Strategic Financial Management · Investment Decisions, Project Planning and Control

Replacement, Lease vs Buy and Special Investment Decisions

Updated 11 October 2026 · Fact-checked

These are capital budgeting decisions solved on incremental after-tax cash flows. For replacement, compare new against old and find the NPV of the difference. For lease versus buy, discount both options at the post-tax cost of debt and pick the lower cost. For inflation, keep cash flows and discount rate on the same basis.

Understand Replacement, Lease and Special Investment Decisions

All three decision types use one idea: only incremental cash flows matter. You compare the world where you act with the world where you do not. Past costs and book values are sunk. Only cash that changes because of the decision counts.

In a replacement decision, you replace an old asset with a new one. The new asset needs an outlay. The old asset gives you sale proceeds today and takes away its own future cash flows and depreciation. Your inflows are the savings in operating cost and the extra depreciation tax shield. Tax on the sale of the old asset (or the tax saved on a loss) belongs in the initial outlay.

In a lease versus buy decision, the question is how to finance the use of an asset. Buying means paying the price now (usually funded by debt) and claiming depreciation. Leasing means paying rentals, which are tax-deductible. Both streams are fairly certain, so you discount them at the post-tax cost of debt, not the WACC. The option with the lower present value of net cost wins. The difference is called the net advantage of leasing (NAL).

In special decisions, two cases come up often. In an abandonment decision, you drop a project early if the salvage value is more than the present value of the cash flows from continuing. In an inflation-adjusted decision, you must not mix bases. Nominal cash flows (inflation included) go with a nominal discount rate. Real cash flows (at today's prices) go with a real discount rate.

Key rules to remember

Initial outlay in replacement: Cost of new asset − Sale proceeds of old asset − Tax saved on loss on sale (or + Tax payable on gain); Add any extra working capital. Use only cash items and the tax effect of the sale.
Incremental annual cash flow (CFAT): (Savings or extra profit before depreciation − Incremental depreciation) × (1 − t) + Incremental depreciation; The same result: Savings × (1 − t) + Incremental depreciation × t. Here t is the tax rate.
Replacement NPV: NPV = PV of incremental CFAT + PV of incremental terminal cash flows − Net initial outlay; Replace if NPV > 0. For unequal lives, use the equivalent annual approach.
Post-tax cost of debt: Kd (post-tax) = Interest rate × (1 − t); The usual discount rate in lease versus buy, because lease and loan flows are debt-like.
Cost of leasing: PV of rentals × (1 − t); Take rentals after tax. Adjust the timing if rentals are paid at the start of the year.
Cost of buying: Purchase price − PV of depreciation tax shield (Depreciation × t) − PV of salvage after tax; Add PV of after-tax maintenance or insurance if the buyer bears them and the lessor does not.
Net advantage of leasing: NAL = Net cost of buying − Net cost of leasing; Lease if NAL > 0. All figures at present value.
Nominal and real rate: (1 + nominal rate) = (1 + real rate) × (1 + inflation rate); The relation is multiplicative. The simple sum is only an approximation.
Abandonment rule: Abandon if Salvage value (after tax) > PV of future cash flows from continuing; Test it at each possible year-end. Compare at the same date.

How to solve Replacement, Lease and Special Investment Decisions questions

Use this order for any replacement, lease or special decision question. Write down the assumptions you make where the question is silent.

1Identify the decision type: replace or keep, lease or buy, continue or abandon, or a nominal versus real issue. Name the two alternatives clearly.
2List only incremental cash flows. Drop sunk costs, book value as such, and allocated overheads. Keep the tax effect of any sale of the old asset.
3Compute the net initial outlay. For replacement, deduct sale proceeds of the old asset and adjust the tax on its loss or gain.
4Work out annual incremental cash flows after tax. Show the depreciation of old and new assets separately, then take the difference.
5Choose the discount rate. Use the project's cost of capital for replacement. Use the post-tax cost of debt for lease versus buy. Match nominal flows to a nominal rate, real flows to a real rate.
6Discount using the annuity factor for level flows and single factors for the terminal values. Show each factor.
7Compute the NPV or NAL and state the decision rule in one line.
8Write a clear recommendation. Mention key assumptions and any non-financial points, such as obsolescence risk or maintenance.

Quickest way: Incremental after-tax shortcut

When to use it: Use it when the time is short and depreciation is straight line, so each year's flow is level and an annuity factor fits.

For replacement, compute the annual flow as Savings × (1 − t) + Extra depreciation × t. This skips the full profit statement.
Net outlay = New cost − Old sale proceeds − Tax saving on the loss on sale.
Multiply the annual flow by the annuity factor and add any terminal values. Subtract the outlay.
For lease versus buy, compare two numbers only: Rental × (1 − t) × annuity factor against Price − Depreciation × t × annuity factor.
State the answer at once as 'Replace' or 'Lease', with the NPV or NAL.

