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Lease vs Buy Decision

When a business needs an asset — say a delivery truck or a CNC machine — it faces a classic question: lease it or buy it outright (usually by borrowing)?

The Lease vs Buy decision is a financing decision, not an investment decision. You've already decided the asset is needed. The only question is: which way of financing it costs less on a present-value basis? Both options involve periodic cash outflows. Buying means loan installments (principal + interest). Leasing means lease rentals. You compare these on an after-tax, present-value basis, discounting at the after-tax cost of debt. Why this rate? Because both options are debt-like — they involve contractual, certain payments. If the loan rate is 10% and tax rate is 30%, after-tax cost of debt = 10% × (1 − 0.30) = 7%. Do NOT use WACC here — that's a very common exam mistake.

Buy Option — Net Outflows: Loan repayment (principal + interest) minus tax saving on interest minus depreciation tax shield (= Depreciation × Tax Rate). If there's a salvage value, deduct its PV too — you get it back because you own the asset.

Lease Option — Net Outflows: Lease rental minus tax saving on lease rental (fully deductible as business expense). No depreciation benefit. No salvage value.

Decision Rule: Compute PV of net outflows under each option at the after-tax cost of debt. The option with lower PV = better choice. Equivalently, use NAL (Net Advantage to Leasing):

  • NAL = PV of Buy Outflows − PV of Lease Outflows
  • NAL > 0 → Lease is cheaper ✓
  • NAL < 0 → Buy is cheaper ✓

This topic consistently appears as a 10–12 mark numerical in FM papers. Examiners often provide a loan amortization schedule and expect you to compute after-tax outflows year by year, discount them, and compare. Master the layout cold and you're guaranteed those marks.

📊 Worked example

Example: Rajesh & Co. — Lease vs Buy Decision

Rajesh & Co. needs machinery costing ₹5,00,000. Useful life: 4 years. Salvage value: Nil. Depreciation: SLM.

  • Buy: Loan at 10% p.a.; equal principal repayment of ₹1,25,000/year
  • Lease: Annual rental ₹1,50,000 (payable year-end)
  • Tax rate: 30% | After-tax cost of debt: 10% × 0.70 = 7%
  • Annual depreciation: ₹5,00,000 ÷ 4 = ₹1,25,000
  • Depreciation tax shield/year: ₹1,25,000 × 30% = ₹37,500

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Step 1 — Net Outflows under BUY (₹)

| Year | Opening Balance | Interest @10% | Principal | Gross Outflow | (−) Tax on Interest | (−) Dep. Shield | Net Outflow |

|------|----------------|--------------|-----------|--------------|-------------------|-----------------|-------------|

| 1 | 5,00,000 | 50,000 | 1,25,000 | 1,75,000 | 15,000 | 37,500 | 1,22,500 |

| 2 | 3,75,000 | 37,500 | 1,25,000 | 1,62,500 | 11,250 | 37,500 | 1,13,750 |

| 3 | 2,50,000 | 25,000 | 1,25,000 | 1,50,000 | 7,500 | 37,500 | 1,05,000 |

| 4 | 1,25,000 | 12,500 | 1,25,000 | 1,37,500 | 3,750 | 37,500 | 96,250 |

Step 2 — PV of Buy Outflows @ 7%

| Year | Net Outflow (₹) | PV Factor | PV (₹) |

|------|----------------|-----------|--------|

| 1 | 1,22,500 | 0.935 | 1,14,538 |

| 2 | 1,13,750 | 0.873 | 99,263 |

| 3 | 1,05,000 | 0.816 | 85,680 |

| 4 | 96,250 | 0.763 | 73,439 |

| Total | | | ₹3,72,920 |

Step 3 — PV of Lease Outflows @ 7%

After-tax lease rental = ₹1,50,000 × (1 − 0.30) = ₹1,05,000/year

PVIFA(7%, 4 yrs) = 0.935 + 0.873 + 0.816 + 0.763 = 3.387

PV of Lease = ₹1,05,000 × 3.387 = ₹3,55,635

Step 4 — NAL

NAL = ₹3,72,920 − ₹3,55,635 = ₹17,285 (Positive)

Conclusion: NAL > 0 → Leasing is the better option for Rajesh & Co.

⚠️ Common exam mistakes

  • Using WACC instead of after-tax cost of debt as the discount rate. Both options have contractual, debt-like outflows — the risk is identical, so use after-tax cost of debt (not WACC). WACC mixes in equity cost which is irrelevant here.
  • Forgetting the depreciation tax shield under the buy option. When you own the asset, depreciation reduces taxable profit, saving real cash. Always subtract (Depreciation × Tax Rate) from each year's buy outflow. Missing this makes buying look artificially expensive.
  • Not tax-adjusting the lease rental. Lease rent is a fully deductible business expense. Net outflow = Lease Rental × (1 − Tax Rate). Using the gross rental figure overstates the cost of leasing.
  • Ignoring salvage value in the buy option. If the question mentions a terminal/residual value, its PV must be deducted from the PV of buy outflows — you receive that cash only if you own the asset. Leasing gives you no scrap proceeds.
  • Misreading the NAL sign. NAL = PV(Buy) − PV(Lease). A positive NAL means buying costs more, so lease is better. Many students panic and reverse the logic — just remember: positive NAL = leasing wins, negative NAL = buying wins.
📖 Reference: Lease vs Buy — Institute of Chartered Accountants of India
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