is
allowed as deduction.
Depreciation is calculated on straight-line basis
using the 5-year useful life (i.e. $18,000,000/5 =
$3,600,000).
Tax shield is subtracted from loan repayments and
maintenance costs while calculating the net cash
outflows because tax shield represents a cash inflow
which arises due to tax deductibility of the expenses.
 Now, we have to calculate the present value of
cash outflows under both the options using the
after-tax cost of debt which is 3.6% (6% * (1-40%))
Present value of leasing at 3.6% = $13,545,157
Present value of purchasing at 3.6% = $13,950,176
Since leasing has a lower present value of cash
outflows, it should be the preferred option.