Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance(^904) 26. Leasing © The McGraw−Hill
Companies, 2002
A Note on Taxes
Susan Smart has assumed that Tasha can use the tax benefits of the depreciation al-
lowances and the lease payments. This may not always be the case. If Tasha were losing
money, it would not pay taxes and the tax shelters would be worth less (unless they
could be shifted to someone else). As we mentioned before, this is one circumstance un-
der which leasing may make a great deal of sense. If this were the case, the relevant
lines in Table 26.2 would have to be changed to reflect a zero tax rate. We will return to
this point later.
LEASE OR BUY?
Based on our discussion thus far, Ms. Smart’s analysis comes down to this: if Tasha
Corp. leases instead of buying, it saves $10,000today because it avoids having to pay
for the machine, but it must give up $2,330per year for the next five years in exchange.
We now must decide whether getting $10,000today and then paying back $2,330per
year is a good idea.
A Preliminary Analysis
Suppose Tasha were to borrow $10,000 today and promise to make aftertax payments of
$2,330 per year for the next five years. This is essentially what Tasha will be doing if it
leases instead of buying. What interest rate would Tasha be paying on this “loan”? Go-
ing back to Chapter 6, note that we need to find the unknown rate for a five-year annu-
ity with payments of $2,330 per year and a present value of $10,000. It is easy to verify
that the rate is 5.317 percent.
The cash flows for our hypothetical loan are identical to the cash flows from leasing
instead of buying, and what we have illustrated is that when Tasha leases the machine,
it effectively arranges financing at an aftertax rate of 5.317 percent. Whether this is a
good deal or not depends on what rate Tasha would pay if it simply borrowed the
money. For example, suppose Tasha can arrange a five-year loan with its bank at a rate
of 7.57575 percent. Should Tasha sign the lease or should it go with the bank?
Because Tasha is in a 34 percent tax bracket, the aftertax interest rate would be
7.57575 (1 .34) 5 percent. This is less than the 5.317 percent implicit aftertax
rate on the lease. In this particular case, Tasha would be better off borrowing the money
because it would get a better rate.
We have seen that Tasha should buy rather than lease. The steps in our analysis can
be summarized as follows:
- Calculate the incremental aftertax cash flows from leasing instead of buying.
- Use these cash flows to calculate the implicit aftertax interest rate on the lease.
- Compare this rate to the company’s aftertaxborrowing cost and choose the cheaper
source of financing.
CONCEPT QUESTIONS
26.4a What are the cash flow consequences of leasing instead of buying?
26.4bExplain why the $10,000 in Table 26.2 has a positive sign.CHAPTER 26 Leasing 88126.5
There’s an online lease
versus buy calculator at
(where else?): http://www.lease-
vs-buy.com.