Financial Management · Sources of, and raising, business finance

Debt Finance, Leasing and Hybrid Instruments for ACCA FM

Updated 11 October 2026 · Fact-checked

Debt finance is borrowed money repaid with interest: bank loans and bonds. Hybrids such as convertibles and preference shares mix debt and equity features. Leasing rents an asset instead of buying it. To solve questions, identify the instrument, list its cash flows, discount at the right rate, and compare the options.

Understand Debt Finance, Leasing and Hybrid Instruments

Debt finance means borrowing money that must be repaid, usually with interest. The lender has a legal claim on the company, ranks ahead of shareholders if the company fails, and is paid interest whether or not profit is made. Interest is normally tax-deductible, which makes debt cheaper than equity for the company. The risk is financial risk: fixed payments raise gearing and can lead to default.

The main forms are bank loans and bonds (also called loan notes or debentures). Bank loans are flexible, often at floating rates, and may carry covenants and security. Bonds are tradable, usually fixed rate, and issued to many investors. They can be irredeemable (interest paid forever) or redeemable (repaid at par or a premium on a set date). Security is either a fixed charge on specific assets or a floating charge on a pool of assets. Secured debt is cheaper because the lender's risk is lower.

Hybrid instruments have both debt and equity features. Convertible bonds pay interest like debt, but the holder can swap them for a fixed number of ordinary shares on set dates. Investors accept a lower coupon for the chance of a share gain. The company gets cheaper finance now but may issue new shares later, which dilutes existing holders. A convertible has a floor value: the higher of its straight debt value and its conversion value. Preference shares pay a fixed dividend and rank before ordinary shares but after debt. The dividend is paid from after-tax profit, so there is no tax relief. They are usually cumulative and non-voting.

Leasing means using an asset in return for rental payments. In an operating lease the lessor keeps most risks and rewards of ownership. The lease is shorter than the asset's life, and the lessor often handles maintenance. It suits assets that date quickly. In a finance lease the lessee takes most risks and rewards. The lease covers most of the asset's life and is not cancellable, and the lessee pays maintenance and insurance. IFRS 16 puts most leases on the lessee's balance sheet, but FM still uses these terms to describe the finance features. A lease can avoid a large upfront payment and may be cheaper after tax than buying. The decision is judged by comparing present values of the after-tax cash flows.

Key rules to remember

Value of redeemable debt: Value = Σ [interest ÷ (1 + kd)^t] + redemption value ÷ (1 + kd)^n; kd is the investor's required yield. Use annuity and discount factors from the tables provided. This is also the straight debt value for a convertible.
Irredeemable debt (pre-tax and post-tax): Value = interest ÷ kd; kd after tax = (interest × (1 − T)) ÷ market value; T is the corporate tax rate. Use this only for debt that is never repaid.
Conversion value of a convertible: Conversion value = share price × (1 + g)^n × number of shares per bond; g is the expected annual share price growth and n the years to the conversion date. For today's conversion value, use the current price with no growth.
Floor value of a convertible: Floor value = higher of (straight debt value, conversion value); The market price should not fall below this. In practice it sits above it because the option has value.
Conversion premium: Premium = market price of convertible − current conversion value; as a % = premium ÷ conversion value; It measures how much extra an investor pays for the option to convert.
Preference shares: Value = dividend ÷ kp; kp = dividend ÷ market price; No tax adjustment, because preference dividends are not tax-deductible.
Lease versus buy: Compare PV of buying (outlay − PV of tax savings on allowances ± scrap) with PV of leasing (rentals − PV of tax saved on rentals); Discount at the post-tax cost of borrowing: pre-tax rate × (1 − T). Choose the lower PV of cost.

How to solve Debt Finance, Leasing and Hybrid Instruments questions

Use the same routine for any debt, hybrid or lease question. It keeps the cash flows, the rate and the tax in order.

1Name the instrument and what the question asks for: value, cost, choice between sources, or lease versus buy.
2Write a timeline of cash flows: interest, redemption, rentals, tax effects, scrap value. Note whether payments fall at the start or end of each year.
3Pick the discount rate. Use the investor's required yield for valuing a bond. Use the post-tax cost of borrowing for lease versus buy. Use the stated rate in other cases.
4Adjust for tax. Interest and lease rentals get tax relief, preference dividends do not, and capital allowances reduce tax on a purchase. Check the timing of the tax cash flow.
5Discount using the table factors and total the present values. For a convertible, calculate both the straight debt value and the conversion value.
6Compare and decide: higher of the two values for the floor value, lower PV of cost for lease versus buy, or the likely investor action at conversion.
7Add one or two qualitative points when asked for advice, such as gearing, covenants, dilution, flexibility, maintenance and obsolescence.

Quickest way: Three-line check for objective test questions

When to use it: Use it in Section A and OT cases, where you have about two minutes per question and no partial marks.

Decide which formula family applies: bond value, convertible, preference share or lease.
Work out the key number only: for a convertible that is straight debt value and conversion value, for a lease the net cost after tax each year.
Remove options that ignore tax, use the wrong rate or treat preference dividends as tax-deductible, then check the arithmetic on the remaining answer.

