it is more fair to compare lease vs borrow instead of buy

• Comparing leasing to purchase with borrowing will put the two on same level in term of advantage (delaying investment) and risk (leveraging)

  • Tax and interests rate advantage due to borrowing (see leasing in oil project is akin to financial borrowing Private or Broken Links
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    ) may make it more attractive to leasing if one can secure more favourable interests rate
  • Thus, to evaluate a lease correctly, we should compare it to purchasing the asset using an equivalent amount of leverage.

• There are two main method to fairly compare lease vs buy

  • 1st method is to compare lease against buy with borrowed fund.
    • This is because leasing is a form of financing. This method is usually known as lease-equivalent loan.
    • for this method, (1) find the incremental cash flow of lease-buy, (2) discount the cash flow by company's after-tax cost of debt. If it's negative lease is not attractive.
  • 2nd method is to de-lever the lease
    • this is done by converting the lease payment into equivalent initial capex as if it is a buy.
    • for this method, (1) discount the lease payment by company's after-tax cost of debt, (2) deduct the equivalent capex from the net cash flow, and (3) add back the lease payment to the net cash flow.

Review #flashcards/economics

What are two main method to fairly compare lease vs buy, and specify the key steps

?

• 1st method is compare lease against buy with borrowed fund. This is because leasing is a form of financing. This method is usually known as lease-equivalent loan.
  • for this method, (1) find the incremental cash flow of lease-buy, (2) discount the cash flow by company's after-tax cost of debt. If it's negative lease is not attractive.
• 2nd method is to de-lever the lease by converting the lease payment into equivalent initial capex as if it is a buy.
  • for this method, (1) discount the lease payment by company's after-tax cost of debt, (2) deduct the equivalent capex from the net cash flow, and (3) add back the lease payment to the net cash flow.

References

• Corporate Finance, 3rd Edition. By Berk & DeMarzo

Metadata

• topic:: 00 Engineering Economics00 Engineering Economics
  #MOC / for economics notes with focus on petroleum fiscal and engineering
  
• updated:: 2022-07-21 Private or Broken Links
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• reviewed:: 2022-11-12 Private or Broken Links
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• #PermanentNote