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ACCA Applied Skills · Financial Management · Specific investment decisions (lease or buy, asset replacement, capital rationing)

Sigma Co is comparing buying a machine with leasing it. Under both options it would pay insurance of $2,000 a year and charge depreciation in its accounts. If it leases, the lessor would bear maintenance costs of $3,000 a year, which Sigma would otherwise pay if it bought. Which item is a relevant cash flow in the lease-or-buy decision?

The relevant item is the $3,000 a year maintenance avoided under the lease. It is the only cash flow that differs between the options. Insurance is paid either way and accounting depreciation is not a cash flow, so neither affects the decision.

  1. AInsurance of $2,000 a year
  2. BMaintenance of $3,000 a year avoided under the leaseCorrect
  3. CDepreciation charged in the accounts
  4. DInsurance and depreciation together

Explanation

Only cash flows that differ between the options are relevant. Maintenance is paid only if Sigma buys, so the saving under a lease is incremental. Insurance is incurred under both options, and accounting depreciation is a non-cash item, so neither is relevant.

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