SOME IMPORTANT POINTS ON LEASE VS BUYING/ BORROWING

• Lease vs. buying/ borrowing is a blend of investing and financing decision.

• Tax shield on depreciation is allowed only for lessor
• Lease rental is an expense for the lessee but and income for the lessor

First Approach
i. Investing decision is evaluated separately based on NPV.
ii. Identify all relevant operating Cash Flows including taxes and capital allowances.
iii. Discount rates always based on WACC or COC.
iv. If NPV is positive, proceed to the financing decision other wise Reject the
proposal.

Second Approach
i. Evaluate financing Decision: Only Cash Flows, which are relevant to the source
of finance, are considered. (Operating Cash Flows are ignored, because they are
same throughout the period).

1. LEASE
Note: Tax authorities consider all
Following Cash Flows are considered only leases as operating leases and
allow full lease rental as
1. Lease Rental deductible allowance
2. Tax Shield on lease rental

2. BUYING/ BORROWING
1. Cost of purchase
2. Tax Shield on Capital Allowance
3. Interest expense and its tax shield are considered only if annual interest payments
are made
4. Do not considered interest expense and its shield if lump sum amount of loan is
paid at the end of the period

After tax-borrowing rate is WAAC/COC is always higher than cost

taken as a yardstick, cost of of debt after tax because Ke is always >
capital (WAAC) is not
considered. Less costly option Kd And Ke is included in WACC
is adopted.
 LEASE VS BUYING/ BORROWING

Method 1

Investment Decision at Cost of

Capital (Relevant Cash Flows)

 Cost of Equipment
 Operating Savings
 Tax Effect on Savings
 Capital Allowance

Negative NPV Positive NPV

(Reject)

Lease related Cash Flows Borrowing related Cash Flows

At after tax borrowing rate At after tax borrowing rate

1. Lease Rental 1- Loan Principal at Zero Year

2. Tax effect on lease rental 2- Tax Effect on Depreciation
 LEASE VS BUYING/ BORROWING

Method 2

( Investing + Financing Decision )

(Combined)

Acquiring with borrowing Acquiring with leasing

 Cost of purchase/ Loan  Operating Savings

Principal  Tax effect on saving
 Operating savings  Lease rental
 Tax effect on operating  Tax effect on lease rental
savings
 Capital Allowance

(Discounted at after tax (Discounted at after tax

borrowing rate) borrowing rate)