Lease Analysis

A contract between two parties called lessor and lessee, whereby lessee gets the right to use an asset provided by the lessor in return of periodic financial payments, called lease payments. Types:
Operating Leases Financial Leases/Capital lease.

Reasons for Leasing

Short-term leases are convenient Cancellation options are valuable Tax shields can be used Avoiding the alternative minimum tax Leasing avoids capital expenditure controls Leasing preserves capital Leasing effects book income

Example Lease or Buy Decision

Q: Company ABC wants to buy a machine that costs $ 80,000 with expected life of 5 years. ABC tax rate is 30% and the cost of borrowing is 12%. ABC can also enter a lease contract to acquire the machine. Under lease arrangement ABC will have to pay Rs. 20,000 as lease payments each year for next 5 years. Determine whether ABC should buy or lease the machine. ABC assumes no salvage value.
Data Summary Tax rate (t) Pre-tax Interest rate (i) After-tax interest = 12 % x (1 - .30) Cost Lease PMT Salvage Value Annual depreciation = 80000 / 5 30% 12% 8.40% $ 80,000.00 -$ 20,000.00 $ 0.00 $ 16,000.00

procedure
Steps involved in Lease Analysis.
1.
2.

Determine PV of ATCO under lease option, (i.e. cost of lease option).

Determine PV of ATCO net of tax savings on interest and deprecation expenses under borrow and buy (B&B) option, (i.e. cost of B&B option). Compare the costs under both options and select whichever is lower.

3.

Step 1: Evaluate lease option.

Lease Evaluation
Year (1) 1 Lease Payment After-tax Lease Payment = 20,000 x (1- .30) (2) (3) -$20,000.00 -14000 PVIF i,n (After tax) PV = 12% x ( 1 - .30) = 8.4% (4) (5) = (3) x (4) 0.923 -$12,915.13

2
3 4 5

-$20,000.00
-$20,000.00 -$20,000.00 -$20,000.00

-14000
-14000 -14000 -14000

0.851
0.785 0.724 0.668

-$11,914.33
-$10,991.08 -$10,139.37 -$9,353.66

PV of Cash outflows in lease option -$55,313.56 Calculations: After-tax lease payments = Before-tax lease payment x (1 tax rate) After-tax rate of interest = Before-tax rate of interest x (1 tax rate)

Note: Net ATCO under lease option is $55,313. Now calculate net ATCO under Borrow and Buy Option and compare it with $55,313. Select an option with lower net ATCO.

Step 2: B&B Evaluation

Prepare Loan Amortization Schedule to calculate annual Interest expense for each year, This is required to determine tax savings on interest expense.

Borrow and Buy (B&B) Evaluation

Table 1: Loan Amortization Schedule Year Loan Interest Exp per year Amortization Beg. Amount Installment (1) (2) (3) (4) = (2) x .12 (5) = (3) (4) 1 $80,000.00 -$22,192.78 $9,600.00 -$12,592.78 End. Amount

(6) = (2) (5) $67,407.22 $53,303.31

$37,506.93 $19,814.98 $0.00

2
3 4 5

$67,407.22
$53,303.31 $37,506.93 $19,814.98

-$22,192.78
-$22,192.78 -$22,192.78 -$22,192.78

$8,088.87
$6,396.40 $4,500.83 $2,377.80
,

-$14,103.91
-$15,796.38 -$17,691.95 -$19,814.98

Calculation:

80000 3.604

= $ 22, 192.78

 Calculate Net ATCO net of savings on interest and depreciation expenses, and determine PV of these CO. The sum of these cashflows is total cost under B&B option.
PV Schedule
Year Loan Installment (2) Tax shield on Depreciation Tax shield on interest expenses Net CO Tax adjusted PVIF I, n @ 8.4% PV

(1)

(3) = ($16000 x 0.3) (4) = (Int Exp x 0.3)

(5) = (2) (3) (4) (6) = 12% x (1-.3)

(7) = (5) x (6)

1 2 3 4 5

-$22,192.78 -$22,192.78 -$22,192.78 -$22,192.78 -$22,192.78

4800 4800 4800 4800 4800

$2,880.00 $2,426.66 $1,918.92 $1,350.25 $713.34

-$14,512.78 -$14,966.12 -$15,473.86 -$16,042.53 -$16,679.44

0.923 0.851 0.785 0.724 0.668

-$13,388.17 -$12,736.52 -$12,148.17 -$11,618.65 -$ 11,143.84 -$61,035.35

PV of Cash outflows in lease option Salvage Value $0.00 Pv of Salvage value $0.00

0.668

Salvage value Adjustment PV B&B option

$ 0.00 -$ 61,035.35

Calculations: Tax saving on depreciation = Annual Depreciation Expense x tax rate Tax savings on interest expenses = Annual Interest Expense x tax rate