Let's assume you're faced with the following lease-or-buy 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
lease-or-buy 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 non-cost factors that may dictate your
decision to lease.
Cash flow analysis of purchase. This analysis 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

29,420

2,942

8,888

20,532

2,053

9,777

10,755

1,075

10,755

Depreciation is computed on the basis of the 200 percent declining balance method.
(A)

Year

(B)

(C)

Cash
Payments

Prior
Year's
Interest

(D)

(E)

(F)

(G)

(H)

Prior Year's
Depreciation

Tax
Savings
[40% x (C
+ D)]

Net Cash
Flow [B
- E]

Discount
Factor (6%
Cost of
Cap.

Present
Value
[F x G]

12,500

12,500

1.0000

12,500

11,830

10,000

4,000

7,830

0.9434

7,387

11,830

3,750

16,000

7,900

3,930

0.8900

3,498

11,830

2,942

9,600

5,017

6,813

0.8396

5,720

11,830

2,053

5,760

3,125

8,705

0.7921

6,895

1,075

5,760

2,734

(2,734)

0.7473

(2,043)

2,880

1,152

(1,152)

0.7050

(812)

(1,000)

(1,500)

0.6274

(941)

7
8
9

(2,500)

Net Cash Flow

32,204

Cash flow analysis of leasing. This analysis 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]

8,500

8,500

1.000

8,500

8,500

3,400

5,100

0.9434

4,811

8,500

3,400

5,100

0.8900

4,539

8,500

3,400

5,100

0.8396

4,282

8,500

3,400

5,100

0.7921

4,040

8,500

3,400

5,100

0.7473

3,811

8,500

3,400

5,100

0.7050

3,596

8,500

3,400

5,100

0.6651

3,392

3,400

(3,400)

0.6274

(2,133)

9
Net Cash Flow

34,838