1 The Lease – Purchase Decision

Lecture Based on Financial Management

Jay K. Shim & Joel G. Siegel

Abdullah Al Yousuf Khan, Course Instructor, FIN 504, MBA, Spring 2018 4/6/2018
 For Lease
2

 Find the annual lease payment: Lease payments are

typically made in advance
1. Use the following formula
Amount of lease  A  A(PVIFA i,n 1 )
or
Amount oflease
A
1  PVIFA i.n 1
2. Find the after-tax cash outflows.
3. Find the present value (PV) of after-tax cash
outflows.
Notice: use n-1, rather than n
Abdullah Al Yousuf Khan, Course Instructor, FIN 504, MBA, Spring 2018 4/6/2018
 For Purchase
3

1. Find the loan amortization by using;

amount of loan for the purchase
A
PVIFAi, n
2. Calculate the interest.
3. Find the cash outflows by adding interest and
depreciation (+ any maintenance cost), and then
compute the after-tax cash outflows.
4. Find the PV of the after-tax cash outflows

Abdullah Al Yousuf Khan, Course Instructor, FIN 504, MBA, Spring 2018 4/6/2018
 EXAMPLE8.12
4

 A firm has decided to acquire an asset costing

$100,000 that has an expected life of 5 years, after
which the asset is not expected to have any residual
value. The asset can be purchased by borrowing or it
can be leased. If leasing is used, the lessor requires a
12 percent return. As is customary, lease payments are
to be made in advance. The tax rate is 50 percent and
the firm's cost of capital, or after-tax cost of borrowing,
is 8 percent.
 Required: Find the PV of after-tax cash outflows for
leasing

Abdullah Al Yousuf Khan, Course Instructor, FIN 504, MBA, Spring 2018 4/6/2018
 First, Compute the PV of After-Tax Cash
Outflows Associated With the Leasing Alternative
5

 Step 1: Find the annual lease payment:

Amount of lease $100,000 $100,000

A    $23,216
1  PVIFA12%, 4 years 1  3.3073 4.3073

 Step 2, and 3 can be done in the same schedule

(shown in next slide)

Abdullah Al Yousuf Khan, Course Instructor, FIN 504, MBA, Spring 2018 4/6/2018
 Step 2, and 3
6

Year (1) (2) (3)=(1) – (2) (4) (5) = (3)x(4)

Lease Tax After-Tax PV at 8% PV of Cash
Payment Savings Cash Outflows
Outflows
0 23,216 23,216 1.000 23,216
1 23,216 11,608* 11,608 .9259 10,747.85
2 23,216 11,608 11,608 .8573 9,951.54
3 23,216 11,608 11,608 .7938 9,214.43
4 23,216 11,608 11,608 .7350 8,531.88
5 11,608 (11,608) .06806 (7,900.40)
53,763

*$23,216x50%

Abdullah Al Yousuf Khan, Course Instructor, FIN 504, MBA, Spring 2018 4/6/2018
 Purchase Option
7

 If the asset is purchased, the firm is assumed to

finance it entirely with a 10 percent unsecured term
loan.
 Straight-line depreciation is used with no salvage
value.
 Therefore, the annual depreciation is $20,000
($100,000/5 years).
 In this alternative, first find the annual loan payment
by using (shown in next slide);
Abdullah Al Yousuf Khan, Course Instructor, FIN 504, MBA, Spring 2018 4/6/2018
 1. Find The Annual Loan Payment
8

amount of loan
A
PVIFAi, n
$100,000 $100,000
   $26,381
PVIFA10%,5 years 3.7906

Abdullah Al Yousuf Khan, Course Instructor, FIN 504, MBA, Spring 2018 4/6/2018
 2. Calculate the Interest by Setting Up
9
a Loan Amortization Schedule
Year (1) (2) (3) = (4) = (1) – (5) = (2) –
Loan Principal at (2)(10%) (3) (4)
Payment Beginning Interest Principal Principal at
of Year end of year
1 26,381 100,000 10,000 16,381 83,619
2 26,381 83,619 8,362 18,019 65,600
3 26,381 65,600 6,560 19,821 45,779
4 26,381 45,779 4,578 21,803 23,976*
5 26,381 23,976* 2,398 23,983* —

* Because of rounding error, there is a slight difference between (2) and (4)

Abdullah Al Yousuf Khan, Course Instructor, FIN 504, MBA, Spring 2018 4/6/2018
 3. Step 3 (cash Outflows) and 4 (PV of Those
Outflows) can be done as follows:
10

Year (1) (2) (3) (4) = (5) = (6) = (1) (7) (8) = (6)
Loan Principal Depreciation (2)+ (3) (4)(50%) – (5) PV at 8% x(7)
Payment at Total Tax Cash PV of
Beginning Depreciat Savings Outflows Cash
of Year ion Outflows
1 26,381 10,000 20,000 30,000 15,000 11,381 0.9259 10,538
2 26,381 8,362 20,000 28,362 14,181 12,200 0.8573 10,459
3 26,381 6,560 20,000 26,560 13,280 13,101 0.7938 10,400
4 26,381 4,578 20,000 24,578 12,289 14,092 0.7350 10358
5 26,381 2,398 20,000 22,398 11,199 15,182 0.6806 10,333
52,088

PV if Leased = 53,763 Purchasing is preferable

PV if Purchased = 52,088
Abdullah Al Yousuf Khan, Course Instructor, FIN 504, MBA, Spring 2018 4/6/2018