Hello there once again. In this lesson, we're going to look at the financing implications of our capital budgeting decision. Now that we have dealt with the stage one capital budgeting decision, we need to have a stage two discussion around the best way to finance the investment required to pursue the opportunity. lease versus buy analysis is another type of analysis that is related but separate part of capital budgeting. Remember, capital budgeting analysis only tells us whether pursuing the capital investment is a good idea. It doesn't tell us how to finance the opportunity.
In lease versus buy analysis. Our objective is to determine the lowest cost way to finance the opportunity. Let's look at an example of this analysis saying we're comparing owning an asset and financing it using debt with a 6% interest rate versus leasing the asset for $100 a year. For five years, the assumptions are as presented on your screen, we can model this out using a spreadsheet. Let's begin with the buy option, we buy the asset and pay for using debt. Once again, we will use a discounted cash flow analysis, the very same tool we use for doing the capital budget.
This tends to confuse people and I often see people trying to put these two analysis together, which is not the correct approach. The difference between these two analysis is that the cash flows of the lease versus buy analysis will only consider the costs associated with owning and financing the asset and the implications there in all operating cash flows are ignored. Why is that? That's right because they aren't relevant. They are the same between each of the two alternatives. Now, let's model out the purchase of the asset the receipt of the loan process.
Seats, the payment of interest in principle and calculate the interest tax shield from the capital cost and the interest payments. next challenge question, what is the relevant discount rate? Hmm? The answer is your incremental after tax cost of debt, we will use this discount rate to evaluate both alternatives. So, in the case of buying the asset, the present value works out to be $256 a number which is otherwise meaningless in and of itself. Let's model the lease alternative.
We are going to prepare a similar discounted cash flow analysis of our lease payments. Remember to strip out the other benefits they may be included in the lease such as maintenance costs, and if you have a bargain purchase option, then assume it is exercised. Pay careful attention to whether the lease payment is due up. Front or at the end of the period, it makes a huge difference. As you can see, the present value cost of the lease option is $286 versus a cost of $256 on a present value basis for the buy option. Therefore, using the bank's financing is cheaper than using a lease.
You can validate this by calculating the implicit cost of lease financing using the rate function in Excel. It turns out that the financing cost of this particular lease is 12.59%. Now, there are other reasons why we may want to own or lease the asset that need to be considered, but those are beyond the financial analysis discussion we are having in this course. Let's close this lesson by reviewing three key takeaways. Financing analysis happens only after the capital budgeting analysis. has been prepared in the decision made.
It's separate and distinct. Secondly, only include the costs that are directly relevant to the financing analysis. This means you would typically exclude all the operating and working capital amounts. And finally, the appropriate discount factor is your after tax cost of borrowing. Your decision is based on accepting the finance alternative with the lowest present value cost. In our final lesson, we're going to wrap up the course by summarizing what we've learned.
Until then,