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

Zeta Co is evaluating whether to lease or buy an item of equipment. The company can borrow at a pre-tax rate of 8% and pays tax at 25%. Which rate should be used to discount the incremental cash flows of the lease-or-buy decision?

The correct rate is 6%, the post-tax cost of borrowing. Leasing is a financing alternative to borrowing and buying, so cash flows are discounted at the cost of debt after tax relief: 8% multiplied by (1 minus 25%) gives 6%.

  1. A8%
  2. B6%Correct
  3. C10.67%
  4. D2%

Explanation

A lease is an alternative to borrowing to buy, so the cash flows are discounted at the post-tax cost of borrowing: 8% × (1 − 0.25) = 6%. Using 8% ignores tax relief on interest. 10.67% grosses the rate up instead of down, and 2% is just the tax saving.

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