ECONOMICS OF LEASE

FINANCING

M. SADIQUL ISLAM
Time Value of Money in Lease vs. Buy
A company will acquire a piece of equipment costing
$100,000. The company has choice of acquiring the
equipment by borrowing at 10% interest, or by leasing
the machine at $16,270 per year. There is an investment
tax credit of 10 percent multiplied by the cost of the
machine, which the firm will get whether it buys or
leases (i.e., the investment tax credit will be passed
through to the lessee by the lessor).

Cost of ownership – debt service payment $16,270 per

year, tax benefits (46%) for depreciation, interest
expense and investment tax credit. The cost of capital of
the firm is 10%.
M. SADIQUL ISLAM
 Year
1 2 3 4 5 6 7 8 9 10 Total
Ownership
1 Debt Service 16,270 16,270 16,270 16,270 16,270 16,270 16,270 16,270 16,270 16,270 162700
2 Interest 10,000 9,370 8,680 7,920 7,090 6,170 5,160 4,050 2,800 1,460 62,700
3 Tax Benefit 4,600 4,310 3,990 3,640 3,260 2,840 2,340 1,860 1,290 680 28,840
4 Depreciation 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 100000
5 Tax benefit 4,600 4,600 4,600 4,600 4,600 4,600 4,600 4,600 4,600 4,600 46,000
6 Inv Tax Cr. 10,000 - - - - - - - - - 10,000
7 Net Cost/Ben 2,930 (7,360)(7,680)(8,030)(8,410)(8,830)(9,300)(9,810) (10380)(10930) (77860)
3+5+6-1
Leasing
8 Rent 16,270 16,270 16,270 16,270 16,270 16,270 16,270 16,270 16,270 16,270 16,270
9 Tax Benefit 7,480 7,480 7,480 7,480 7,480 7,490 7,490 7,490 7,490 7,490 74,840
10 Inv Tax Cr. 10,000 - - - - - - - - - 10,000
11 Net Cost/Ben 1,210 (8790) (8,790) (8,790)(8,790)(8,780)(8,780)(8,780)(8,780)(8,780)77,860
9+10-8
12 Net Cost/Ben 1,710 1,430 1,110 760 380 (50) (520) (1,030)(1,600)(2,190) 0
Ownership M. SADIQUL ISLAM
Ownership Vs Leasing

• The previous table illustrates one key fact.

• From a financial perspective/rationale (after taking

into account Time value of money), Ownership will
be a more superior option than leasing to acquire
an asset, most of the time.

• Nevertheless, many firms still go for leasing because

of its economic rationale.

M. SADIQUL ISLAM
Economic Rationale of Leasing

 A firm tries to create more financial capital. It is theoretically

unnecessary to acquire tangible capital in the form of owned assets.
The simple use of the asset should be equally satisfactory.

M. SADIQUL ISLAM
Economic Rationale of Leasing

There are Economic incentives to go for leasing when:

1. The business does not pay income taxes. Thus, it cannot

benefit from the depreciation, interest and investment tax
benefits. In such situation, it is wiser to transfer tax benefits
to those who can use them most appropriately. This can be
done through leasing. The firm can lease the assets, allow
the lessor to enjoy the tax benefits and negotiate a lower
rental payment in return for this tax benefit transfer.

M. SADIQUL ISLAM
Economic Rationale of Leasing

Leasing has arisen in response to an economic need

to:

2. The useful life of the asset is so short (e.g.,

computers) that the tax benefits of ownership are
irrelevant and the residual value is immaterial.
3. Ownership is not possible and leasing could be the
only alternative. i.,e govt owned lands, nuclear
reactors etc.

M. SADIQUL ISLAM
Economic Rationale of Leasing

4. In addition, leasing is preferred in industries

where there is rapid technological
obsolescence. Lessor assumes the risk of
obsolescence and spreads it among a number of
lessees over a multiple assets.
5. Also, equipment leasing can provide flexibility that may
not be available through other methods of
financing. For example, it does not restrict further
borrowing. Leasing tends to smooth out
imperfections in the capital markets.

M. SADIQUL ISLAM
Economic Rationale of Leasing

 Although, leasing is said to improve financial

position through off-balance-sheet financing, it
cannot escape the eye of a sophisticated financial
analyst. Moreover, the savings is only in the initial
cash outflow. In the long run, the total rental
payments of a lease surpass the cash involved in a
outright purchase of asset.

