Evaluation of Lease transaction

-

Evaluation of Lease Transactions

Lessee’s Point of View: Lease or Buy/Lease or Borrow Decisions

Overview: When a firm decides to invest in an asset, it must choose between leasing the asset or buying it using traditional financing methods (debt and equity). The primary focus is on acquiring the use of the asset, not necessarily ownership. The decision involves comparing the cost of leasing the asset with the cost of buying it through borrowing.

Steps for Evaluation:

  • Calculate the Present Value of Net Cash Flow for Buying (NPV(B)):
    • Net Cash Flow: Includes initial purchase cost, maintenance costs, operating costs, and any tax benefits from depreciation.
    • Discount Rate: Typically the firm's cost of capital.
    • Present Value Calculation: Sum of all discounted cash flows over the asset’s life.
  • Calculate the Present Value of Net Cash Flow for Leasing (NPV(L)):
    • Lease Payments: Include all lease payments over the lease term.
    • Tax Benefits: Include any tax deductions for lease payments.
    • Discount Rate: Typically the firm's cost of debt.
    • Present Value Calculation: Sum of all discounted lease payments and related tax effects.
  • Decision Criteria:
    • Buy: If NPV(B) > NPV(L) and NPV(B) is positive, it is financially better to purchase the asset.
    • Lease: If NPV(L) > NPV(B) and NPV(L) is positive, it is financially better to lease the asset.
    • Reject: If both NPV(B) and NPV(L) are negative, the investment is not financially viable and should be rejected.

Detailed Comparison of Leasing and Borrowing:

  • Present Value of After-Tax Cash Outflows for Leasing:
    • Calculate lease payments over the lease term.
    • Adjust for tax savings due to lease payment deductions.
    • Discount the net after-tax lease payments to present value using the firm's cost of debt.
  • Present Value of After-Tax Cash Outflows for Buying/Borrowing:
    • Calculate the purchase price and any associated costs.
    • Include maintenance, insurance, and operating costs.
    • Factor in tax benefits from depreciation and interest deductions.
    • Discount the net after-tax cash outflows to present value using the firm's cost of capital.
  • Comparison:
    • Select the financing option (leasing or borrowing) with the lower present value of after-tax cash outflows, as it represents the cheaper financing option.

Financial Evaluation of Leasing

Lessor’s Point of View: The lessor evaluates the financial viability of leasing out an asset using capital budgeting methods: the Present Value Method and the Internal Rate of Return (IRR) Method.

  • Present Value Method:
    • Step-by-Step Process:
      • Cash Outflows: Calculate initial investment, maintenance costs, and subtract any tax advantages like investment allowances.
      • Cash Inflows: Estimate lease payments, tax benefits from depreciation, and other inflows over the lease term.
      • Discount Rate: Use the lessor's weighted average cost of capital (WACC) to discount cash flows.
      • Net Present Value (NPV): Calculate NPV by subtracting the present value of cash outflows from the present value of cash inflows.
      • Decision Rule: Lease the asset if NPV is positive, indicating profitability.
  • Internal Rate of Return (IRR) Method:
    • Definition: IRR is the discount rate that makes the present value of cash inflows equal to the present value of cash outflows.
    • Calculation Steps:
      • Estimate Net Cash Inflows: Calculate future net cash inflows from leasing the asset, excluding depreciation but including tax benefits.
      • Determine IRR:
        • Equal Cash Flows: Use the formula: Present Value Factor = Initial Outlay / Annual Cash Flow. Find the corresponding discount rate using present value annuity tables.
        • Unequal Cash Flows: Use the hit-and-trial method to find the discount rate where the sum of discounted cash inflows equals the initial investment.
      • Decision Rule: Accept the proposal if IRR is greater than or equal to the required rate of return (cost of capital). For multiple proposals, select the one with the highest IRR above the cost of capital.

Summary:

  • Lessee’s Perspective: Focuses on comparing NPVs of leasing and buying to choose the most cost-effective option.
  • Lessor’s Perspective: Uses NPV and IRR methods to evaluate the profitability of leasing out an asset, ensuring that inflows exceed outflows and IRR meets the required threshold.