PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY
the assets, using these resources is viewed as equivalent to borrowing. Therefore, we will compare only
the leasing and purchasing alternatives.
The lease-versus-purchase decision involves application of the capital budgeting methods presented
in chapters 10 and 11. The analysis can be framed in two different ways, but both approaches yield
the same answer if done correctly. In one approach, we first list the cash flows associated with the
purchase option and the lease option; then we take the differences in cash flows between the two
options and calculate the NPV of the incremental cash flow stream discounting at the after-tax cost
of debt. The alternative approach is simply to calculate the NPVs of the purchase and lease options
separately (discounting each at the after-tax cost of debt) and then compare them. Note that either
method can be used to determine whether the lease option or the purchase option is better, but neither
method addresses whether leasing or purchasing is worthwhile in the first place. (You should perform
this analysis separately.) That is, the lease-versus-purchase analysis merely allows us to make statements
about the relative merits of leasing versus buying.
The following ‘Example’ demonstrates application of both approaches: (1) calculating the NPV of the
incremental lease-versus-purchase cash flows; and (2) separately calculating the NPVs of the lease and
purchase option cash flows and comparing them.exampleFastTrak Movers has already conducted a standard NPV analysis and determined that acquiring a new
delivery truck would increase company value. Now, FastTrak needs to decide whether to lease or purchase
the truck.
The truck costs $25,000, and will reduce operating costs by $4,500 annually over its five-year life. If
FastTrak buys the truck, then it will be depreciated on a straight-line basis, and the truck will have no resale
value after five years. Alternatively, the company can lease the truck for $6,300 per year (with payments at
the end of each year). The lease payments are tax-deductible. FastTrak faces a 35% tax rate, and its pre-tax
cost of debt is 8%.
Table 14.6 shows the cash flows for both the lease and the purchase option. Under either scenario, the
company realises $4,500 in savings each year, or $2,925 after taxes [$4,500 × (1 – 35%)]. Under the purchase
option, the company has a large initial cash outflow, but it can deduct $5,000 per year in depreciation, saving
$1,750 in taxes each year ($5,000 × 35%). With the lease option, the company pays $6,300 per year before
taxes, or $4,095 after taxes [$6,300 × (1 – 35%)]. Subtracting the net cash flows associated with the purchase
option from those tied to the leasing decision and then discounting them at the after-tax cost of debt of 5.2%
[8% x (1 – 35%)], we obtain the following incremental NPV of leasing versus purchasing:NPV $25, 000
$5, 845
1.052
$5, 845
1.052
$5, 845
1.052
$5, 845
1.052
$5, 845
1.052
12345 $166
()()()()()
=−−−−−=−
The NPV is negative, so the incremental benefits of purchasing exceed those of leasing. Therefore, FastTrak
should purchase the truck they need.
> >