Handbook of Finance: Investment Management and Financial Management

Chapter 81. Lease versus Borrow-to-Buy Analysis

FRANK J. FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

Abstract: Several models have been proposed in the finance literature, as well as in promotional material circulated by lessors, for evaluating whether equipment should be purchased or leased. The lease versus borrow-to-buy decision requires a careful analysis of the cash flows associated with the two alternatives for obtaining the use of the equipment. The key concept in the lease versus borrow-to-buy decision is the need to neutralize the financial risk between the two alternative financing methods.

Keywords: lease, borrow-to-buy decision, adjusted discount rate, direct cash flow from leasing, equivalent loan, residual value, debt displacement, tax shield

The decision by corporate management to lease equipment or borrow funds to purchase equipment should be based on careful economic analysis of the cash flows associated with the two alternatives. These cash flows will be affected by tax considerations (including current and future tax rates) and the projected residual value at the end of the lease term. In this chapter, we present a model for evaluating leasing developed by Myers (1975) and then applied by Myers, Dill, and Bautista (1976) that is appropriate when the firm is in a tax-paying position and can realize in each year the entire tax shield associated with the expenses for a lease or borrow-to-buy decision. We then provide a model ...