What discount rate should be used to evaluate a lease? Why?

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What discount rate should be used to evaluate a lease? Why?

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What discount rate should be used to evaluate a lease? Why?

Explanation & AnswerSolution by a verified expert

Explanation

The cost of debt of the lessee should be used as a discounting rate to determine the present value of the lease payments.
The cost of debt is used as a discount rate because a lease is treated similar to a loan as  the lessee has an obligation to pay regular fixed payments to the lessor until the completion of the lease term. Therefore, the lease payments are the liability of the lessee and the initial lease liability is measured at the present value of these lease payments discounted at the incremental borrowing rate of the lessee.

Verified Answer

To evaluate a lease, the cost of debt (rd) of the lessee should be used as a discount rate because a lease is considered as a loan, that is, debt because it requires periodic payments by the lessee to the beneficial lessor and enhances the liability of the firm as such in case of a loan.

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