Concept Of Lease Or Purchase Decision And Its Evaluation Process

Lease Or Purchase
Leasing is a contract between the owner(lesser) and the lessee for the hiring of a specific assets. Leasing can apply to any fixed assets and quite commonly used for plant and machinery, office equipment and motors vehicles. Instead of acquiring these assets for itself, the company enters into an agreement with a leasing company whereby the latter purchase the assets in question and then lease them ( rent or hire them) on a long-term basis to the former. No initial funds are required but there is instead a regular charge for lease payments to be charged in the profit and loss account. The lessee obtains possession and use of the asset in exchange for the rentals, while the lessor retains legal ownership.
Leases are of two types:
a) operating Leases, and
b) finance leases
Operating lease is one where an asset leased or hired for a period of time substantially less than that of its useful life. A finance lease is one which last for the whole of an asset's useful life and where the lessee effectively takes all the risks and benefits associated with ownership.

Leasing an asset from the lessor or purchase of asset by borrowing the full purchase price of asset should be compared as financing alternatives that are dependent on the investment decision. As such, such investment have been evaluated as part of a company's capital budgeting process and mostly use the NPV method by analysis using the after tax cost of debt as the discount rate for decision making. It means a firm should evaluate whether to purchase an asset or acquire by leasing. Lease rental payments are similar to the payments of interest on debt so leasing may be an good alternative to borrowing for the firm. Thus, lease financing is made using NPV method using the after-tax cost of debt as the discount rate.

Steps Involve In Evaluating The Lease Or Purchase For Decision Making

1. Determine the after tax cash outflow for each year under lease alternative as under:
(Lease payment amount - tax benefit on lease payment=$..) tax rate X lease payment

2. Determine the NPV of after tax cash outflow amount using after tax cost of capital (cost of capital X tax rate) or Cost of capital(1-tax rate). That is, determine PV of cash flows associated with the leasing alternative.

3. Determine the after tax cash outflow under buying alternative based on borrowing (PV of purchase price - PV of tax benefits of depreciation provided). That is, PV of cash flow associated with the buying alternative will be ascertained.

4. The decision between buying or leasing will be made by comparing the NPV under each of the alternatives. The alternative having lower NPV will be preferred

Note: Principle and interest payments when discounted at the appropriate borrowing rate will always be equal to the amount borrowed. Therefore, there is no need to consider the principal and interest repayments.
Select the alternative with low present value of cash outflows.

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