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CMA Final · Strategic Financial Management

Leasing Decisions for CMA Final Strategic Financial Management

Leasing decisions ask whether an asset should be leased or bought, and at what rental a lease is worth offering. The lessee compares the present value of after-tax lease costs with the cost of buying. The lessor checks that the NPV of rentals is not negative. Solve it by discounting after-tax cash flows.

What this chapter covers

This chapter in Paper 14 covers leasing as a way to finance an asset. You first learn the types of lease: finance lease and operating lease, sale and leaseback, and leveraged lease. Then you learn the advantages, limitations and the factors that decide whether leasing suits a firm.

The core of the chapter is numerical. From the lessee's side, you compare leasing with borrowing to buy, using the present value of after-tax cash outflows. From the lessor's side, you test whether the rentals earn an acceptable return on the asset cost, using NPV or IRR. The last topics cover the equated annual charge, the break-even lease rental and cross-border leasing.

The chapter links closely to the rest of the paper. It uses capital budgeting ideas such as NPV, IRR and the cost of capital. It also draws on the cost of debt after tax, and on the lease-or-buy choice that sits inside long-term financing and investment decisions. If your time value and NPV basics are weak, fix them first.

Leasing is a compact chapter with a clear method, so you can score well once the steps are in your hand. It can feed Section A as short conceptual MCQs on lease types and features, and a descriptive question can ask for a lease-or-buy workings with a recommendation. The same NPV method repeats across questions, so effort here is reused. Marks are lost mostly through small errors in tax, depreciation and discount rate, which practice can remove.

Leasing Decisions: topics in the order to study them

  1. 1Introduction to Leasing and Types of LeasesYou need the terms and lease types first, because every later calculation depends on who bears what cost in each type.
  2. 2Advantages, Limitations and Lease Evaluation FactorsThis is mostly theory and builds the reasoning behind the numbers, so it is quick to finish before the calculations.
  3. 3Lease Evaluation from the Lessee's PerspectiveThis is the main numerical method, the lease-or-buy comparison, and the most likely area for a written question.
  4. 4Lease Evaluation from the Lessor's PerspectiveIt reverses the same cash flows, so it is easy once you have done the lessee's view.
  5. 5Equated Annual Charge, Break-even Lease Rental and Cross-border LeasingThese extend the earlier methods, so they come last, when NPV and annuity workings are comfortable.

How to prepare Leasing Decisions

Treat the chapter as one method applied from two sides. Build the method first, then practise until the workings are automatic.

  1. Read the lease types and write a one-line definition of each, with who owns the asset and who bears maintenance and risk.
  2. Learn the advantages, limitations and evaluation factors as short lists you can reproduce in a few lines of a descriptive answer.
  3. Solve a lease-or-buy problem slowly, laying out a table of year, cash flow, tax effect and discount factor. Always use the after-tax cost of debt as the discount rate unless the question says otherwise.
  4. Note how depreciation, tax shield and salvage value are treated in the buy option, and how the rental and its tax saving are treated in the lease option.
  5. Redo the same data from the lessor's side and check that you understand why the lessee's gain and the lessor's gain are linked.
  6. Practise equated annual charge and break-even rental, then read the cross-border points as theory.
  7. Finish with timed questions that end in a clear recommendation, stated in one sentence with the figures that support it.

Common mistakes in Leasing Decisions

  • Discounting at the wrong rate

    Fix: Read the question for the rate to use. For lease versus borrow, the after-tax cost of debt is the usual base.

  • Ignoring the tax shield on depreciation or on rentals

    Fix: Make tax a separate column in your table, and check it for every year.

  • Leaving out salvage value or counting it in the wrong option

    Fix: Include salvage in the buy option, and in the lease option only if the question gives it to the lessee.

  • Mixing up the timing of rentals

    Fix: Mark each cash flow on a timeline, and use year 0 for payments made in advance.

  • Stopping at a number without a recommendation

    Fix: Write one final line: which option to choose and why, quoting the present values.

  • Writing generic theory for advantages and limitations

    Fix: Pick the points that fit the firm in the question, and tie each to its facts.

Last-day revision: Leasing Decisions

  • In a finance lease the lessee bears most risks and rewards of ownership; an operating lease is short term and the lessor bears them.
  • Sale and leaseback means selling an owned asset and taking it back on lease.
  • Lease or buy: compare present values of after-tax cash outflows under each option.
  • Rentals are tax deductible, so the lessee's relevant outflow is rental × (1 − tax rate), unless the question states otherwise.
  • Under buying, count the loan repayment or purchase cost, depreciation tax shield and salvage value.
  • Discount at the after-tax cost of debt when the lease is treated as a debt substitute.
  • Choose the option with the lower present value of net cost.
  • Lessor's view: accept if the NPV of rentals, tax and residual value is not negative against the asset cost.
  • Equated annual charge = present value of cost ÷ annuity factor; the lower charge is preferred.
  • Break-even lease rental is the rental at which the lessee is indifferent between leasing and buying.
  • Cross-border leasing adds exchange rate, tax treaty and legal issues.
  • State the recommendation clearly at the end of every numerical answer.

Leasing Decisions practice questions

Leasing Decisions in other exams

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

Leasing Decisions: frequently asked questions

Is Leasing Decisions a numerical or theory chapter in CMA Final SFM?

It is both. The types, advantages and limitations can come as short theory or MCQs. The lessee and lessor evaluations are numerical and need a clear recommendation.

Which discount rate should I use for a lease-or-buy problem?

Use the rate the question gives. If nothing else is stated, the after-tax cost of debt is the usual choice, because a lease is treated as a substitute for borrowing.

How do the lessee's and lessor's evaluations differ?

The lessee compares the net cost of leasing with the net cost of buying. The lessor checks whether the rentals and residual value give an acceptable return on the asset cost. The cash flows are linked, but the decision rule differs.

What is the break-even lease rental?

It is the rental at which the lessee is indifferent between leasing and buying, because the present value of costs is the same. Above that rental, buying is better for the lessee.