Case
Study: Leasing vs. Purchasing
Let's assume you're faced with the following leaseorbuy
decision. You can purchase a $50,000 piece of equipment by
putting 25 percent down and paying off the balance at 10 percent
interest with four annual installments of $11,830. The equipment
will be used in your business for eight years, after which it
can be sold for scrap for $2,500. The alternative is that you
can lease the same equipment for eight years at an annual rent
of $8,500, the first payment of which is due on delivery. You'll
be responsible for the equipment's maintenance costs during the
lease.
You expect that your combined federal and state income tax
rate will be 40 percent for the entire period at issue. You
further assume that your cost of capital is 6 percent (the 10
percent financing rate adjusted by your tax rate).
The following tables demonstrate how you can use a
cash flow analysis to assist you with a leaseorbuy
decision. In this case, if cost were the sole criterion for the
decision, you would be inclined to purchase the asset because in
current dollars, the cost of purchasing is $32,204, while the
cost of leasing is $34,838. Even if cost isn't your sole
criterion, a cash flow analysis is useful because it can show
you how much you're paying for noncost factors that may dictate
your decision to lease.
Cash flow analysis of purchase: Assumes the financed
purchase of a $50,000 piece of equipment for 25 percent down,
interest at 10 percent, and four annual payments of $11,830 (all
payments are made on the first day of the year).
Interest is deemed to accrue on the outstanding balance of
the loan at the end of each year and is computed as follows (the
last column shows the portion of each annual payment that goes
to principal and that reduces the outstanding loan):
Year End 
Outstanding
Loan 
Interest 
Principal 
1 
37,500 
3,570 
8,080 
2 
29,420 
2,942 
8,888 
3 
20,532 
2,053 
9,777 
4 
10,755 
1,075 
10,755 
Depreciation is computed on the basis of the 200 percent
declining balance method.
(A) 
(B) 
(C) 
(D) 
(E) 
(F) 
(G) 
(H) 
Year 
Cash Pmts. 
Prior Year's Interest 
Prior Year's Deprec. 
Tax Savings [40% x (C + D)] 
Net Cash Flow [B  E] 
Discount Factor (6% Cost of Cap. 
Present Value
[F x G] 
1 
12,500 
0 
0 
0 
12,500 
1.0000 
12,500 
2 
11,830 
0 
10,000 
4,000 
7,830 
0.9434 
7,387 
3 
11,830 
3,750 
16,000 
7,900 
3,930 
0.8900 
3,498 
4 
11,830 
2,942 
9,600 
5,017 
6,813 
0.8396 
5,720 
5 
11,830 
2,053 
5,760 
3,125 
8,705 
0.7921 
6,895 
6 

1,075 
5,760 
2,734 
(2,734) 
0.7473 
(2,043) 
7 


2,880 
1,152 
(1,152) 
0.7050 
(812) 
8 







9 
(2,500) 


(1,000) 
(1,500) 
0.6274 
(941) 
Net Cash
Flow 
32,204 
Cash flow analysis of leasing: Assumes that equipment
costing $50,000 will be leased for eight years for an annual
rent of $8,500, with the first payment being due on delivery and
the following payments being due on the first day of each
subsequent year. The business is assumed to have a combined
federal and state income tax rate of 40 percent (tax benefits
are computed as of the first day of year following the year for
which the rental deduction was claimed) and a 6 percent cost of
capital.
(A) 
(B) 
(C) 
(D) 
(E) 
(F) 
Year 
Lease Payment 
Prior Year's Tax Savings [40% x B] 
Net Cash Flow [B  C] 
Discount Factor (6% Cost of Capital) 
Present Value [D x E] 
1 
8,500 

8,500 
1.000 
8,500 
2 
8,500 
3,400 
5,100 
0.9434 
4,811 
3 
8,500 
3,400 
5,100 
0.8900 
4,539 
4 
8,500 
3,400 
5,100 
0.8396 
4,282 
5 
8,500 
3,400 
5,100 
0.7921 
4,040 
6 
8,500 
3,400 
5,100 
0.7473 
3,811 
7 
8,500 
3,400 
5,100 
0.7050 
3,596 
8 
8,500 
3,400 
5,100 
0.6651 
3,392 
9 

3,400 
(3,400) 
0.6274 
(2,133) 
Net Cash Flow 
34,838 
