Lease vs Buy Decision: Lessee's Perspective

Understand Lease Evaluation from the Lessee's Perspective

Key rules to remember

After-tax cost of debt (discount rate)

Kd after tax = Pre-tax interest rate × (1 − t)

Use this to discount both the lease and the buy cash flows, unless the question gives a different rate.

After-tax lease rental

Rental × (1 − t)

The rental is tax-deductible. If rentals are paid at the start of each year, discount them from year 0.

Depreciation tax shield

Depreciation × t

Depreciation itself is not a cash flow. Use the depreciation as per the question's method (SLM or WDV).

Present value of cost of buying

Purchase price − PV of depreciation tax shield − PV of after-tax salvage value

Add maintenance or other costs only if they differ between the two options. Interest on the loan is ignored because the discount rate already covers it.

Present value of cost of leasing

Σ [Rental × (1 − t)] ÷ (1 + Kd after tax)^n

Add lessee-borne costs (such as a security deposit, net of its refund) if the question gives them.

Net advantage to leasing (NAL)

NAL = PV cost of buying − PV cost of leasing

If NAL > 0, lease. If NAL < 0, buy. The same result comes from PV of leasing outflows vs PV of buying outflows.

How to solve Lease Evaluation from the Lessee's Perspective questions

1. 1Compute the discount rate: after-tax cost of debt = interest rate × (1 − tax rate). Use the rate the question specifies, if it gives one.
2. 2List the timing of the cash flows: year 0 to year n. Note whether rentals fall at the start or end of each year.
3. 3Build the leasing column: after-tax rental = rental × (1 − t) in each year.
4. 4Build the buying column: price at year 0, depreciation × t each year as a saving, and after-tax salvage at the end.
5. 5Treat salvage correctly. If the asset is fully depreciated, the whole salvage is taxed at t. If a book value remains, tax applies only to the gain or loss over that book value, as the question's tax rule states.
6. 6Discount each column at the after-tax rate. Use the annuity factor for level flows.
7. 7Compute the PV cost of buying and the PV cost of leasing, then NAL = buying − leasing.
8. 8State the recommendation in one sentence: lease if NAL is positive, buy if it is negative, with the amount.

Quickest way: Annuity-factor shortcut for level flows

Common mistakes in Lease Evaluation from the Lessee's Perspective

• Discounting at the company's WACC or the pre-tax interest rate

  Students are used to NPV with the cost of capital and forget that a lease replaces debt.

  Fix: Use the after-tax cost of debt, pre-tax rate × (1 − t), unless the question names a different rate.

• Treating depreciation as a cash outflow or inflow

  Depreciation appears in the working, so it looks like a cash item.

  Fix: Only the tax saved, depreciation × t, is a cash flow. Add nothing for the depreciation itself.

• Forgetting to tax the rentals

  The rental looks like a plain annual payment, so the tax saving is missed.

  Fix: Always take rental × (1 − t) for leasing. Do this before you discount.

• Ignoring or mis-taxing the salvage value

  Salvage appears at the end of the question and gets left out, or it is added without tax.

  Fix: Include it in the buying column. Take it net of tax as per the given tax rule, and discount it at the year-n factor.

• Wrong timing of rentals

  Students assume year-end payments when the question says rentals are paid in advance.

  Fix: Read the timing in the question. Advance rentals start at year 0 and are discounted with factor 1.000 for the first one.

• Subtracting in the wrong direction for NAL

  There are two ways to present the answer, and the signs get mixed.

  Fix: Use NAL = PV cost of buying − PV cost of leasing. A positive result means lease. Check this against the two PVs before you write the conclusion.

Worked examples