IAI Actuarial Core Principles · Business Finance · Financial instruments issued or used by companies
Sundaram Textiles can buy a machine for ₹10,00,000 financed by a 5-year bank loan at 10% pre-tax, or lease it. Tax is 30% and the lessee's after-tax cost of borrowing is used to discount lease flows. Which discount rate should be used in a lease-versus-borrow comparison?
The appropriate rate is 7%, the after-tax cost of borrowing. Interest on the loan is tax deductible, so 10% is multiplied by one minus the 30% tax rate. Using the pre-tax 10% would ignore the tax shield and bias the lease-or-borrow decision.
- A10%
- B7%Correct
- C13%
- D3%
- 30%
Explanation
Lease payments and loan interest are both tax deductible, so the comparison uses the after-tax cost of debt: 10% x (1 - 0.30) = 7%. Using 10% ignores the tax shield. 13% adds tax instead of deducting it, and 3% is the tax shield alone.
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