When deciding on whether to purchase or lease an asset, a firm should compare after-tax cash outflows associated with each option. The option with the lowest present value of after-tax cash outflows should be selected.
To make a decision between purchase and lease alternatives, we need to do the following:
- Determine after-tax cash outflows for lease alternatives.
- Determine after-tax cash outflows for purchase alternatives.
- When completing steps 1 and 2, the purchase option at the end of the lease should be incorporated into analysis in step 1 and sale of purchased asset at the end of the term (equivalent to the lease term) should be incorporated in analysis in step 2. This will ensure that we compare assets of equal lives.
- Find the present value of the cash outflows under lease and purchase. The after-tax cost of debt should be used as a discount rate. One can use a financial calculator to find present value of the mixed stream of outflows or find the present value of the annuity.
- Select an option with the lowest present value.
It is also important to remember that financial manager must always attempt to find options with the lowest cost of capital to ensure maximization of the owners’ wealth.