Management accounting--financial strategy: William Parrott proposes a structured approach to tackling questions on a common topic that many students find hard: the buy/lease decision.
| Author | Parrott, William |
| Position | Study notes |
A choice between leasing and buying an asset can be viewed as a finance decision. An investment decision will normally have been made beforehand, which is likely to have involved the calculation of the net present value (NPV) of all the cash flows that would arise from obtaining and using the asset. In most P9 exam questions concerning buy/lease decisions, the scenario indicates that a positive NPV has already been calculated for the investment decision (usually based on the assumption that the asset will be purchased), indicating that the company will benefit from using the asset.
The scope of this article is restricted to a comparison of costs and benefits of leasing or buying an asset. It won't cover the relative merits of operating and financial leases or go into great detail on the tax consequences, which differ from country to country.
The best way to make a fair comparison between the costs of acquiring the asset through purchasing and the costs of acquiring it through leasing is to take the following three-step approach:
* Calculate the NPV of the cost of buying the asset. The basic cash flows to include here are the initial asset cost, any tax savings that will arise as a result of purchasing the asset and any residual value that's expected.
* Calculate the NPV of the cost of leasing the asset. The basic cash flows to include here are the periodic lease charge and the tax relief on the lease charge.
* Choose the cheaper of the two alternatives. The option with the lowest NPV of cost is the preferred method of obtaining the asset.
All cash flows that will arise from actually operating the asset are usually ignored, so the labour costs of operating the asset and the materials it will use are left out of the analysis. Only the cash flows that arise directly from acquiring the asset are included. This is because the operational cash flows will already have been considered in the original investment decision.
The discount rate to be used when calculating the NPV in the first two steps is the lessee's after-tax cost of debt. This assumes that leasing is seen as a substitute for borrowing to buy the asset, and that leasing and borrowing to buy an asset carry a similar level of risk. The company's normal cost of capital is not generally used, because this discount rate reflects the operational risk of the business whereas the cash flows to be evaluated in the finance decision carry less operational risk and do not, therefore, warrant such a high discount rate.
The tax savings arising on purchasing the asset should be calculated in accordance with the tax regime detailed in the question. You...
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