Financial Management · Specific investment decisions (lease or buy, asset replacement, capital rationing)

Lease or Buy Decisions in ACCA Financial Management

Updated 11 October 2026 · Fact-checked

A lease or buy decision compares the present value of the after-tax cost of leasing an asset with the cost of borrowing to buy it. Discount both sets of cash flows at the post-tax cost of debt, include lease payments, tax relief, capital allowances and disposal proceeds, then choose the lower present value cost.

Understand Lease or Buy Decisions

A business that needs an asset has two financing routes. It can lease the asset and pay rentals to the owner (the lessor). Or it can borrow money, buy the asset and own it. The investment decision (do we need the asset?) has already been made. This topic is only about the financing decision: which route costs less?

There are two types of lease. In an operating lease, the lease term is short compared with the asset's life, the lessor keeps most risks and rewards of ownership, and the lessor often pays for maintenance. The lessee can usually hand the asset back. In a finance lease, the lease runs for most of the asset's life, usually cannot be cancelled, and the lessee takes most of the risks and rewards, including maintenance and insurance. Under IFRS 16, a lessee normally shows almost all leases on its statement of financial position as a right-of-use asset and a lease liability. The main exceptions are short-term and low-value leases. For the FM calculation, the cash flows matter more than the label.

To compare the routes, you list only the cash flows that differ. If you buy: the purchase price, the tax saved from capital allowances, and any sale proceeds at the end. If you lease: the rentals and the tax saved because the rentals are tax deductible. Costs that are the same under both routes, such as running costs, are ignored. If the lessor pays maintenance under the lease, that saving is a relevant benefit of leasing.

The discount rate is the post-tax cost of debt. A lease is a substitute for borrowing. Lease payments are fixed and contractual, like loan repayments, so they carry debt-like risk. The correct rate is therefore what the company would pay to borrow, after the tax relief on interest: pre-tax borrowing rate × (1 − tax rate). Do not use the WACC. The WACC reflects the risk of the business's operating cash flows, not of a financing choice.

Both routes are costs, so you are comparing present value costs. The route with the lower present value cost is cheaper. Remember that the answer is only one input. Non-financial points also matter: flexibility, obsolescence risk, maintenance, and whether the lessor's rates are fair.

Key rules to remember

Post-tax cost of debt: Kd (post-tax) = pre-tax borrowing rate × (1 − tax rate); Use this to discount all lease and buy cash flows. Use the rate for borrowing to buy the asset, not the WACC.
Tax relief on lease payments: Tax saved = lease payment × tax rate; Assume rentals are tax deductible unless told otherwise. Check whether tax is paid in the same year or a year later.
Tax saved from capital allowances: Tax saved = capital allowance × tax rate; Use the allowance pattern the question gives, for example 25% reducing balance or straight line. Use the rates given in the question.
Balancing allowance or charge: Tax written-down value − disposal proceeds; A positive result is a balancing allowance (extra tax relief). A negative result is a balancing charge (extra tax payable).
Net cost of buying: PV(purchase cost) − PV(tax saved on allowances) − PV(disposal proceeds); Disposal proceeds are a cash inflow for the buyer. A lessee gets none.
Net cost of leasing: PV(lease payments) − PV(tax saved on payments); Rentals paid in advance start at time 0. Rentals paid in arrears start at time 1.
Decision rule: Choose the option with the lower present value cost; Equivalent: compute the lease-minus-buy difference and lease if it is negative.

How to solve Lease or Buy Decisions questions

Use this method for any lease or buy question. Set out a time-line table with a column for each year, starting at time 0.

