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CMA Final · Strategic Financial Management · Leasing Decisions

Sri Venkat Textiles can buy a machine for Rs 10,00,000 or lease it for 5 years at an annual rental of Rs 2,60,000 payable at the end of each year. Which is the correct statement about the nature of the lease decision, when the lessee's after-tax cost of debt is the discount rate?

The lease-or-buy question is a financing decision, because the investment in the asset is already justified. Rentals are fixed contractual obligations similar to debt service, so they are discounted at the lessee's after-tax cost of borrowing rather than WACC or cost of equity.

  1. AIt is purely an investment decision, so the lease rental must be discounted at the WACC
  2. BIt is a financing decision, so the cash flows are discounted at the after-tax cost of debtCorrect
  3. CIt is purely an operating decision, so the discount rate is the cost of equity
  4. DIt is a dividend decision, so no discount rate is required

Explanation

Once the asset is chosen on investment merits, lease versus buy is a financing choice. Lease rentals are contractual and debt-like, so they are discounted at the after-tax cost of debt. Using WACC or cost of equity would misstate the risk of these fixed flows.

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