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Asset investment decisions and capital rationing

Lease versus buy

A separate decision to the investment decision is on how to finance the asset
purchase. The choice is between:

 leasing – effectively financing the purchase of the asset with the lease contract

 buying – acquiring the asset with separate finance arranged for the purchase

The NPVs of the two financing options are calculated and the lowest cost option
selected. The cash flows of this option would then be included as relevant cash
flows in the NPV calculation for the project.

Cash flows for leasing:

 The lease payments (often paid at the start of a year)

 The tax relief on the lease payments (watch out for timing – if the lease
payment is at the start of a year the tax saving will be two years later if tax is
paid a year in arrears)

Cash flows for buying:

 The purchase payment and scrap value

 The tax savings from tax-allowable depreciation

Cost of capital

Use the post-tax cost of borrowing for both sets of calculations:

Cost of borrowing × (1 – tax rate)

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