1Find the discount rate: pre-tax borrowing rate × (1 − tax rate). Say that you are using it because leasing is a substitute for borrowing.
2Read the timing details: are lease payments in advance (time 0) or in arrears (time 1), and is tax paid in the same year or one year later?
3Build the buy cash flows: purchase cost at time 0, capital allowance tax savings, any balancing allowance or charge, and sale proceeds. Allow for any tax timing delay.
4Build the lease cash flows: each rental, and the tax saved on each rental at the tax rate, in the correct year.
5Include only the differences. Ignore costs that are the same under both routes. Include maintenance only if it differs.
6Discount each option at the post-tax rate using annuity or discount factors, and total each to get a net present value cost.
7Compare the two costs. Choose the lower. State the difference.
8Add short comments: operating or finance lease features, who pays maintenance, risk of obsolescence, and sensitivity to the assumptions.

Quickest way: Net lease-minus-buy cash flow shortcut

When to use it: Use it when the question gives annual lease payments and a clear allowance pattern, and you are short of time in Section C.

Compute the post-tax discount rate first and write it at the top of your answer.
Draw one row per year for the buy option and one for the lease option, with time 0 to the last tax year.
Work out the after-tax cost of each lease payment (payment × (1 − tax rate)) if tax is paid in the same year. If tax is delayed, keep the payment and the tax relief in separate years.
Use cumulative annuity factors and subtract, for example AF(1–5) − AF(1) for years 2 to 5, rather than discounting each year one by one.
Compare the two totals and write the conclusion in one sentence before adding the qualitative points.

Common mistakes in Lease or Buy Decisions

Discounting at the WACC or the pre-tax cost of debt
Students remember that DCF uses the cost of capital and do not link the rate to the financing nature of the decision.
Fix: Use the post-tax cost of debt: borrowing rate × (1 − tax rate). Write one line explaining that leasing is a substitute for debt.
Putting lease payments in the wrong year
Students assume payments are always in arrears, but many questions say they are in advance.
Fix: Underline the timing in the question. Payments in advance start at time 0, so use 1 + the annuity factor for the remaining years.
Ignoring the delay in tax payments
Students apply tax in the same year as the cash flow out of habit.
Fix: If the question says tax is paid one year in arrears, move every tax saving, on both rentals and allowances, one year later.
Missing the balancing allowance on disposal
Students include the sale proceeds but forget the tax effect of selling for less than the written-down value.
Fix: At the sale date, compute tax written-down value minus proceeds. Apply the tax rate to that figure as an extra tax saving or charge.
Treating the lower number as a profit, or mixing signs
Both options are costs, but students show some items as inflows and some as outflows inconsistently.
Fix: Write all costs as positives and all savings as negatives. Choose the option with the lower net present value cost.
Including costs that are identical under both routes
Students add running costs or revenues that do not depend on the financing method.
Fix: Include only cash flows that differ. Add maintenance only if one option includes it and the other does not.

Worked examples

Example 1

A company can buy a machine for $120,000 or lease it for four years at $34,000 a year payable in advance (at the start of each year). The machine would be used for four years and would have no resale value. Tax is 30%, paid one year in arrears. The machine receives tax allowances of $30,000 a year in years 1 to 4. Lease payments are tax deductible. The pre-tax borrowing rate is 10%. Decide whether to lease or buy.

Show the solution

Post-tax cost of debt = 10% × (1 − 0.30) = 7%.
Factors at 7%: AF year 1 = 0.935; AF years 1–3 = 2.624; AF years 1–4 = 3.387; AF years 1–5 = 4.100.
Buy: cost $120,000 at time 0. Tax saved each year = $30,000 × 30% = $9,000. Tax is one year in arrears, so the savings arise in years 2 to 5.
Annuity factor for years 2–5 = 4.100 − 0.935 = 3.165. PV of tax savings = $9,000 × 3.165 = $28,485.
Net cost of buying = $120,000 − $28,485 = $91,515.
Lease: payments of $34,000 at times 0, 1, 2 and 3. Annuity factor = 1 + 2.624 = 3.624. PV of payments = $34,000 × 3.624 = $123,216.
Tax relief = $34,000 × 30% = $10,200, received one year later, in years 1 to 4. PV = $10,200 × 3.387 = $34,547 (to the nearest dollar).
Net cost of leasing = $123,216 − $34,547 = $88,669.
Compare: leasing costs $88,669 and buying costs $91,515.

