Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate Edition
VIII. Topics in Corporate
Finance
- Leasing © The McGraw−Hill^907
Companies, 2002
fact, we reasoned that if Tasha leased the machine, it would be better off by $10,000 to-
day because it wouldn’t have to pay for the machine. It is tempting to argue that if Tasha
borrowed the money, it wouldn’t have to come up with the $10,000. Instead, Tasha
would make a series of principal and interest payments over the next five years. This ob-
servation is true, but not particularly relevant. The reason is that if Tasha borrows
$10,000 at an aftertax cost of 5 percent, the present value of the aftertax loan payments
is simply $10,000, no matter what the repayment schedule is (assuming that the loan is
fully amortized). Thus, we could write down the aftertax loan repayments and work
with these, but it would just be extra work for no gain, assuming the lessee is currently
paying taxes (see Problem 10 at the end of the chapter for an example).
A LEASING PARADOX
We previously looked at the lease versus buy decision from the perspective of the po-
tential lessee, Tasha. We now turn things around and look at the lease from the perspec-
tive of the lessor, Johnson Leasing. The cash flows associated with the lease from
Johnson’s perspective are shown in Table 26.3. First, Johnson must buy the machine for
$10,000, so there is a $10,000outflow today. Next, Johnson depreciates the machine at
a rate of $10,000/5 $2,000 per year, so the depreciation tax shield is $2,000 .34
$680each year. Finally, Johnson receives a lease payment of $2,500 each year, on which
it pays taxes. The aftertax lease payment received is $1,650, and the total cash flow to
Johnson is $2,330per year.
What we see is that the cash flows to Johnson are exactly the opposite of the cash
flows to Tasha. This makes perfect sense because Johnson and Tasha are the only par-
ties to the transaction, and the lease is a zero-sum game. In other words, if the lease has
a positive NPV to one party, it must have a negative NPV to the other. In our case, John-
son hopes that Tasha will do the deal because the NPV for Johnson would be $87.68,
the amount Tasha would lose.
CONCEPT QUESTIONS
26.5a What is the relevant discount rate for evaluating whether or not to lease an as-
set? Why?
26.5bExplain how to go about a lease versus buy analysis.
884 PART EIGHT Topics in Corporate Finance
Lease Evaluation
In our Tasha Corp. example, suppose Tasha is able to negotiate a lease payment of $2,000 per
year. What would be the NPV of the lease in this case?
With this new lease payment, the aftertax lease payment would be $2,000 (1 .34)
$1,320, which is $1,650 1,320 $330 less than before. Referring back to Table 26.2, note
that the aftertax cash flows would be $2,000 instead of $2,330. At 5 percent, the NPV
would be:
NPV $10,000 2,000 (1 1/1.05^5 )/.05
$1,341.05
Thus, the lease is very attractive.
EXAMPLE 26.1