Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VIII. Topics in Corporate

Finance

26. Leasing © The McGraw−Hill^903
    Companies, 2002

Tasha has a corporate tax rate of 34 percent. For simplicity, we assume that five-year

straight-line depreciation will be used for the pipe-boring machine, and, after five years,

the machine will be worthless. Johnson Leasing Corporation has offered to lease the

same pipe-boring machine to Tasha for lease payments of $2,500 paid at the end of each

of the next five years. With the lease, Tasha would remain responsible for maintenance,

insurance, and operating expenses.^5

Susan Smart has been asked to compare the direct incremental cash flows from leas-

ing the IBMC machine to the cash flows associated with buying it. The first thing she

realizes is that, because Tasha will get the machine either way, the $6,000 savings will

be realized whether the machine is leased or purchased. Thus, this cost savings, and any

other operating costs or revenues, can be ignored in the analysis.

Upon reflection, Ms. Smart concludes that there are only three important cash flow

differences between leasing and buying:^6

1. If the machine is leased, Tasha must make a lease payment of $2,500 each year.
   However, lease payments are fully tax deductible, so the aftertax lease payment
   would be $2,500 (1
   .34) $1,650. This is a cost of leasing instead of buying.


2. If the machine is leased, Tasha does not own it and cannot depreciate it for tax
   purposes. The depreciation would be $10,000/5 $2,000 per year. A $2,000
   depreciation deduction generates a tax shield of $2,000 .34 $680per year.
   Tasha loses this valuable tax shield if it leases, so this is a cost of leasing.


3. If the machine is leased, Tasha does not have to spend $10,000today to buy it. This
   is a benefit from leasing.
   The cash flows from leasing instead of buying are summarized in Table 26.2. Notice
   that the cost of the machine shows up with a positive sign in Year 0. This is a reflection
   of the fact that Tasha savesthe initial $10,000 equipment cost by leasing instead of
   buying.

880 PART EIGHT Topics in Corporate Finance

(^5) We have assumed that all lease payments are made in arrears, that is, at the end of the year. Actually, many
leases require payments to be made at the beginning of the year.
(^6) There is a fourth consequence of leasing that we do not discuss here. If the machine has a nontrivial
residual value, then, if we lease, we give up that residual value. This is another cost of leasing instead of
buying.

TABLE 26.2

Incremental Cash Flows

for Tasha Corp. from

Leasing Instead of

Buying

Lease

versus Buy Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Aftertax 
$1,650 
$1,650 
$1,650 
$1,650 
$1,650

lease

payment

Lost 
 680 
 680 
 680 
 680 
 680

depreciation

tax shield

Cost of $10,000

machine

Total cash $10,000 
$2,330 
$2,330 
$2,330 
$2,330 
$2,330

flow