Lease:

Leasing enables the firm to obtain the use of certain fixed assets for which it must make a series
of contractual, periodic, tax-deductible payments. The lessee is the receiver of the services of the
assets under the lease contract, and the lessor is the owner of the assets. Leasing can take a
number of forms.

Suppose, Square Company needs “Machine Z” for use. Prime Finance Company has the “
Machine Z”. Now Square Company can make a contract with Prime Finance Company for 5
years that will allow the Square Company to use the machine. In exchange for the use of the
machine, the Square Company has to pay $5000 at the end of each year for 5 years to Prime
Finance Company. Here, $5000 is known as lease payment. Square Company is called lessee
and Prime Finance Company is called lessor.

Lease-Versus-Purchase decision

Suppose, Square Company needs “Machine Z” for use. Cost of the asset is TK. 1000,000. Square
can acquire fixed assets in three ways.

1) Purchase the assets using Tk. 1000,000 cash of the company, or

2) Borrow Tk.1000,000 from bank to purchase the assets, or
3) lease the assets from a leasing company

In this chapter we will discuss whether the firm should acquire the asset using “option 2”
(borrowing funds to purchase the assets) or “option 3” (leasing) the assets from a leasing
company

The following steps are involved in the analysis:

Step 1 Find the after-tax cash outflows for each year under the lease alternative.
Step 2 Find the after-tax cash outflows for each year under the purchase alternative.
 The annual interest expense deductible for tax purposes for each of years.
 The after-tax cash outflow resulting from the purchase for each years.
Step 3 Calculate the present value of the cash outflows associated with the lease (from Step 1)
and purchase (from Step 2) alternatives using the discount rate.
Step 4 Choose the alternative with the lower present value of cash outflows from Step 3. It will
be the least-cost financing alternative.

Example:
Roberts Company, a small machine shop, is contemplating acquiring a new machine that costs
$24,000. Machine can be acquired either though lease or purchase the machine through
borrowing. The firm is in the 40% tax bracket.

Lease: The firm would obtain a 5-year lease requiring annual end-of-year lease payments of
$6,000. All maintenance costs would be paid by the lessor, and insurance and other costs would
be borne by the lessee. The lessee would exercise its option to purchase the machine for $1,200
at termination of the lease.

Purchase The firm would finance the purchase of the machine with a 9%, 5-year loan requiring
end-of-year installment payments of $6,170. The machine would be depreciated under MACRS
using a 5-year recovery period. The firm would pay $1,500 per year for a service contract that
covers all maintenance costs; insurance and other costs would be borne by the firm. The firm
plans to keep the machine and use it beyond its 5-year recovery period. Using these data, we can
apply the steps presented earlier:

Cash out flow: installment 6170 interest + principal

Maintenance 1500

Tax advantage on:

Interest, maintenance cost, depreciation

Requirements:

1. Find the after-tax cash outflows for each year under the lease alternative.

2. Find the after-tax cash outflows for each year under the purchase alternative.
3. Calculate the present value of the cash outflows associated with the lease and purchase
alternatives using the 6% discount rate.

4. Which of the alternatives firm should use to acquire the asset?

Solution:

Requirement 1: After tax lease payment = Lease Payment (1- Tax Rate)
a

= $6000 (1 - 0.40)
= $3600
After tax cash outflow associated with lease
Year 1 2 3 4 5
After tax $3600 $3600 $3600 $3600 $3600
lease +$1200
payment = $4800b

Given , lease payment = $6000

Purchase price at the termination of lease= $1200
a
Lease payment is an expenses. When it ($ 6000) is shown in income statement, it will reduce profit by

$ 6000. Therefore, company can save tax of ($6000 *.4) or $2400.

As company can save tax of $2400 because of lease payment. So actual cost of lease = $6000- $2400 =
$3600

That is , After tax lease payment = lease payment – tax saving

= lease payment- (lease payment * tax rate)

= lease payment (1- tax rate) = $6000(1-.4) = $3600

b
Since the company will buy the machine at the end of 5th year for $1200, the at the end of 5th, after
tax lease payment will be sum of purchase price and after tax lease payment.

Requirement 2:
In order to find out after tax cash outflows of purchase, first we need to find interest payment on
borrowing using amortization schedule.

End of year Loan Beginning of Interest Principal End of year

 payment year principal payment payment principal
(1) (2) (3) (4) (5)
[0.09 × (2)] a [(1) - (3)] [(2)- (4)]
1 $6170 $24000 $2,160 $4,010` 19990
2 6170 19990 1,799 4,371 15619
3 6170 15619 1,406 4,764 10,855
4 6170 10,855 977 5,193 5662
5 6170 5662 510 5,660 2*
* because of rounding the figure is not equal to zero.
a
interest rate on loan is 9%.
After tax cash outflow associated with purchase
End Loan Maintenanc Depreciation Interest Total Tax After tax cash outflow
of payment e costs Deduction savings (7)=
year (1) (2) a b (5)= (6) e
(3) (4) [(1)+(2)-(6)]
[(2)+(3)+(4)] d
[(5)×.4]
c

1 $6170 $1500 $4,800 $2,160 $ 8,460 $3,384 $4,286

2 6170 1500 7,680 1,799 10,979 4,392 3,278
3 6170 1500 4,560 1,406 7,466 2,986 4,684
4 6170 1500 2,880 977 5,357 2,143 5,527
5 6170 1500 2,880 510 4,890 1,956 5,714

a
Depreciation method used in math is known as MACRS (modified accelerated cost recovery
systems). Under this method, depreciation is charged on cost of the machine using different
percentages depending on the maturity of the asset. The applicable MACRS 5-year recovery
period (maturity of asset) depreciation percentages—20% in year 1, 32% in year 2, 19% in year
3, and 12% in years 4 and 5.
Since cost of the machine is $24,000.
Depreciation for 1st year= $24000×20% = $4800
Depreciation for 2nd year= $24000×32% = $7,680
Depreciation for 3rd year= $24000×19% = $4,560
Depreciation for 4th year= $24000×12% = $2880
Depreciation for 5th year= $24000×12% = $2880
These percentages will be given in the questions.

b
interest is taken from previous table.
c
Total deduction means total expenses that will be deducted as expenses in the income
statement if the machine is acquired using purchase though borrowing. So, maintenance cost,
interest expenses and depreciation are expenses that will be shown as expenses. Loan payment is
not expenses.
d
as we know that any expense that is shown in income statement reduces the profit and thereby
provides tax saving benefit to company. Therefore, tax saving is calculated on total deduction
amount that will reduce the profit of the company.
e.
After tax cash outflow include only net cash outlay. So, loan payment and maintenance cost are
outflow and tax saving is reduction of cash outflow. So we add maintenance costs with loan
payments and deduct tax savings from them to get after tax cash outflow. Depreciation is non
cash expenditure and not cash outflow. Interest cash outflow but it is already included in loan
payment. So we need not to add it again.

Requirement 3:

Present value (PV) of cash inflow

CFn= cash flow at the end of year n
K= discount rate
PV of Cash outflow of lease=

= $16,062
PV of cash outflow of purchase=

= $19,541

Requirement 4: Because the present value of cash outflows of lease ($16,062) is lower than the
present value of cash outflows of purchase ($19,541), the cost of leasing is lower than cost of
purchase. Therefore, the firm should acquire the asset using lease alternative.