Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance- Leasing © The McGraw−Hill^905
Companies, 2002
The most important thing to note from our discussion thus far is that in evaluating a
lease, the relevant rate for the comparison is the company’s aftertaxborrowing rate. The
fundamental reason is that the alternative to leasing is long-term borrowing, so the af-
tertax interest rate on such borrowing is the relevant benchmark.Three Potential Pitfalls
There are three potential problems with the implicit rate that we calculated on the lease.
First of all, we can interpret this rate as the internal rate of return, or IRR, on the deci-
sion to lease rather than buy, but doing so can be confusing. To see why, notice that the
IRR from leasing is 5.317 percent, which is greater than Tasha’s aftertax borrowing cost
of 5 percent. Normally, the higher the IRR, the better, but we decided that leasing was a
bad idea here. The reason is that the cash flows are not conventional; the first cash flow
is positive and the rest are negative, which is just the opposite of the conventional case
(see Chapter 9 for a discussion). With this cash flow pattern, the IRR represents the rate
we pay, not the rate we get, so the lowerthe IRR, the better.
A second, and related, potential pitfall has to do with the fact that we calculated the
advantage of leasing instead of buying. We could have done just the opposite and come
up with the advantage of buying instead of leasing. If we did this, the cash flows would
be the same, but the signs would be reversed. The IRR would be the same. Now, how-
ever, the cash flows would be conventional, so we could interpret the 5.317 percent IRR
as saying that borrowing and buying is better.
The third potential problem is that our implicit rate is based on the net cash flows of
leasing instead of buying. There is another rate that is sometimes calculated, which is
based solely on the lease payments. If we wanted to, we could note that the lease pro-
vides $10,000 in financing and requires five payments of $2,500 each. It would be
tempting to then determine an implicit rate based on these numbers, but the resulting
rate would not be meaningful for making lease versus buy decisions, and it should not
be confused with the implicit return on leasing instead of borrowing and buying.
Perhaps because of these potential sources of confusion, the IRR approach we have
outlined thus far is not as widely used as the NPV-based approach that we describe next.NPV Analysis
Now that we know that the relevant rate for evaluating a lease versus buy decision is the
firm’s aftertax borrowing cost, an NPV analysis is straightforward. We simply discount the
cash flows back to the present at Tasha’s aftertax borrowing rate of 5 percent as follows:
NPV$10,000 2,330 (1 1/1.05^5 )/.05
$87.68
The NPV from leasing instead of buying is $87.68, verifying our earlier conclusion
that leasing is a bad idea. Once again, notice the signs of the cash flows; the first is pos-
itive, the rest are negative. The NPV we have computed here is often called the net ad-
vantage to leasing (NAL). Surveys indicate that the NAL approach is the most popular
means of lease analysis in the real world. Our nearby Work the Webbox illustrates the
use of lease-versus-buy analysis of automobiles.A Misconception
In our lease versus buy analysis, it looks as though we ignored the fact that if Tasha bor-
rows the $10,000 to buy the machine, it will have to repay the money with interest. In882 PART EIGHT Topics in Corporate Finance
net advantage to leasing
(NAL)
The NPV that is
calculated when deciding
whether to lease an asset
or to buy it.