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CMA Intermediate · Financial Management and Business Data Analytics · Sources of Finance

Kaveri Engineering can buy a machine for ₹10,00,000 or take it on a 5-year lease with annual rental of ₹2,60,000 payable at the end of each year. The machine's life is 5 years with nil salvage value; ignore tax. The firm's cost of capital is 10%. The PV annuity factor for 5 years at 10% is 3.791. Which decision is correct?

Leasing is preferable. The present value of the rentals is ₹2,60,000 × 3.791 = ₹9,85,660, which is lower than the ₹10,00,000 purchase cost, so leasing costs less in present value terms when there is no salvage value or tax.

  1. ABuy, because PV of lease rentals (₹9,85,660) is less than ₹10,00,000 so buying is cheaper
  2. BLease, because PV of lease rentals is ₹9,85,660, which is less than the purchase cost of ₹10,00,000Correct
  3. CLease, because total rentals of ₹13,00,000 exceed cost
  4. DBuy, because PV of rentals is ₹13,00,000

Explanation

PV of rentals = 2,60,000 × 3.791 = ₹9,85,660. Purchase outlay is ₹10,00,000 with no salvage or tax effects, so leasing has a lower present cost by ₹14,340. The first option states the right numbers but draws the wrong conclusion; undiscounted totals are irrelevant.

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