Lease versus Buy Analysis
The common methodology for deciding if taking an asset on a finance lease is more economic than buying, is to compare and select the lowest Net Present Value of the after-tax cash flows of each alternative. To complete the analysis requires four items of information in addition to the initial equipment cost.
These are: -
- The prospective lessee’s marginal tax rate. In the case where the lessee is not a taxpayer, e.g. an NHS Trust, a Local Authority or a tax-exempt body, pre-tax cash flows are identical to after-tax cash flows, as tax is ignored.
- The lessee’s own cost of raising fixed-rate incremental funds. In the case of NHS Trusts this equates to the NHS Appraisal Rate. For private companies this rate will be the cost of borrowing fixed-rate funds from the bank, while for public companies the rate will be the Weighted Average Cost of Capital (WACC), a blended cost of fixed-rate bank borrowing and capital (dividends, the costs of raising new equity and the Return on Equity expected from it) applicable to the lessee. In the case of a cash-rich lessee the rate used would be the fixed-rate deposit interest rate that the lessee would be forsaking by spending the cash.
- The lessee’s likely fixed deposit rate on surplus funds.
- An estimate of the disposal value of the asset at the end of the period of use.
TAX PAYING LESSEE
LEASE ALTERNATIVE
Assumptions: Equipment Cost is £1000.00
Lessee’s Incremental tax rate is 33%
Lessee’s Incremental WACC is 8.75% (assuming leverage 4:1 and ROE of 20%)
Lessee’s Incremental long-term fixed-rate borrowing rate is 5%
Lessee’s Incremental Deposit interest rate is 3%
Estimated asset disposal value is £50.00
Lease Terms:
Lease Rate: 5.25%
Twenty quarterly rentals payable in advance
Lessee is appointed sales agent for equipment at the end of the lease, and receives 98% of the proceeds as sales commission
|
|
0
|
1
|
2
|
3
|
4
|
5
|
6
|
|
Lease Payments
(given)
|
56.43
|
169.30
|
225.74
|
225.74
|
225.74
|
225.74
|
Sales
Comm.
(49)
|
|
Tax relief (X0.33)
|
(18.62)
|
(55.87)
|
(74.49)
|
(74.49)
|
(74.49)
|
(74.49)
|
16.17
|
|
Net Cash Cost
|
37.81
|
113.43
|
151.25
|
151.25
|
151.25
|
151.25
|
32.83
|
BUY ALTERNATIVE
|
|
0
|
1
|
2
|
3
|
4
|
5
|
6
|
|
Down Payment
Loss of interest
|
250
|
7.50
|
7.50
|
7.50
|
7.50
|
7.50
|
|
|
Loan Payment (1)
|
|
174.72
|
174.72
|
174.72
|
174.72
|
174.72
|
|
|
Interest tax relief(2)
|
|
(13.87)
|
(11.18)
|
(8.33)
|
(5.30)
|
(2.10)
|
|
|
WDA benefit (3)
|
|
(82.50)
|
(61.88)
|
(46.41)
|
(34.80)
|
(26.07)
|
(61.71)
|
|
Disposal proceeds(4)
|
|
|
|
|
|
|
(50)
|
|
Net Cash Cost
|
250
|
85.5
|
109..16
|
127.48
|
142.12
|
154.05
|
(111.71)
|
Notes: -
1.Equal repayment loan of £750.00 repaid quarterly in arrears over five years
2.Loan repayment table
|
Year
|
Capital
Element
|
Interest
Element
|
Tax relief
On interest
|
Annual loan
repayments
|
|
1
|
132.68
|
42.04
|
(13.87)
|
174.72
|
|
2
|
140.83
|
33.89
|
(11.18)
|
174.72
|
|
3
|
149.47
|
25.25
|
(8.33)
|
174.72
|
|
4
|
158.66
|
16.06
|
(5.30)
|
174.72
|
|
5
|
168.36
|
6.36
|
(2.10)
|
174.72
|
|
Totals
|
750.00
|
123.60
|
(40.78)
|
873.60
|
3.Writing Down Allowances table (showing Tax Written Down Values)
|
Year
|
Opening
TWDV
|
WDA
25%
|
Tax relief
At 33%
|
Closing
TWDV
|
|
1
|
1000.00
|
250.00
|
(82.50)
|
750.00
|
|
2
|
750.00
|
187.50
|
(61.88)
|
562.50
|
|
3
|
562.50
|
140.63
|
(46.41)
|
421.87
|
|
4
|
421.87
|
105.47
|
(34.80)
|
316.00
|
|
5
|
316.00
|
79.00
|
(26.07)
|
237.00
|
On disposal the value of tax relief is calculated as
Balancing Allowance (237.00 – 50) X 0.33 = (61.71)
4.Disposal Proceeds £50.00
COMPARISON OF ALTERNATIVES
|
Discount Rate
|
NPV Lease
|
NPV Buy
|
|
After-tax cost of debt
(5.0% X 0.67) = 3.35%
|
713.97
|
714.30
|
|
After-tax WACC = 8.75%
|
615.03
|
655.72
|
The example shows Leasing to give a lower net present value cost than Buying, although in the case of using After-tax cost of debt as the discount rate (as a private company would) the difference is very small. Given the fact that leasing has a clear cash flow advantage in the early years (costing only £151.24 by the end of the first year compared with £335.85 in the case of buying) coupled to the fact that leasing is quicker to arrange than bank finance, these advantages should be enough to persuade many private company financial controllers to go for leasing.
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