Araditionally, firms have owned fixed assets and reported them on their balance sheets as assets. However, there may be certain benefits associated with leasing an asset rather than to buying it. The question of whether to lease or buy is rarely a simple decision, although there are formulas and techniques that are used that offer simplified answers to this complex decision. The person performing the lease or buy analysis must do so details about the transaction in hand as well as certain facts about the company considering the asset acquisition including its operational, tactical and strategic goals.
Companies usually analyze the costs of the lease versus buy decision using discounted cash flow analysis. This analysis compares the cost of each alternative by considering the timing of the payments, tax benefits, rate of interest on a loan if the asset purchased is being financed through borrowing, the lease term, lease payments, its salvage or residual value, expected rate of use of the asset, the options for depreciating the asset if it is purchased, as well as the expected speed of obsolescence and the economic life of the asset.
Using the discounted cash flow analysis method, one of the first steps is to determine the net cash outlay in each year of the lease term. Each year's net cash outlay under the lease must be discounted to take into account the time value of money. This discounting allows the calculation of the present value of each of the future series of payments. The way to analyze the lease-versus-buy decision is to compare the acquiring company's expected after-tax costs for each option on a total life cycle cost. The sum of the discounted cash flows is called the net present value of the cost of leasing. Another value that must be calculated is the expected value of the asset at the end of the lease term, known as the residual value or salvage value.
Evaluation of the option to purchase an asset is com...