Answer: Leasing is cheaper by about $2,846 in present value terms, so lease the machine on financial grounds. Check non-financial points such as maintenance and flexibility before deciding.

Example 2

A company can buy equipment for $100,000, use it for three years and sell it at the end of year 3 for $30,000. Tax allowances are 25% reducing balance, with a balancing allowance or charge on sale. Tax is 25% and paid in the same year as the cash flow. Alternatively it can lease the equipment for $32,000 a year payable at the end of each of the three years. The pre-tax borrowing rate is 8%. Which is cheaper?

Show the solution

Post-tax cost of debt = 8% × (1 − 0.25) = 6%. Discount factors: year 1 = 0.943, year 2 = 0.890, year 3 = 0.840. AF years 1–3 = 2.673.
Allowances: year 1 = 25% × $100,000 = $25,000, leaving a written-down value of $75,000. Year 2 = 25% × $75,000 = $18,750, leaving $56,250.
Year 3: sale proceeds $30,000, so balancing allowance = $56,250 − $30,000 = $26,250.
Tax saved at 25%: year 1 = $6,250; year 2 = $4,687.50; year 3 = $6,562.50.
PV of tax savings = 6,250 × 0.943 + 4,687.50 × 0.890 + 6,562.50 × 0.840 = $5,893.75 + $4,171.88 + $5,512.50 = $15,578.13.
PV of sale proceeds = $30,000 × 0.840 = $25,200.
Net cost of buying = $100,000 − $15,578 − $25,200 = $59,222 (to the nearest dollar).
Lease: after-tax payment = $32,000 × (1 − 0.25) = $24,000 a year in years 1 to 3. PV = $24,000 × 2.673 = $64,152.
Compare: buying costs $59,222 and leasing costs $64,152.

Answer: Buying is cheaper by about $4,930 in present value terms, so buy the equipment. The lessee under the lease receives no sale proceeds, which is why leasing is more expensive here.

Exam tips

Write the post-tax discount rate calculation at the top of your answer and give one line of reasoning. Markers look for it.
Mark the timing words in the question: in advance, in arrears, tax paid one year later. Most lost marks come from timing.
Present the answer as a clear table by year, with a total PV for each option, then a one-sentence decision.
In Section A and B objective questions, expect a short question on the discount rate or the difference between operating and finance leases. Answers are all or nothing, so check that the option matches the exact wording.
In written parts, give both financial and non-financial points: maintenance, obsolescence, flexibility, the statement of financial position effect under IFRS 16 (right-of-use asset and lease liability, with short-term and low-value exemptions) and the lessor's interest rate.

Practice questions from Specific investment decisions (lease or buy, asset replacement, capital rationing)

Lease or Buy Decisions in other exams

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

Lease or Buy Decisions: frequently asked questions

Why do we discount lease cash flows at the post-tax cost of debt?

A lease is an alternative to borrowing, and its payments are fixed and contractual, so they carry debt-like risk. The company gets tax relief on interest if it borrows, so the relevant rate is the borrowing rate after tax. Using the WACC would mix a financing decision with the business's operating risk.

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

In an operating lease, the lessor keeps most risks and rewards and often pays for maintenance, and the term is short compared with the asset's life. In a finance lease, the lessee takes most risks and rewards, the term covers most of the asset's life, and it is usually non-cancellable. Under IFRS 16, a lessee generally reports both types on its statement of financial position, with limited exemptions.

How do I treat tax in a lease or buy question?

Lease payments are normally tax deductible, so multiply each payment by the tax rate to find the tax saved. When buying, multiply each capital allowance, and any balancing allowance, by the tax rate. Apply the timing given in the question, either the same year or one year in arrears.

Do I include maintenance costs in the comparison?

Only if they differ between the two options. If the lessee pays maintenance either way, ignore it. If the lessor pays under an operating lease, the saving is a relevant benefit of leasing and should be included.