Lease Evaluation: Another Capital Budgeting Decision

Abstract

Although leasing has grown as a practice, there has not been corresponding agreement on the correct method for analyzing the impact of a lease on the firm. In determining the correct method, three essential factors must be considered. First, is the correct decision only a financing decision, lease-or-borrow, or is the correct decision a joint investment-financing decision, lease-or-buy? Second, what are the appropriate cash flows to be incorporated in the analysis? Third, what is (are) the appropriate rate(s) at which these flows should be discounted? These issues can be most clearly highlighted by comparing the lease-or-borrow method as presented by Vancil [2] with the lease-or-buy analysis presented by Johnson and Lewellen [1] (hereafter J-L). We show that with the incorporation of the correct cash flows and the appropriate discount rates, Vancil's model can be converted into a more complete leaseor-buy model that fits the capital budgeting framework. Finally, through the vehicle of a very simple numerical example in which the correct decision is obvious, we illustrate that Vancil's lease-or-borrow model gives the correct comparative decision, that our extension of Vancil's model gives the correct absolute decision, and that J-L's lease-or-buy model leads to the incorrect decision.