Valuing the Direct Cash Flow from Leasing Because the lease displaces debt, the direct cash flow from leasing

Valuing the Direct Cash Flow from Leasing Because the lease displaces debt, the direct cash flow from leasing

should be further modified by devising a loan that in each period except the initial period engenders a net cash flow that is identical to the net cash flow for the lease obligation; that is, financial risk is neutralized. Such a loan, called an equivalent loan, is illustrated later. Fortunately, it has been mathematically demonstrated that rather than going through the time-consuming effort to construct an equivalent loan, all the decision- maker need do is discount the direct cash flow from leasing by an adjusted discount rate. The adjusted discount rate can be approximated using the following formula: 10

Adjusted discount rate = (1 − Marginal tax rate) × (Cost of borrowing money)

The formula assumes that leasing will displace debt on a dollar-for-dollar basis. 11

Given the direct cash flow from leasing and the adjusted discount rate, the NPV of the lease can be computed. We shall refer to the NPV of the lease as simply the value of the lease. A negative value for a lease indicates that leasing will not be more economically beneficial than bor- rowing to purchase. A positive value means that leasing will be more economically beneficial. However, leasing will be attractive only if the NPV of the asset assuming normal financing is positive and the value of the lease is positive, or if the sum of the NPV of the asset assuming nor- mal financing and the value of the lease is positive.

In order to evaluate the direct cash flow from leasing for the machine considered by the Hieber Machine Shop Company in our illus- tration, we must know the firm’s cost of borrowing money. Suppose that the cost of borrowing money has been determined to be 10%. The adjusted discount rate is then found by applying the formula:

Adjusted discount rate = (1 − 0.40) × (0.10) = 0.06, or 6%

10 As noted by Brealey and Myers , “The direct cash flows are typically assumed to be safe flows that investors would discount at approximately the same rate as the in-

terest and principal on a secured loan issued by the lessee” (Richard Brealey and Stewart Meyers, Principles of Corporate Finance [New York: McGraw Hill, 1981], p. 629). There is justification for applying a different discount rate to the various components of the direct cash flow from leasing.

11 Brealey and Myers, Principles of Corporate Finance, p. 634. The formula must be modified, as explained later, if the lessee believes that leasing does not displace debt

on a dollar-for-dollar basis.

SELECTED TOPICS IN FINANCIAL MANAGEMENT

EXHIBIT 27.3 Worksheet for Determining the Value of a Lease

End of Direct Cash Flow Present Value of Present Year

from Leasing

(6,626) Value (or NPV) of lease

The adjusted discount rate of 6% is then used to determine the value of the lease. The worksheet is shown as Exhibit 27.3. The value of the lease is −$448. Hence, from a purely economic point of view, the machine should be purchased by the Hieber Machine Shop Company rather than leased. Recall that the NPV of the machine assuming normal financing is $11,540.