Another Approach to Lease Valuation Rather than determining the NPV of a lease, many lessors use a differ-

Another Approach to Lease Valuation Rather than determining the NPV of a lease, many lessors use a differ-

ent approach when attempting to demonstrate to potential lessees the economic attractiveness of a particular leasing arrangement. The approach is a comparison of the after-tax interest rate on the lease with the after-tax cost of borrowing money. The reason this approach appears to be popular is that management finds it easy to comprehend a rate concept but difficult to appreciate the NPV of a lease concept.

The after-tax interest rate on the lease is found by determining the dis- count rate that equates the direct cash flow from leasing to zero; that is, it is the discount rate that makes the value of the lease equal to zero. This dis- count rate is also referred to as the internal rate of return. The after-tax interest rate on the lease is then compared to the after-tax cost of borrow- ing money. When the after-tax interest rate on the lease exceeds the after- tax cost of borrowing money, borrowing to purchase is more economical than leasing. Leasing is more economical when the after-tax cost of bor- rowing money is greater than the after-tax interest rate on the lease.

Exhibit 27.2 shows the direct cash flow from leasing for the lease arrangement available to the Hieber Machine Shop Company. The dis- count rate that produces a present value close to zero for the direct cash flow from leasing is 6.3%. Hence, the after-tax interest rate on the lease is about 6.3%. 13

13 The precise answer may be obtained using a financial calculator that has the IRR program or by using a spreadsheet program function, such as the IRR function in Microsoft’s Excel.

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When the after-tax cost of borrowing is 6%, the lease arrangement is not attractive. However, when the after-tax cost of borrowing money is 8%, the lease arrangement is attractive.

In the previous illustration, the determination that was made as to whether the lease was economically attractive was precisely the same determination that was made when the NPV lease valuation model was used. The identity of the result is not peculiar to this illustration. The two approaches will always produce the same result.

The advantage of the NPV lease valuation model presented is that it permits interaction of the investment and financing decisions. As a result, it is simple to determine whether an investment proposal that has a nega- tive NPV assuming normal financing can be made economically attractive by a favorable lease arrangement. With the after-tax interest on the lease approach, this is not done as easily. That approach requires management to revise its estimate of the cost of capital when the after-tax interest rate on the lease is less than the after-tax cost of borrowing money and then to reevaluate the investment proposal with the revised cost of capital. This is an extremely complicated and awkward approach since it requires a con- tinuous revision of the cost of capital as attractive lease arrangements become available. No simple solution to this problem has been proffered in the literature.

The rate approach will not always provide the same solution as the NPV approach when lease arrangements are compared. Differences in the selection of the best lease arrangement may result when the number of advance payments is different, when the lease payments are not uni-

form, or when the tax credit is handled any differently. 14 The best lease arrangement is the one with the greatest NPV. Therefore, if conflicts arise when comparing lease arrangements by the two methods, the deci- sion should be based on the NPV of the lease.