LEASE OR BORROW DECISIONS

A typical lease related question may involve following two decisions: Acquisition Decision Financing (Lease Vs Borrow & buy) Decision

Acquisition Decision
This is in principle an investment appraisal decision is it worth investing in the asset/is it financially viable to acquire the asset? Important points in arriving at this decision are: Cash flows will be prepared in the same manner as for any project appraisal scenario o We will assume that the asset will be purchased by the company using its available pool of funds (Debt + Equity). Accordingly tax depreciation, tax gain/loss etc will be incorporated for tax working Financing cash flows will not form part of overall cash flows for decision here

o -

Discounting will be done using companys Appropriate cost of capital/WACC/Required Rate +NPV will depict that acquisition using companys long-term pool of funds is feasible and NPV means that decision is not favourable

Financing Decision
The financing decision involves choosing better alternative from: Lease; Vs Borrow and buy

The decision in this case would be made by: Plotting all relevant cash-flows separately for both options including financing cash flows where relevant (see below) Discounting the cash flows under both options with same Incremental borrowing rate (IRR of the loan)

The option with either higher +NPV or lower NPV (PV of costs) will be selected

The financing decision is considered separately from the investment decision.

Approaching the Solution

For acquisition decision, take all cash flows of the project (no financing cash flows) and discount the same with the after-tax cost of capital/WACC. This is the usual investment decision. For financing decision, the following guidelines should be followed. Please note, only Step 1 is different keeping in view whether tax is payable in same year or in arrears. Step 1 Tax payable in same year Take the interest rate I on loan (incremental borrowing rate) as given in question. Make it net of tax i.e. I (1-t). This net of tax rate will be the IRR of the loan to be used as discount rate for lease or borrow decision. Borrow and buy option: The net cash flows in the borrow and buy decision will be same as those for the acquisition decision. a) If cash-flows for acquisition decision have already been plotted, then the net cash flows of acquisition decision will be used without any further working b) If it is just a financing decision question, then here cash-flows will be prepared similar to those of acquisition decision. As discount rate being used is the IRR of loan; so all loan cash flows when discounted with this rate will have zero PV. Accordingly, there is no need to incorporate loan cash flows in the working. Discount these cash flows with IRR of loan (calculated in step 1 above) to arrive at NPV. 3 Leasing option: Take the cash flows of leasing option and include all the operational costs / savings as included under both the acquisition and borrowing decisions - to ensure we are comparing like with like. Please refer important notes below. Tax payable in arrears Calculate the accurate IRR of the loan by plotting all loan cash flows including tax savings on interest. This IRR of loan will be used as discount rate for lease or borrow decision.

Discount these cash flows with IRR of loan (calculated in step 1 above) to arrive at NPV. 4 Compare the two NPVs calculated in steps 2 and 3. The option with comparatively higher +NPV or comparatively lower NPV (PV of costs), will be chosen.

Important notes for leasing option: 1. Dont include the initial investment under the leasing option. Instead include the outflows of lease rentals. Also include the tax benefit on lease payments. 2. Dont include tax savings from depreciation as tax benefit.

3. Include any security deposit (if given in question). This should be an outflow at time 0. 4. Include salvage value at end as an inflow. But this sould be net of any BPO cost for lessee (if given in question) 5. If the lease rentals are payable quarterly / semi annually, we will have to discount them using the equivalent periodic rate. However, their tax benefit will be discounted using the annual rate.