You can analyze the costs of the lease versus purchase problem through discounted cash flow analysis. This analysis compares the cost of each alternative by considering: the timing of the payments, tax benefits, the interest rate on a loan, the lease rate, and other financial arrangements.
To make the analysis you must first make certain assumptions about the economic life of the equipment, salvage value, and depreciation.
To evaluate a lease you must first find the net cash outlay (not cash flow) in each year of the lease term. You find these amounts by subtracting the tax savings from the lease payment. This calculation gives you the net cash outlay for each year of the lease.
Each year's net cash outlay must next be discounted to take into account the time value of money. This discounting gives you the present value of each of the amounts.
The present value of an amount of money is the sum you would have to invest today at a stated rate of interest to have that amount of money at a specified future date. Say someone offered to give you $100 five years from now. How much could you take today and be as well off?
Common sense tells you you could take less than $100, because you'd have the use of the money for the five year period. Naturally, how much less you could take depends on the interest rate you thought you could get if you invested the lesser amount. For example to have $100 five years from now at six percent compounded annually, you’d have to invest $74.70 today. At 10 percent, you could take $62.10 now and have the $100 at the end of five years.
Fortunately, there are tables which provide the discount factors for present value calculations. There are also relatively inexpensive special purpose pocket calculators programmed to make these calculations. And better yet, most spreadsheets such as Excel, Lotus123 or QuattroPro have present value calculations built in and even have templates to use for analyzing a lease vs. a purchase.
Why bother with making these present value calculations? Well, you've got to make them to compare the actual cash flows over the time periods. You simply can't realistically compare methods of financing without taking into account the time value of money. If may seem confusing and complex at first, you will begin to see that the technique isn't difficult - just sophisticated.
The sum of the discounted cash flows is called the net present value of the cost of leasing. It is this figure that will be compared with the final sum of the discounted cash flows for the loan and purchase alternative.
Evaluation of the borrow/buy option is a little more complicated because of the tax benefits that go with ownership through the investment tax credit, loan interest deductions, and depreciation. The interest portion of each loan payment is found by multiplying the loan interest rate by the outstanding loan balance for the preceding period.
As noted earlier, the salvage value is one of the advantages of ownership. It must be considered in making the comparison; however, it is discounted at a higher rate (the firm's assumed average cost of capital, 9%). This rate is used because the salvage value is not known with any certainty, as are the loan payment, depreciation, and interest payments.
The major difference in cost, of course, comes from the salvage value. If you ignore that value (a highly conservative approach), the alternatives are very close in their net present vale of costs. Naturally, its possible that salvage costs for each asset could be very high or be next to nothing. Salvage value assumptions need to be made carefully.
Thus, while this sort of analysis is useful, you can't make a lease/buy decision solely on cost analysis figures. The advantages and disadvantages, while tough to quantify, may outweigh differences in cost - especially if costs are reasonably close.