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One of the toughest decisions a business faces involves whether to lease or to purchase property or equipment. While buying provides the business with a significant asset, it also involves a substantial outlay of capital. When businesses compare the costs of leasing versus purchasing, the incremental after-tax effect of the decision is often ignored, -- yet taxes can greatly influence the business’s decision.
The comparison methodology typically used involves a net present value analysis of the cash flows resulting from each the option to purchase and the option to lease. In this method, the business forecasts the costs incurred through each the purchase and lease of the asset during each year of the asset’s life. For a purchase, this is the initial acquisition cost and continuing maintenance and financing costs. For a lease, these are the annual lease payments. A discount rate (typically equivalent to the firm’s marginal borrowing costs) is used to compute the net present value of each year’s expenditures. The method (lease or purchase) with the lowest net present value typically is the preferred method for acquiring the asset.
In an incremental after-tax analysis, the annual costs are adjusted to account for the value of the deductions allowed for income tax purposes. For example, owners of real property can claim an annual depreciation deduction to account for the declining value of an owned asset. For a taxpayer paying a marginal tax rate of 40 percent, a depreciation deduction of $100 has a net cash value of $40. This means that the income tax paid by the taxpayer is reduced by $40 as a result of the depreciation deduction. This benefit of an income tax deduction is deducted from the annual cost of the asset when forecasting annual costs for purposes of the net present value analysis.
In addition to a depreciation deduction, which is typically the largest deduction available to owners of property or equipment, owners may claim a tax deduction for financing costs that do not represent a reduction of the principal balance owed. Lessees may generally deduct the amount of rent paid during a year or the amount of rent expense accrued during a year. The Internal Revenue Service does not typically allow taxpayers to deduct rent paid in advance.
When a lease confers substantially all the risks and rewards of ownership, it is considered a capital lease and generally must be accounted for as owned property for income tax purposes. With a capital lease, many of the tax adjustments that must be made to the net present value analysis are the same as with the ownership of the property. The analysis is based on the actual cash flows alone.