Discounted Cash Flow Methods in Lease versus Purchase Analysis—A Technical Note

Guan Jun Wang

doi:10.22158/ijafs.v3n1p67

Abstract

The earlier framework uses the before-tax cost of debt as the discount rate in valuation of lease contracts for the reason that such framework explicitly includes the interest tax credits as a component of each period’s cash flows. The short-cut or modern standard textbook approaches use after-tax cost of debt as the discount rate for the reason that it ignores the interest tax credits. Some existing literatures state the two approaches are equivalent without exploring the reasons analytically. This note provides a mathematical demonstration showing, the two approaches are not equivalent accompanied by numerical examples.

Highlights

When a firm wishes to obtain the use of an equipment, it can either purchase it or lease it
Purchasing an expensive equipment can use up available funds and may saddle a firm with an outdated asset and leasing can be an excellent way to update the business without significant upfront costs
A comprehensive paper by Myers, Dill, and Bautista (1976) discusses the fundamental issues in leasing and presents a thorough analysis of the valuation of leasing contracts based upon fundamental financial principles

Summary

Introduction

When a firm wishes to obtain the use of an equipment, it can either purchase it or lease it. Lessors benefit from leasing in a number of ways Compared to lessees, they are often able to acquire equipment at a low cost, and obtain acceptable financing terms. A comprehensive paper by Myers, Dill, and Bautista (1976) discusses the fundamental issues in leasing and presents a thorough analysis of the valuation of leasing contracts based upon fundamental financial principles Their framework, along with Lewellen et al (1976), use the before-tax cost of debt as the discount rate because they explicitly include the interest tax credits as a component of each period’s cash flows for lessee’s NAL calculation. A simpler, “short-cut” approach ignores the interest tax credits and use after-tax cost of debt as the discount rate for lessee’s NAL and lessor’s NPV. We will present a mathematical demonstration showing that the two approaches are not equivalent and material errors can arise accompanying with numerical examples

A Mathematical Presentation

Conclusion