M. SADIQUL ISLAM
Evaluating the Cost of Leasing
 The evaluation of the cost of lease involves discounting a stream of
after-tax cash flows.
 Different methods for evaluating the cost of leasing have been
proposed to resolve two basic issues in the lease/purchase decision:
1. Should the investment decision be separated from financing
decision?
2. What is the appropriate interest rate for discounting the
component cash flows?

M. SADIQUL ISLAM
Evaluating the Cost of Leasing

 Two major approaches are generally followed:

(a) NPV under each alternative;
(b) IRR under each alternative;

M. SADIQUL ISLAM
Financing vs. Investment Decision

In the theory of capital budgeting, it is accepted

that financing decision and investment decision
should be separated.

 But leasing is both a financing and an investment

decision. The lessor is supplying both the use of
asset as well as the funds to acquire the asset and
charging for the both (explicit rental payments
including an implicit interest rate).

M. SADIQUL ISLAM
Financing vs. Investment Decision
 Under the conventional methods for lease analysis (which attempts
to separate the investment and financing decision), the analyst
typically compares the after-tax cash outflows under leasing with
those of a cash purchase.
 This comparison implies that only the operating cash flows
pertaining to the investment decision will be analyzed.

M. SADIQUL ISLAM
Financing vs. Investment Decision
 However, since the cash outflows in the leasing alternative implicitly
contain an interest element (due to lack of an initial investment), a
financing charge should be identified as part of the leasing cash outflows.
This would be compared to the outflows arising from a pure cash
purchase.

 Unfortunately, inclusion of an interest element in the lease analysis

introduces an imputed cash flow, which distorts the analysis.

M. SADIQUL ISLAM
Financing vs. Investment Decision
 To compare the cost of leases with other methods of acquisition, it is
necessary to distinguish between those cash flows that arise from the
financing and those that arise from the investment.
 A loan can be assumed for the cash purchase price at the firm’s
incremental borrowing rate. The principal payments, as well as the after
tax interest charges then would be discounted. The result would then be
compared to the after-tax cash flows of leasing.

M. SADIQUL ISLAM
Choosing the Appropriate Discount Rate

The choice of discount rate depends on depends on one of two

factors:
1. The approach for evaluating leases (comparison of NPV or IRR).
2. The assumptions behind the assumed risk in each cash flow
component.

M. SADIQUL ISLAM
A Framework for Lease Evaluation

- One problem with the NPV method is that by varying the amount or timing
of installment payments under the purchase alternative, the PV
alternative of either alternative can be altered.

M. SADIQUL ISLAM
A Framework for Lease Evaluation
To resolve the problem, Vancil proposed the
Basic Interest Rate Method.
Lease payments are discounted at the
firm’s incremental borrowing rate to
estimate the PV.
 Amount available for 
 PV of Lease Rental -   
    risk premiums, Admn. 
 Cash Purchase Price   Costs and Financial Exp. 
 

M. SADIQUL ISLAM
A Framework for Lease Evaluation

- All these costs would be borne by the lessee, had it obtained the loan
itself.
Therefore, to equate the lease alternative and the installment
purchase alternative, the premium should be added as an additional
imputed payment at the beginning of the lease.

M. SADIQUL ISLAM
A Framework for Lease Evaluation

 In our previous example, since the PV of lease payments, when

discounted at the lessee’s incremental borrowing rate, is equal to the
cash purchase price, there is no lessor premium.
 Hence it is only the excess of PV of depreciation and interest above
the PV of rent that gives advantage to ownership.

M. SADIQUL ISLAM
Bower, Herringer, Williamson Method
 The method put forth by Bower, Herringer and Williamson
recognizes that a lease may require a premium to the lessor (in PV)
over and above a cash purchase.
- According to them, the advantage or disadvantage of a lease versus
a purchase can be expressed as the sum of the financial advantage
or disadvantage (less amounts financed) and the operating
advantage or disadvantage.

M. SADIQUL ISLAM
  tDn tIn   Rn tRn 
L  C    n  
  n
 (1  i ) n
(1  i )   (1  r ) n
(1  i ) 
L  Advantage or Disadvantage of lease alternative
C  Cash purchase price of leased asset
Dn  Annual depreciation for year, n  1,2,...., N
In  Interest portion of lease or loan
Rn  Total lease payment per year
t  Marginal tax rate
i  Firm' s after - tax cost of capital
r  Firm' s incremental borrowing rate
M. SADIQUL ISLAM
Beak-Even Tax Rate

- If the marginal tax rate is zero, the advantage of lease alternative is

reduced to only the financial advantage, which is equal to the excess
of cash purchase price above the PV of lease payments discounted at
the firm’s incremental borrowing rate.

