Case Study: Leasing vs. Purchasing

Let's assume you're faced with the following lease-or-buy decision. You can purchase a $50,000 piece of equipment by putting 25 percent down and paying off the balance at 10 percent interest with four annual installments of $11,830. The equipment will be used in your business for eight years, after which it can be sold for scrap for $2,500. The alternative is that you can lease the same equipment for eight years at an annual rent of $8,500, the first payment of which is due on delivery. You'll be responsible for the equipment's maintenance costs during the lease.

You expect that your combined federal and state income tax rate will be 40 percent for the entire period at issue. You further assume that your cost of capital is 6 percent (the 10 percent financing rate adjusted by your tax rate).

The following tables demonstrate how you can use a cash flow analysis to assist you with a lease-or-buy decision. In this case, if cost were the sole criterion for the decision, you would be inclined to purchase the asset because in current dollars, the cost of purchasing is $32,204, while the cost of leasing is $34,838. Even if cost isn't your sole criterion, a cash flow analysis is useful because it can show you how much you're paying for non-cost factors that may dictate your decision to lease.

Cash flow analysis of purchase. This analysis assumes the financed purchase of a $50,000 piece of equipment for 25 percent down, interest at 10 percent, and four annual payments of $11,830 (all payments are made on the first day of the year).

Interest is deemed to accrue on the outstanding balance of the loan at the end of each year and is computed as follows (the last column shows the portion of each annual payment that goes to principal and that reduces the outstanding loan):

Year End	Outstanding Loan	Interest	Principal
1	37,500	3,570	8,080
2	29,420	2,942	8,888
3	20,532	2,053	9,777
4	10,755	1,075	10,755

Depreciation is computed on the basis of the 200 percent declining balance method.

(A)	(B)	(C)	(D)	(E)	(F)	(G)	(H)
Year	Cash Payments	Prior Year's Interest	Prior Year's Depreciation	Tax Savings [40% x (C + D)]	Net Cash Flow [B - E]	Discount Factor (6% Cost of Cap.	Present Value [F x G]
1	12,500	0	0	0	12,500	1.0000	12,500
2	11,830	0	10,000	4,000	7,830	0.9434	7,387
3	11,830	3,750	16,000	7,900	3,930	0.8900	3,498
4	11,830	2,942	9,600	5,017	6,813	0.8396	5,720
5	11,830	2,053	5,760	3,125	8,705	0.7921	6,895
6		1,075	5,760	2,734	(2,734)	0.7473	(2,043)
7			2,880	1,152	(1,152)	0.7050	(812)
8
9	(2,500)			(1,000)	(1,500)	0.6274	(941)
Net Cash Flow							32,204

Cash flow analysis of leasing. This analysis assumes that equipment costing $50,000 will be leased for eight years for an annual rent of $8,500, with the first payment being due on delivery and the following payments being due on the first day of each subsequent year. The business is assumed to have a combined federal and state income tax rate of 40 percent (tax benefits are computed as of the first day of year following the year for which the rental deduction was claimed) and a 6 percent cost of capital.

(A)	(B)	(C)	(D)	(E)	(F)
Year	Lease Payment	Prior Year's Tax Savings [40% x B]	Net Cash Flow [B - C]	Discount Factor (6% Cost of Capital)	Present Value [D x E]
1	8,500		8,500	1.000	8,500
2	8,500	3,400	5,100	0.9434	4,811
3	8,500	3,400	5,100	0.8900	4,539
4	8,500	3,400	5,100	0.8396	4,282
5	8,500	3,400	5,100	0.7921	4,040
6	8,500	3,400	5,100	0.7473	3,811
7	8,500	3,400	5,100	0.7050	3,596
8	8,500	3,400	5,100	0.6651	3,392
9		3,400	(3,400)	0.6274	(2,133)
Net Cash Flow					34,838