Strategic Financial Management · Leasing Decisions

Advantages, Limitations and Lease Evaluation Factors

Updated 11 October 2026 · Fact-checked

Leasing lets a firm use an asset by paying rentals instead of buying it. Advantages include less upfront cash, tax shield on rentals and flexibility; limitations include no ownership, higher total cost and lost salvage value. To decide, compare lease with borrow-and-buy on after-tax cost, and add non-financial factors.

Understand Advantages, Limitations and Lease Evaluation Factors

A lease is a contract where the lessor owns an asset and lets the lessee use it for rentals over a period. The lessee gets use. The lessor keeps ownership and earns a return.

For the lessee, the main benefits are: little or no upfront outlay, so cash and borrowing capacity are preserved; rentals are usually tax-deductible; the asset can be matched to its useful life; and the risk of obsolescence can be shifted to the lessor, especially in an operating lease. Leasing can also be quicker to arrange than a term loan.

The lessee's drawbacks are: no ownership, so no salvage value or capital gain; the total rentals often exceed the cost of buying with a loan; the lessee cannot claim depreciation (the lessor does); there is a fixed commitment which is hard to cancel in a finance lease; and the lessee may face restrictions on modifying the asset.

For the lessor, the benefits are a steady rental income, tax benefit from depreciation, and retained ownership as security. The risks are default by the lessee, obsolescence or a low residual value, the lessor's own funding cost, and the tax-law risk that depreciation benefits cannot be fully used if the lessor has insufficient profits.

A lease proposal is evaluated by both financial and non-financial factors. Financially, you compare the after-tax cost of leasing with the after-tax cost of borrowing and buying, discounting at the after-tax cost of debt. Non-financial factors include obsolescence, maintenance, flexibility and effect on credit capacity.

Key rules to remember

Discount rate for lease vs buy: Kd (after tax) = Kd × (1 − t); Lease and loan flows are fairly certain, so the after-tax cost of debt is the usual discount rate.
Net advantage of leasing (NAL): NAL = PV of cost of buying − PV of cost of leasing; Positive NAL means lease. Express both as costs on the same basis.
After-tax lease rental: Rental × (1 − t); Use when rentals are tax-deductible and the firm pays tax.
Tax shield on depreciation: Depreciation × t; Applies only under buying, since the lessee does not claim depreciation on a leased asset.

How to solve Advantages, Limitations and Lease Evaluation Factors questions

Use this method for both theory and numerical questions on whether to lease or buy.

1Identify the role asked: lessee, lessor, or both. Advantages differ by role.
2List the financial points: upfront cash, tax effect of rentals versus depreciation and interest, total cost, salvage value.
3List the non-financial points: obsolescence, maintenance, flexibility, borrowing capacity, restrictive covenants.
4If numbers are given, find the after-tax cost of debt, Kd × (1 − t), as the discount rate.
5Compute the PV of the after-tax cost of leasing, and the PV of the after-tax cost of buying net of depreciation tax shield, interest shield and salvage.
6Compare the two costs and compute NAL.
7Give a clear recommendation and mention at least one non-financial factor that could change it.

Quickest way: Two-column lease vs buy check

When to use it: Use for short theory answers and for 2-mark MCQs on merits and demerits.

Draw two columns: Lease and Buy.
Under Lease, note cash saved, tax-deductible rentals, obsolescence passed on.
Under Buy, note ownership, salvage value, depreciation shield, lower long-run cost.
Name the deciding test: the lower PV of after-tax cost.
Close with the recommendation and one qualitative factor.

Common mistakes in Advantages, Limitations and Lease Evaluation Factors

Mixing lessee and lessor advantages in one list.
Students recall a general list of merits without checking the role.
Fix: Write the role at the top of the answer and keep points separate.
Claiming leasing is always cheaper.
Lower upfront cash feels like lower cost.
Fix: Say the total cost is decided by comparing PV of after-tax costs. Leasing often costs more overall.
Discounting at the cost of capital instead of the after-tax cost of debt.
Habit from capital budgeting.
Fix: Lease flows are debt-like, so use Kd × (1 − t).
Giving the lessee depreciation on a leased asset.
Confusion over who owns the asset.
Fix: The lessor claims depreciation. The lessee claims it only if it buys.
Ignoring salvage value in the buy option.
Focus is on rentals and loan payments.
Fix: Include the salvage value as an inflow, with any tax on it, in the buying option.

Worked examples

Example 1

Explain four advantages and four limitations of leasing from the lessee's point of view, ending with a view on how a lessee should decide.

Show the solution

Advantages: little upfront cash; rentals are tax-deductible; obsolescence risk can be passed to the lessor; arranged quickly without heavy security.
Limitations: lessee does not own the asset or get salvage value; total rentals often exceed the cost of buying with a loan; lessee cannot claim depreciation; finance leases are hard to cancel.
Decision: compare the PV of after-tax cost of leasing with the PV of after-tax cost of borrowing and buying.
Discount at the after-tax cost of debt, and add qualitative factors such as obsolescence and flexibility.

Answer: Lease if the net advantage of leasing is positive, after considering non-financial factors.

Example 2

A firm can lease a machine at an annual rental of ₹1,00,000 for 3 years, paid at year-end. The tax rate is 30% and the pre-tax cost of debt is 10%. Find the PV of the after-tax cost of leasing.

Show the solution

After-tax cost of debt = 10% × (1 − 0.30) = 7%.
After-tax rental = ₹1,00,000 × 0.70 = ₹70,000 per year.
PV factor for 3 years at 7% = 1/1.07 + 1/1.07² + 1/1.07³ = 0.9346 + 0.8734 + 0.8163 = 2.6243.
PV of cost = ₹70,000 × 2.6243 = ₹1,83,701.

Answer: PV of the after-tax cost of leasing is about ₹1,83,701. Compare this with the PV of the cost of buying to decide.

Exam tips

Read whether the question asks for the lessee, the lessor or both, and structure the answer accordingly.
In theory answers, give 4 to 5 points each for advantages and limitations, then add the evaluation factors.
In numericals, state the discount rate and why you chose it.
Always finish with a recommendation, and mention one qualitative factor.
For MCQs, remember that the lessor claims depreciation and leasing does not give ownership.

Practice questions from Leasing Decisions

Advantages, Limitations and Lease Evaluation Factors in other exams

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

Advantages, Limitations and Lease Evaluation Factors: frequently asked questions

What are the main advantages of leasing for a lessee?

Less upfront cash, tax-deductible rentals, protection from obsolescence and quicker arrangement. It also keeps borrowing capacity free for other uses.

What are the main disadvantages of leasing?

The lessee does not own the asset or get its salvage value. Total cost can exceed that of buying, and a finance lease is a fixed commitment that is hard to cancel.

Why is the after-tax cost of debt used in lease vs borrow decisions?

Lease rentals are contractual and fairly certain, like loan payments. So they carry debt-like risk and are discounted at the after-tax cost of debt.

What factors apart from cost affect a lease decision?

Obsolescence risk, maintenance responsibility, flexibility, effect on credit capacity, lease terms and the lessor's reliability.