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Lease-Buy analysis from the lessee's perspective compares leasing to the alternative to borrowing to buy.

A. The basic approach of the lease-buy analysis model is to compute the net advantage to
leasing (NAL):

Installed cost of the asset


Less: Present value of the after-tax lease payment
Less: Present value of the depreciation tax shield
Plus: Present value of after-tax operating costs incurred if owned but not if
leased
Less: Present value of the after-tax salvage value
Equals: Net Advantage to Leasing (NAL)

B. If the NAL is positive, it is cheaper for the lessee to lease the asset than to borrow and buy
it. If the NAL is negative, leasing is unattractive. It is easy to see how each of the items
above affects the attractiveness of leasing. For example, a larger lease payment reduces
the NAL.

C. Problem 2 illustrates the calculation of the lessee's net advantage of leasing. There are
several things to keep in mind.

1. The installed cost is the purchase price plus installation and shipping charges.

2. The present value of the after-tax lease payment is found by discounting at the
lessee's after- tax marginal cost of borrowing. The lease payment is usually an
annuity due.

3. The annual depreciation tax shield is the depreciation times the lessee's marginal
tax rate. The present value of the depreciation tax shield is found using the lessee's
after-tax marginal cost of borrowing.

4. If leased, some operating costs (such as property tax payments, insurance, and
some maintenance costs) may be paid by the lessor. If so, these savings are
discounted at a rate reflecting their relative certainty, frequently the lessee's
after-tax marginal cost of borrowing.

5. Because the salvage value belongs to the lessor, this amount lost to the lessee is
discounted at a rate reflecting its uncertainty, frequently the lessee's weighted cost
of capital (which is higher than the after-tax cost of borrowing).

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