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NPV ANALYSIS

Now that we know that the relevant rate for evaluating a lease versus buy decision is the firm`s aftertax borrowing cost, an NPV analysis is straightforward. We simply discount the cash flows back to the present at Tasha`s aftertax borrowing rate of 5 percent as follows:

NPV _ $10,000 _ 2,330 _ (1 _ 1/1.055)/.05 __$87.68

The NPV from leasing instead of buying is 2$87.68, verifying our earlier conclusion that leasing is a bad idea. Once again, notice the signs of the cash flows; the first is positive, the rest are negative. The NPV we have computed here is often called the net advantage to leasing (NAL). Surveys indicate that the NAL approach is the most popular means of lease analysis in the real world.

A MISCONCEPTION

In our lease versus buy analysis, it looks as though we ignored the fact that if Tasha borrows the $10,000 to buy the machine, it will have to repay the money with interest. In fact, we reasoned that if Tasha leased the machine, it would be better off by $10,000 today because it wouldn`t have to pay for the machine. It is tempting to argue that if Tasha borrowed the money, it wouldn`t have to come up with the $10,000. Instead, Tasha would make a series of principal and interest payments over the next five years.

This observation is true, but not particularly relevant. The reason is that if Tasha borrows $10,000 at an aftertax cost of 5 percent, the present value of the aftertax loan payments is simply $10,000, no matter what the repayment schedule is (assuming that the loan is fully amortized). Thus, we could write down the aftertax loan repayments and work with these, but it would just be extra work for no gain.

LEASE EVALUATION

In our Tasha Corp. example, suppose Tasha is able to negotiate a lease payment of $2,000 per year. What would be the NPV of the lease in this case?

With this new lease payment, the aftertax lease payment would be $2,000 _ (1 _ .34) _ $1,320, which is $1,650 _ 1,320 _ $330 less than before. Referring back to Table B.2, note that the aftertax cash flows would be _$2,000 instead of _$2,330. At 5 percent, the NPV would be: NPV _ $10,000 _ 2,000 _ (1 _ 1/1.055)/.05 __$1341.05

Thus, the lease is very attractive.

CONCEPT QUESTIONS

What is the relevant discount rate for evaluating whether or not to lease an asset? Why?

Explain how to go about a lease versus buy analysis.

The Capital Structure Question

How should a firm go about choosing its debt-equity ratio? Here, as always, we assume that the guiding principle is to choose the course of action that maximizes the value of a share of stock. However, when it comes to capital structure decisions, this is essentially the same thing as maximizing the value of the whole firm, and, for convenience, we will tend to frame our discussion in terms of firm value.

The WACC (Weighted Average Cost of Capital) tells us that the firm`s overall cost of capital is a weighted average of the costs of the various components of the firm`s capital structure. When we described the WACC, we took the firm`s capital structure as given. Thus, one important issue that we will want to explore is what happens to the cost of capital when we vary the amount of debt financing, or the debt-equity ratio.

A primary reason for studying the WACC is that the value of the firm is maximized when the WACC is minimized. The WACC is the discount rate appropriate for the firm`s overall cash flows. Since values and discount rates move in opposite directions, minimizingthe WACC will maximize the value of the firm`s cash flows.

Thus, we will want to choose the firm`s capital structure so that the WACC is minimized. For this reason, we will say that one capital structure is better than another if it results in a lower weighted average cost of capital. Further, we say that a particular debtequity ratio represents the optimal capital structure if it results in the lowest possible WACC. This optimal capital structure is sometimes called the firm`s target capital structure as well.

CONCEPT QUESTIONS

What is the relationship between the WACC and the value of the firm?

What is an optimal capital structure?

NET ADVANTAGE TO LEASING (NAL) The NPV that is calculated when deciding whether to lease an asset or to buy it.