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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