Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VIII. Topics in Corporate

Finance

(^908) 26. Leasing © The McGraw−Hill
Companies, 2002
We seem to have a paradox. In any leasing arrangement, one party must inevitably
lose (or both parties exactly break even). Why would leasing take place? We know that
leasing is very important in the real world, so the next section describes some factors
that we have omitted from our analysis thus far. These factors can make a lease attrac-
tive to both parties.
REASONS FOR LEASING
Proponents of leasing make many claims about why firms should lease assets rather
than buy them. Some of the reasons given to support leasing are good, and some are not.
We discuss here the reasons for leasing that we think are good, and some of the ones that
we think aren’t so good.
CONCEPT QUESTIONS
26.6a Why do we say that leasing is a zero-sum game?
26.6bWhat paradox does the previous question create?
CHAPTER 26 Leasing 885

TABLE 26.3

Incremental Cash Flows

for Johnson Leasing

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

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

payment

Depreciation  680  680  680  680  680

tax shield

Cost of 
$10,000

machine

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

flow

It’s the Lease We Can Do

In our Tasha example, a lease payment of $2,500 makes the lease unattractive to Tasha, and

a lease payment of $2,000 makes the lease very attractive. What payment would leave Tasha

indifferent between leasing and not leasing?

Tasha will be indifferent when the NPV from leasing is zero. For this to happen, the present

value of the cash flows from leasing instead of buying will have to be 
$10,000. From our

previous efforts, we know that the lease payment must be somewhere between $2,500 and

$2,000. To find the exact payment, we note that there are five payments and the relevant rate

is 5 percent per year, so the cash flow from leasing instead of borrowing must be 
$2,309.75

per year.

Now that we have the cash flow from leasing instead of borrowing, we have to work back-

wards to find the lease payment that produces this cash flow. Suppose we let LP stand for the

lease payment. Referring back to Table 26.2, we see that we must have that 
LP (1 
.34)


$680 
$2,309.75. With a little algebra, we see that the zero NPV lease payment is

$2,469.32.

EXAMPLE 26.2

26.7