M. SADIQUL ISLAM
Break Even Tax Rate

- The effect of investment tax credit can be introduced by setting C

equal to the cash purchase price less the investment tax credit
realizable by the lessee.

M. SADIQUL ISLAM
Break Even Tax Rate

If the advantage of leasing (L) is set equal to zero and the expression
is rearranged to solve for the marginal tax rate (t):

Rn
 (1  r ) n  C
t
( Rn  Dn  In)
 (1  i) n
M. SADIQUL ISLAM
Break Even Tax Rate
- Tax rate greater than the break-even rate would indicate a
preference for owning over leasing.
- When the PV of the lease payments discounted at the incremental
borrowing are is equal to the cash purchase price of the asset, the
break-even tax rate is zero.
This means that at any positive effective tax rate, there would be a
preference for towards owning.

M. SADIQUL ISLAM
Break Even Rental

If the equation is solved for Rn:

( Dn  In)
N
C  t
n  0 (1  i )
n
Rn  N
1
(1  t )
n  0 (1  i )
n

M. SADIQUL ISLAM
Problem - 1
Rabbi International is considering the acquisition of
an equipment costing Taka 350,000. The
equipment has an economic life of 5 years. The
company can purchase the equipment by
borrowing at 12 percent. If the loan is taken, Taka
70,000 plus interest should be repaid annually.
Under the lease alternative, a rental of Taka 85,190
should be paid annually. The rental includes
maintenance expense of Taka 3000 annually. The
estimated salvage value is Taka 35,000. Tax rate is
30 percent. The company charges depreciation in
straight line method. WACC is 14 percent. Which
alternative should the firm choose? Estimate the
break even rental.
M. SADIQUL ISLAM
Problem – 1a
Rabbi International is considering the acquisition of
an equipment costing Taka 350,000. The
equipment has an economic life of 5 years. The
company can purchase the equipment by
borrowing at 12 percent. Loan installments are
equal and payable at the beginning of every year.
Under the lease alternative, a rental of Taka 85,190
should be paid annually (beginning). The rental
includes maintenance expense of Taka 3000
annually. The estimated salvage value is Taka
35,000. Tax rate is 30 percent. The company
charges depreciation in straight line method.
WACC is 14 percent. Which alternative should the
firm choose? Estimate the break even rental.

M. SADIQUL ISLAM
Problem – 1b
Rabbi International is considering the acquisition of
an equipment costing Taka 350,000. The
equipment has an economic life of 5 years. The
company can purchase the equipment by
borrowing at 12 percent. Loan installments are
equal and payable at the end of every year. Under
the lease alternative, a rental of Taka 85,190
should be paid annually (beginning). The rental
includes maintenance expense of Taka 3000
annually. The estimated salvage value is Taka
35,000. Tax rate is 30 percent. The company
charges depreciation in straight line method.
WACC is 14 percent. Which alternative should the
firm choose? Estimate the break even rental.

M. SADIQUL ISLAM
Problem - 2
Shantanu International is considering the acquisition of
an equipment costing Taka 150,000. The equipment
has an economic life of 5 years. The company can
purchase the equipment by borrowing at 10 percent. If
the loan is taken, Taka 30,000 plus interest (on
outstanding loan) should be repaid annually (at the
year end). Government provides 5% tax credit for
purchasing new industrial equipments. Under the lease
alternative, a rental of Taka 44,500 should be paid
annually. The rental includes maintenance expense of
Taka 2000 annually. Tax rate is 30% and WACC is 13%
for the firm. The company charges depreciation in
straight line method. Which alternative should the firm
choose?

M. SADIQUL ISLAM
Problem –2a

What if the lease rental includes a maintenance expense of Taka 5,000

annually?

M. SADIQUL ISLAM
 Problem 3
Shujan International is considering the acquisition of an
equipment costing Taka 550,000. The equipment has an
economic life of 5 years. The company can purchase the
equipment by borrowing at 14 percent. Loan
installments are equal and payable at the end of every
period. Government provides 5% tax credit (Cost x tax
rate) for purchasing new industrial equipments. Under
the lease alternative, a rental of Taka 138,000 should be
paid at the beginning of every year. The rental includes
maintenance expense of Taka 12000 annually. Tax rate is
30% and WACC is 15% for the firm. The company charges
depreciation in straight line method. Which alternative
should the firm choose?

M. SADIQUL ISLAM