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Financial evaluation of finance lease

Arya Muralidharan (Student) (32 Points)

26 April 2015

Can anybody please explain me the concept of net advantage of leasing(NAL) with example?

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If asset bought from taking Loan

in that case, what will be your cash flows are:
1. Loan instalments (outflow)
2. Proceeds from sale of asset at end of its useful life (inflow)
3. You'll pay less tax, since you can claim deduction of Interest on Loan & Depreciation every year (leads to less outflow)

Because, you are evaluating proposal now, thats why you need Present value of all cash flows. i.e.

PV of Loan instalments i.e. Loan amount or Cost of Asset	XXX
Less: PV of Salvage value	(YY)
Less: PV of tax saved due to loan Interest & Depreciation	(ZZ)
Total Cash Outflow (TCO)	XXX

If asset is taken on Lease
here, cash flows will be:
1. Lease rents (outflow)
2. Less tax payments due to deduction of Lease rents every year (leads to less outflow)

here PV's are:

PV of Lease rents	XXX
PVof tax saved due to Lease rents deduction	(YY)
Total Cash Outflow (TCO)	XXX

NAL is TCO under Loan option (minus) TCO under Lease option
if it's positive i.e. TCO under Loan option is more, then its better to go for Lease Option.

In study material, you'll find formula as:
Cost of Asset
Less PV of Lease rentals (LR)
Add PV of tax shield on LR
Less PV of interest on debt tax shield
Less PV of tax shield on depreciation
Less PV of salvage value

which is nothing but, TCO under Loan option (minus) TCO under Lease option. You may check yourself.

Hope you understand. And, let me know if I did a mistake.

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Arya Muralidharan (Student) (32 Points)
Replied 26 April 2015

Thank you sir. It was indeed a good explanation. Can you please further elaborate on the discounting factor used in discounting each of those cash flows? Whether it's pre-tax or post-tax rate? I was a little confused with the explanation given in our institute material.