Lease vs.

Buy
Lease or buy decision involves applying capital budgeting principles to determine if leasing as asset is a
better option than buying it.

Leasing is 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.

Buying the asset involves purchase of the asset with company’s 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 better.

Factors to Consider when comparing lease vs buy

Item Buy Lease
Repairs Yes No
Down Payment Yes No
Up-front Charges No Yes
Loan Payments Yes No
Lease Payments No Yes
Tax Reduction Yes Yes
Lease expenses No Yes
Interest cost Yes No
Salvage Value Yes No

After-tax cash flows of lease

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 must be included. These payments
have associated tax shield (they are allowed as deduction from the company’s 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 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.

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 company’s after-tax cost of debt and choosing the option that has lower
present value of cash outflows.