Lease or Buy Prob

I hope the following explanation helps you to understand the nature of Lease or Buy decisions a little bit better.

There are 2 decision-making aspects to consider:

(1) The FINANCING DECISION
(2) The INVESTMENT DECISION

(1) The FINANCING DECISION ….. is it better to purchase the machine outright using a bank loan = to 100% of the cost of the asset, OR is it better to purchase the asset using a Finance Lease ?.

IF you BUY, you receive tax relief on the interest payable on the loan + tax relief on the capital allowances associated with the cost and use of the asset.
If you LEASE, you only receive tax relief on the annual lease payments/rents.

In both cases you discount the AFTER TAX cash flows associated with the loan or the lease at the BANK BORROWING RATE or Bank Overdraft Rate given in the question.

Remember: the FINANCING cash flows are absolutely CERTAIN. Thus, the discount rate that reflects these certain cash flows is the AFTER TAX COST OF DEBT.

When you come to consider the INVESTMENT DECISION you will appreciate that the OPERATING CASH FLOWS are NOT CERTAIN (they are RISKY) (Demand may change, production costs may vary to plan, etc.,) and therefore the appropriate discount factor to use is the WACC.

(1) The FINANCING DECISION….. If you assume that you are going to undertake the investment (i.e. acquire the asset) and you have a choice of whether to lease or buy (purchase outright) the asset then surely, from a purely financial point of view, you will want to choose the cheapest of these two options.

So, how will you find the cheapest of these two alternatives?

PROCEDURE:
(1) Forecast the NET OF TAX cash flows associated with the Lease and the Buy options.
(2) Discount each of these NCF’s to a Present Value at the AFTER tax discount rate .
(3) Choose the cheapest ….the option with the lowest PV of costs.

(2) The INVESTMENT DECISION… is it WORTHWHILE (economically speaking) to ACQUIRE the asset?

(1) Calculate the PV of the NET (after) TAX cash flows associated with the OPERATION of the equipment …i.e. those c/f’s which are not affected by the lease or buy decision. (NB: these cash flows do NOT include the CAPITAL COST of the equipment)

The DISCOUNT RATE must be appropriate to the cash flows you are discounting …i.e RISKY in nature … therefore this implies the WACC.

(2) Calculate the NPV (NET PRESENT VALUE) of the project by deducting the PV of the FINANCING cash flows from the PV of the OPERATING cashflows.

(3) If the NPV is POSITIVE …. ACCEPT … i.e. the investment is WORTHWHILE undertaking.

Aside: The critics say we are not comparing like with like – in using 2 different discount factors (costs of capital) to discount the FINANCING C/f’s and the OPERATING c/f’s but it needs to be recognised that both sets of cash flows are QUALATIVELY different….. therefore we must use different discount factors to reflect the different RISKS involved !

I do hope that you find answering Parts (a) and (b) of ASOP, Question 1 December 2009, has NOW become a quite a straight forward exercise!

Best of luck Kevin Kelly