CMA Final · Strategic Financial Management · Leasing Decisions
A lessee compares leasing with borrowing to buy an asset costing Rs 10,00,000. Pre-tax cost of debt is 12% and the tax rate is 25%. Which discount rate should be used to discount the after-tax lease cash flows in the lease-versus-buy analysis?
The discount rate is 9%, the after-tax cost of debt, calculated as 12% multiplied by one minus the 25% tax rate. Lease flows are debt-like and risk-comparable to borrowing, so the after-tax borrowing cost is appropriate rather than the pre-tax rate.
- A12%
- B9%Correct
- C25%
- D15%
Explanation
Lease payments are a financing alternative to debt, so the after-tax cost of debt is used: 12% x (1 - 0.25) = 9%. Using 12% ignores the tax shield on interest. 25% is the tax rate, not a cost of capital.
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