Common mistakes in Replacement, Lease and Special Investment Decisions

Using the book value of the old machine as its cash inflow.
The book value is printed in the question and looks relevant.
Fix: Use only the market sale price. Book value matters only to compute the loss or gain on sale and the tax effect of it.
Ignoring the tax effect of the loss or gain on sale of the old asset.
Students stop once they subtract the sale price from the new cost.
Fix: If the sale price is below book value and the loss can be set off, add the tax saved to your inflow. If it is above, deduct the tax payable.
Discounting lease and buy cash flows at WACC.
Students default to WACC for every NPV problem.
Fix: Leasing is a financing choice with debt-like flows. Use the post-tax cost of debt unless the question says otherwise.
Taking full depreciation instead of the incremental depreciation in replacement.
The old asset's depreciation is forgotten once it is sold.
Fix: Compute new depreciation less the old depreciation you lose. Only the difference changes the tax bill.
Mixing nominal cash flows with a real discount rate, or the reverse.
Inflation details are given in separate lines and are easy to skip.
Fix: Decide the basis first. Either inflate the flows and use the nominal rate, or keep flows at today's prices and use the real rate. Convert the rate with (1 + n) = (1 + r)(1 + i).
Forgetting that depreciation is not a cash flow when computing CFAT.
Students stop at profit after tax.
Fix: Add depreciation back, or use the tax shield method. Never leave it deducted.

Worked examples

Example 1

Sri Venkatesh Textiles Ltd is considering replacing a machine. The old machine has a book value of ₹3,00,000 and 5 years of life left. It is depreciated straight line at ₹60,000 a year, with nil salvage. It can be sold now for ₹1,00,000. The new machine costs ₹8,00,000, has a 5-year life, and is depreciated straight line to nil salvage. It saves ₹2,50,000 a year in operating costs before tax. The tax rate is 30%. The loss on sale of the old machine can be set off against other income. The cost of capital is 12%. The 5-year annuity factor at 12% is 3.6048. Should the company replace? Assume all flows occur at year-end.

Show the solution

Loss on sale of old machine = ₹3,00,000 − ₹1,00,000 = ₹2,00,000. Tax saved = 30% × ₹2,00,000 = ₹60,000.
Net initial outlay = ₹8,00,000 − ₹1,00,000 − ₹60,000 = ₹6,40,000.
Depreciation on new machine = ₹8,00,000 ÷ 5 = ₹1,60,000. Incremental depreciation = ₹1,60,000 − ₹60,000 = ₹1,00,000.
Incremental profit before tax = ₹2,50,000 − ₹1,00,000 = ₹1,50,000. Tax at 30% = ₹45,000. Profit after tax = ₹1,05,000.
Annual incremental CFAT = ₹1,05,000 + ₹1,00,000 = ₹2,05,000. Check: ₹2,50,000 × 0.7 = ₹1,75,000, plus ₹1,00,000 × 0.3 = ₹30,000, gives ₹2,05,000.
PV of CFAT = ₹2,05,000 × 3.6048 = ₹7,38,984.
NPV = ₹7,38,984 − ₹6,40,000 = ₹98,984.

Answer: NPV of replacement is ₹98,984, which is positive. The company should replace the old machine.

Example 2

Kaveri Logistics Ltd needs equipment costing ₹10,00,000 with a 5-year life and nil salvage value. It can buy it with a bank loan at 10% interest, or lease it for a year-end rental of ₹2,60,000 for 5 years. Depreciation is straight line and the tax rate is 30%. Ignore maintenance and other costs. The 5-year annuity factor at 7% is 4.1002. Should the company lease or buy?

Show the solution

Discount rate = post-tax cost of debt = 10% × (1 − 0.30) = 7%.
Cost of leasing: after-tax rental = ₹2,60,000 × 0.70 = ₹1,82,000 a year.
PV of leasing cost = ₹1,82,000 × 4.1002 = ₹7,46,236 (rounded).
Cost of buying: annual depreciation = ₹10,00,000 ÷ 5 = ₹2,00,000. Tax shield = 30% × ₹2,00,000 = ₹60,000 a year.
PV of tax shield = ₹60,000 × 4.1002 = ₹2,46,012.
Net cost of buying = ₹10,00,000 − ₹2,46,012 = ₹7,53,988.
NAL = ₹7,53,988 − ₹7,46,236 = ₹7,752 (rounded).

Answer: Leasing is cheaper by about ₹7,752 in present value terms, so Kaveri Logistics should lease. The gain is small, so a change in rental or salvage value could reverse the decision.

Exam tips

Start every written answer by naming the discount rate and why you chose it. Examiners give marks for that reasoning.
Set out a clean table of years against flows. Show the old and new depreciation as separate lines, so partial marks are safe if the arithmetic slips.
State assumptions where the question is silent, for example year-end flows, loss set off, or nil salvage.
In MCQs on inflation, check which basis the cash flows and the rate are in before computing anything.
End each answer with a one-line recommendation, and add a brief qualitative point such as technological risk or maintenance.

Practice questions from Investment Decisions, Project Planning and Control

Replacement, Lease and Special Investment Decisions in other exams

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

CMA IntermediateMaintenance Cost and Replacement Decisions

Replacement, Lease and Special Investment Decisions: frequently asked questions

Which discount rate do I use in a lease versus buy problem?

Use the post-tax cost of debt, which is the interest rate × (1 − tax rate). Lease rentals and loan payments are fixed, debt-like flows. If the question gives a specific rate for the comparison, use that.

How is the loss on sale of the old asset treated in a replacement decision?

The sale price is a cash inflow. If it is below book value, the loss can save tax if it can be set off, and that saving is an extra inflow at time zero. If the sale price is above book value, the gain adds to tax payable and reduces your inflow.

How do I handle inflation in capital budgeting?

Keep the basis consistent. Nominal cash flows go with a nominal rate. Real cash flows go with a real rate. Convert between rates with (1 + nominal) = (1 + real) × (1 + inflation). Different items may inflate at different rates, so inflate each one separately.

When should a project be abandoned?

Abandon when the after-tax salvage value is higher than the present value of the cash flows you expect from continuing. Test this at each possible abandonment date, and compare values at the same point in time.