In normal situations, the lease decision has been evaluated from the point of the lessee in terms of the lease or buy decision. However, the lessor also has to evaluate the lease decisions from the point of view of his return. The lessor is financing the assets out of the funds procured from different sources, and obviously there is a cost of all these funds to the lessor. So, the lessor will like to provide lease financing only if the return from the lease is at least equal to the overall cost of capital of the lessor.
The lease decision for a lessor is in fact a capital budgeting decision, where the lessor invests the funds in expectation of the returns in the form of lease rentals. The lessor will accept the proposal for the lease financing only if the NPV of the decision is positive at the required rate of return i.e., overall cost of capital, k . In terms of the IRR methodology, the lease financing may be accepted only when the Internal Rate of Return (IRR) of the lease financing is more than the cut-off rate. As a capital budgeting decision, therefore, the lease decision may be evaluated as follows:
- Cash Outflows: In case of lease situation, the lessor has to ‘buy’ the asset. Therefore, the initial cash outflow is the amount paid by the lessor at the time of purchasing the assets. If there is any other incidental expense or outflow then it should also be included in the initial outflows.
- Cash Inflows: In case of lease financing, the cash inflows are in terms of periodic lease rentals. In order to find out the after tax cash inflows, these periodic lease rentals are to be adjusted for (i) tax liability on account of income from lease rentals, and (ii) tax shield on account of depreciation on the asset.
The annual net cash flows may be ascertained as follows:
Net Cash flows = (Lease Rental – Depreciation) x (1 – Tax Rate)+Depreciation.
These cash inflows are then discounted at the required rate of return to find out the present value of inflows. This present value of inflows may be compared with the initial cash outflows to find out the NPV of the lease decision. If the present value of the inflows is more than the present value of outflows, the lessor may accept the lease financing. In case, the lessor is using the IRR technique, the IRR of the cash inflows and outflows may be computed. If this IRR is higher than the cut-off rate, the lessor may accept the lease financing.