Lease vs Buying, Borrowing

SOME IMPORTANT IMPORTANT POINTS ON LEASE VS BUYING/ BORROWING • • •

Lease vs. buying/ borrowing is a blend of investing and financing decision. Tax shield on depreciation is allowed only for lessor  Lease rental is an expense for the lessee but and income for the lessor 

First Approach i. ii. iii. iii. iv. iv.

Invest Investing ing decisio decision n is evaluat evaluated ed separ separate ately ly based based on on NPV NPV.. Identi Identify fy all all releva relevant nt operat operating ing Cash Cash Flows Flows incl includi uding ng taxes taxes and and capital capital allo allowan wances ces.. Disc Discou ount nt rat rates es alway alwayss bas based ed on WACC ACC or or COC COC.. If NPV NPV is posit positive, ive, procee proceed d to the the finan financin cing g decisi decision on other other wise wise Reject Reject the the  proposal.

 Second Approach i.

Evaluate financing Decision : Only Cash Flows, which are relevant to the source of finance, are considered. (Operating Cash Flows are ignored , because they are same throughout the period).

1. LEASE  Following Cash Flows are considered only 1. Lease ase Re Rental ntal 2. Tax Shi Shiel eld d on leas leasee renta rentall

 Note: Tax authorities consider all leases as operating leases and allow full lease rental as deductible allowance

2. BUYI BUYING NG// BORR BORROW OWIN ING  G  1. Cost Cost of purc purcha hase se 2. Tax Shiel Shield d on Capit Capital al Allowan Allowance ce 3. Interest Interest expense expense and its its tax shield shield are considered considered only only if annual annual interest interest payment paymentss are made 4. Do not considered considered interes interestt expense expense and its shield shield if lump lump sum amount amount of loan loan is  paid at the end of the period

After tax-borrowing rate is taken as a yardstick, cost of  capital (WAAC) is not considered. Less costly option is adopted.

WAAC/COC is always higher than cost of debt after tax because K e is always > K d And K e is included in WACC

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LEASE VS BUYING/ BORROWING Method 1

Investment Decision at Cost of  Capital (Relevant Cash Flows)    

Cost of Equipment Operating Savings Tax Effect on Savings Ca ital ital Allo Allowa wanc ncee

Negative NPV (Reject)

Positive NPV

Lease related Cash Flows At after tax borrowing rate

Borrowing related Cash Flows At after tax borrowing rate

1. Lease Lease Rental Rental 2. Tax effect on lease rental

1- Loan Princi Principal pal at Zero Zero Year  2- Tax Effect on Depreciation

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LEASE VS BUYING/ BORROWING Method 2

( Investing + Financing Decision ) (Combined)

Acquiring with borrowing

   

Cost of purchase/ Loan Principal Operating savings Tax effect on operating savings Capital Allowance

(Discounted at after tax borrowing rate)

Acquiring with leasing

   

Operating Savings Tax effect on saving Lease rental Tax effect on lease rental

(Discounted at after tax borrowing rate)