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Lease Vs Buy Conceptual Overview

1. To analyze whether to lease or purchase a building, calculate the net present value (NPV) of the purchase cash flows subtracted from the lease cash flows. If the NPV is positive, purchase is better. If the NPV is negative, leasing is better. Alternatively, compare the internal rate of return (IRR) to the cost of capital. 2. The concept of subtracting cash flows works both ways - either purchase cash flows minus lease cash flows or vice versa. 3. A capital lease is treated like ownership for tax purposes, allowing the lessee to take depreciation deductions like an owner. The interest portion of the lease payments is tax deductible as well. To determine

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55 views

Lease Vs Buy Conceptual Overview

1. To analyze whether to lease or purchase a building, calculate the net present value (NPV) of the purchase cash flows subtracted from the lease cash flows. If the NPV is positive, purchase is better. If the NPV is negative, leasing is better. Alternatively, compare the internal rate of return (IRR) to the cost of capital. 2. The concept of subtracting cash flows works both ways - either purchase cash flows minus lease cash flows or vice versa. 3. A capital lease is treated like ownership for tax purposes, allowing the lessee to take depreciation deductions like an owner. The interest portion of the lease payments is tax deductible as well. To determine

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ozart visual grafx
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© © All Rights Reserved
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Simple Example

A couple of comments about Lease versus Buy analysis.

1) When you are looking at the difference between Purchase and Lease Cash Flows while
analyzing a lease, subtract the lease cash flows from the Purchase cash flows.

For example:
Assume you buy a building for $5,000,000 that is worth $6,000,000 in 5 years
You can lease it for $350,000 per year. Should you lease or buy? Assume
an interest rate of 10% for the NPV calculation
(Purchase subtract Lease)
Period Purchase Cash Flows Lease Cash Flows Difference
0 (5,000,000) (5,000,000)
1 (350,000) 350,000
2 (350,000) 350,000
3 (350,000) 350,000
4 (350,000) 350,000
5 6,000,000 (350,000) 6,350,000
NPV $47,548
IRR 10.3%

If the NPV is >0, then you should purchase. If the NPV is < 0 then you should Lease
If the IRR is > than your cost of capital, you should purchase. Otherwise, lease.
If the rules conflict, follow the NPV rule.

2) The concept of subracting cash flows to get incremental cash flows works either way.
For example:

+ Purchase - Lease + Salvage (or residual) > 0 (if NPV>0 then you should Purchase)
OR
+ Lease - Purchase - Salvage > 0 (if NPV>0 then you should Lease)
Purchase is actually a cash outflow (negative number)
Lease becomes a positive cash flow (subtract a negative number)
Salvage is a positive number

3) When evaluating the capital lease, you are merely comparing two interest rates. Remember
a capital lease is structured just like ownership, so you get the depreciation benefits just like
as if you were an owner. Similarly, you get the interest tax shields, just like an owner would.

To figure out how much the interest tax shields are worth, do the following:
Using the information in (1) above and assuming the amortization is 5 years.
PMT = -350,000
n=5
PV = 5,000,000
FV = 6,000,000
R=?
Use your calculator or Excel to solve for R
R = 10.3%
Now that you know R, you can build an amortization schedule and calculate the interest and
principle payments.

4) Now that you have a conceptual understanding of the mechanics of lease versus buy, the next
step is to incorporate the tax components. They have already been incorporated into this
spreadsheet.
Cash Value Calculation
Interest Expense interest expense * (1 - tax rate)
depreciation depreciation * tax rate
Operating lease payment pmt * (1 - tax rate)
operating expense operating exp * (1 - tax rate)
Capital Lease payment lease payment
- imputed interest payment * (tax rate)
- depreciation * (tax rate)

For the sake of this exercise, you can ignore the option valuation.

Last comment. Remember many assets don't appreciate, which means the NPV calculations
can be negative. Don't let that throw you. The higer NPV the better (even if they are both negative).
Stick to the basic principles above and you should be ok.

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