Common mistakes in Debt Finance, Leasing and Hybrid Instruments

Discounting lease and buy cash flows at the pre-tax borrowing rate.
The rate in the question is the headline loan rate and students use it directly.
Fix: Multiply the pre-tax rate by (1 − T) whenever the cash flows include tax effects. Say that you are doing so.
Ignoring share price growth when calculating the conversion value at a future date.
Students use the current share price because it is the only price given.
Fix: Grow the price at g for n years first, then multiply by the number of shares per bond. Use today's price only for the current conversion value.
Deducting tax from preference share dividends.
They are treated like interest because both are fixed payments.
Fix: Preference dividends are paid from after-tax profit. Cost = dividend ÷ price, with no (1 − T) adjustment.
Treating the floor value of a convertible as the conversion value only.
Students forget that the bond is also worth its straight debt value.
Fix: Calculate both and take the higher. Say which one sets the floor.
Putting lease rentals in the wrong year.
Rentals can be in advance or in arrears, and tax relief may be delayed a year.
Fix: Read the wording. In advance means the first payment is at time 0. Draw the timeline before discounting.
Treating nominal value as market value when valuing or costing bonds.
The $100 nominal figure is the number students see first.
Fix: Interest is based on nominal value. The cost and valuation use the market price or the calculated present value.

Worked examples

Example 1

A company has a convertible bond with a nominal value of $100, a coupon of 6% and redemption in 5 years at par. Alternatively, the holder can convert into 25 ordinary shares at that date. The current share price is $3.20 and is expected to grow by 5% a year. Investors require a yield of 8% on similar straight debt. The bond is currently priced at $100. Ignore tax and use annuity factor 3.993 and discount factor 0.681 at 8% for 5 years. Calculate (a) the straight debt value, (b) the conversion value in 5 years, (c) the current conversion premium and (d) what the holder will do.

Show the solution

(a) Interest is 6% × $100 = $6 a year. PV of interest = 6 × 3.993 = $23.96.
PV of redemption = 100 × 0.681 = $68.10. Straight debt value = 23.96 + 68.10 = $92.06.
(b) Share price in year 5 = 3.20 × 1.05^5. 1.05^5 = 1.27628, so the price is $4.084. Conversion value = 4.084 × 25 = $102.10.
(c) Current conversion value = 3.20 × 25 = $80. Premium = 100 − 80 = $20, which is 20 ÷ 80 = 25% of the conversion value.
(d) Conversion value of $102.10 is higher than the $100 redemption value, so the holder will convert.

Answer: Straight debt value $92.06; conversion value in year 5 $102.10; current premium $20 (25%); the holder converts.

Example 2

A company needs a machine costing $200,000 with no scrap value after 4 years. It can buy the machine, or lease it for $55,000 a year paid at the end of each year. Tax is 25%, paid in the same year as the profit, and the machine qualifies for tax-allowable depreciation of $50,000 a year. The pre-tax cost of borrowing is 8%. Using the 4-year annuity factor at 6% of 3.465, decide whether to lease or buy.

Show the solution

Post-tax cost of borrowing = 8% × (1 − 0.25) = 6%, which is the discount rate.
Buy: tax saved each year = 25% × 50,000 = $12,500. PV of tax savings = 12,500 × 3.465 = $43,312.50.
PV of cost of buying = 200,000 − 43,312.50 = $156,687.50.
Lease: the rental of $55,000 gives tax relief of 25% × 55,000 = $13,750. Net cost a year = 55,000 − 13,750 = $41,250.
PV of cost of leasing = 41,250 × 3.465 = $142,931.25.
Leasing costs about $13,756 less in present value terms than buying.

Answer: Lease. PV cost of leasing is $142,931 against $156,688 for buying, assuming the machine is worth acquiring at all. Also consider flexibility, maintenance and obsolescence.

Exam tips

In OT cases the same scenario often gives data for both a bond or convertible and a lease, so read the whole scenario before you start calculating.
Show the straight debt value and the conversion value separately in Section C. Marks are given for each part even if your final comparison is wrong.
Say which discount rate you use and why. A single sentence such as 'post-tax cost of borrowing' earns the method mark.
In discussion parts, link each feature to the user: lower coupon for the company, upside for the investor, dilution for existing shareholders, gearing effect for lenders.
Check table factors carefully. Use the correct rate and year count, because OT answers get no partial credit.

Practice questions from Sources of, and raising, business finance

Debt Finance, Leasing and Hybrid Instruments in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Debt Finance, Leasing and Hybrid Instruments: frequently asked questions

How do I value a convertible loan note in ACCA FM?

Work out the straight debt value by discounting interest and redemption at the investor's required yield for similar debt. Then work out the conversion value from the share price, expected growth and the number of shares per bond. The floor value is the higher of the two.

What is the difference between an operating lease and a finance lease?

In an operating lease the lessor keeps most risks and rewards, the term is short compared with the asset's life and the lessor often pays maintenance. In a finance lease the lessee takes most risks and rewards, the lease covers most of the asset's life and the lessee pays maintenance. Under IFRS 16 most leases are on the lessee's balance sheet, but FM still uses these terms.

Why do companies issue convertible bonds?

They can pay a lower coupon than on straight debt because investors value the right to convert. They may also issue shares later at a price above today's, and do so without a new share issue. The downsides are dilution if holders convert and the repayment burden if they do not.

Are preference shares debt or equity?

They are a hybrid. They pay a fixed dividend and rank ahead of ordinary shares, like debt, but the dividend is not tax-deductible and non-payment is not a default, like equity. For cost of capital, treat them separately, with cost = dividend ÷ market price.