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CA Intermediate · Financial Management and Strategic Management · Types of Financing

A company leases a machine from a lessor for 5 years with annual lease rentals payable at the end of each year. The lessee's after-tax analysis shows that the lease is preferred when the present value of after-tax lease payments, discounted at the after-tax cost of borrowing, is less than the net cost of buying. Which discount rate is conventionally used in this lease-versus-buy comparison?

The lessee's after-tax cost of debt is used. Lease rentals are fixed, contractual obligations similar to loan repayments, so their risk is debt-like, and tax shields are already reflected, making after-tax cost of debt the appropriate rate for comparing leasing with borrowing to buy.

  1. AThe lessee's after-tax cost of debtCorrect
  2. BThe lessee's cost of equity
  3. CThe lessor's pre-tax yield
  4. DThe overall WACC before tax

Explanation

Lease payments are contractual and debt-like, so their risk matches borrowing. They are therefore discounted at the after-tax cost of debt. Using cost of equity would overstate the discount rate and undervalue the lease obligations.

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