Lease Versus Buy Decision Analysis for Corporates (CAIIB ABFM)

Every CAIIB ABFM paper carries at least one problem on lease versus buy decision analysis, and the marks are lost less often on the arithmetic than on the framing. The investment decision — should the asset be acquired at all — is assumed settled before this analysis begins. What remains is purely a financing choice: fund the asset through a term loan and own it, or route the same asset through a lessor and pay rentals instead. This article builds the incremental cash flow schedule for both sides, fixes the correct discount rate, and walks through the net advantage of leasing the way the exam actually sets it.

📊 Why Lease Versus Buy Is a Financing Decision, Not an Investment Decision

The starting assumption in any lease versus buy decision analysis is that the capital budgeting call has already been made. NPV or IRR has cleared the project; the asset is going onto the books one way or another. That discipline mirrors the same instinct you build while studying Planning as a management function — commit to the objective first, then choose the route. Confusing the two decisions is the single most common exam trap: candidates try to re-run project NPV inside a leasing problem and lose time on cash flows that are irrelevant here.

Because the investment decision is closed, only the cash flows that differ between financing routes matter: the loan instalment and its tax shields on one side, the lease rental and its tax shield on the other. Revenue from using the asset, operating costs, and working capital effects are identical whether you lease or buy, so they net out and never enter the schedule. This is what makes the problem a pure financing comparison, and it is why the discount rate has to be a financing rate, not a project hurdle rate.

Getting this framing wrong early costs the rest of the answer, because every subsequent cash flow line depends on treating only financing-side flows as incremental.

💰 Building the Buy Option Cash Flow Schedule

Under the buy option, the firm takes a term loan, owns the asset, and claims depreciation. The cash outflow schedule has four components in every year of the loan tenor: the loan instalment (principal plus interest), the interest tax shield, the depreciation tax shield, and — only in the terminal year — the salvage value net of any tax on the profit or loss on sale.

💡 Exam Tip: Write the buy cash flow schedule as a year-by-year table in your answer sheet — loan instalment, interest tax shield, depreciation tax shield, terminal salvage — before touching present values. Examiners award marks line by line even if the final figure slips.

The interest tax shield equals interest paid multiplied by the marginal tax rate; it falls each year as the outstanding principal amortises. The depreciation tax shield equals the depreciation charge (written down value or straight line, as the question specifies) multiplied by the tax rate, and it is available regardless of how the purchase was funded — cash, loan, or internal accruals — because ownership, not the financing route, drives the depreciation claim under the Income-tax Act. Candidates frequently forget that the loan instalment already contains the interest that is separately tax-shielded; double count that and the whole schedule is wrong.

The terminal salvage value is added back in the last year, and if the asset is sold above written down value, the excess is taxed as a short-term gain. Lay this out year by year and you have the complete outflow side of the buy option.

📝 The Lease Option Cash Flows and the Discount Rate

The lease option is simpler to lay out but easy to misprice. The lessee pays a lease rental each year, which is generally allowable in full as a deduction against income, giving a tax shield equal to the rental multiplied by the tax rate. In exchange, the lessee gives up two things it would have had under ownership: the depreciation tax shield and the residual salvage value at the end of the asset's life, both of which now belong to the lessor.

The net after-tax cash outflow under the lease, year by year, is simply the lease rental less its tax shield. There is no principal repayment line and no separate interest line — the rental already bundles the financing cost and is not split for tax purposes the way a loan instalment is.

⚠️ Common Mistake: Discounting the buy and lease schedules at the weighted average cost of capital. Both schedules are streams of financing cash flows with debt-like certainty, so the correct rate is the after-tax cost of debt, not WACC. Using WACC understates the tax shields and skews the comparison toward leasing.

The after-tax cost of debt is used because both alternatives are debt substitutes — a lease is, in substance, a way of borrowing to acquire the use of an asset. The cash flows are contractual and near-certain, matching the risk profile of debt, not of the firm's overall operations. This is the crux that separates lease versus buy decision analysis from ordinary capital budgeting: financing risk is being compared with financing risk, so a financing rate must do the discounting, not the project's WACC.

⚖️ Net Advantage of Leasing and Break-Even Lease Rental

The net advantage of leasing, NAL, is the present value of the buy option's after-tax outflows minus the present value of the lease option's after-tax outflows, both discounted at the after-tax cost of debt. A positive NAL means leasing saves money relative to buying; a negative NAL means the loan route is cheaper once tax shields and salvage are accounted for.

Take a compact illustration of the kind the exam sets. An asset costs 50 lakh, financed either by a five-year loan at 12 percent or a five-year lease at an annual rental of 13 lakh, tax rate 25 percent, straight-line depreciation to a nil residual value, and no expected salvage. Under the buy option you compute the yearly loan instalment, split it into interest and principal, apply the 25 percent tax shield to both the interest and the 10 lakh annual depreciation, and discount the net outflow at the after-tax cost of debt of 9 percent (12 percent less the 25 percent tax rate). Under the lease option, the rental of 13 lakh less its 25 percent tax shield gives a net annual outflow of 9.75 lakh, discounted at the same 9 percent. Comparing the two present values gives the NAL for this lease versus buy decision analysis.

The break-even lease rental is the annual rental at which NAL equals zero — the ceiling rental a lessee should be willing to pay before buying becomes cheaper. Solve for it by setting the present value of the buy outflows equal to the present value of (rental minus its tax shield), and back-solve for the rental. Any quoted rental above this figure tips the decision toward buying.

The table above summarises the core trade-offs a lease versus buy decision analysis must weigh before the numbers are even run.

🏦 The Lessor's Side: Target IRR and Ind AS 116 Classification

Every lease versus buy decision analysis has a mirror image on the lessor's desk. The lessor prices the lease rental so that the internal rate of return on its own cash flows — the asset cost paid out, the rentals received, the tax shields the lessor claims as owner, and the residual value at lease end — clears its required return, typically its own cost of capital adjusted for the credit risk of the lessee. Set the rental too low and the lessor's IRR falls short; set it too high and the lessor loses the deal to a bank loan. If the lessee later defaults, the lessor's recovery runs through the same insolvency machinery as any other creditor — see our guide on the corporate insolvency resolution process for how that plays out under the IBC.

Classification under Ind AS 116 decides how both sides account for the transaction. A finance lease transfers substantially all the risks and rewards of ownership to the lessee — a long lease term relative to asset life, a bargain purchase option, or the present value of rentals covering nearly the full fair value — and the lessee recognises a right-of-use asset with a matching lease liability, depreciating the asset and expensing interest separately, much like the buy option's own tax shields. Under Ind AS 116 most lessee accounting looks similar whether the lease is classified as finance or operating, but the lessor still splits its own books between the two: a finance lease lessor derecognises the asset and books a receivable, while an operating lease lessor keeps the asset on its own balance sheet, along with its depreciation and residual value risk. Where lease exposures sit within a bank's lending book, they follow the credit appraisal and provisioning discipline outlined by the Reserve Bank of India for such financing exposures.

Recognising which side of the transaction you are being asked to evaluate — lessee cash outflows or lessor IRR — is often what separates a correctly scoped answer from a wrong one built on the right formulas.

🧠 Practice MCQs: Lease vs Buy Decisions

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Practising This Topic Before the Exam

CAIIB ABFM numericals on lease versus buy decision analysis reward candidates who separate the investment decision from the financing decision, build both cash flow schedules cleanly, and never let WACC creep into the discounting. Revisit the chapter on Controlling for how post-decision monitoring of loan and lease commitments fits into the broader ABFM syllabus, and pair this topic with capital structure theories and economic value added EVA to see how financing choices connect across the paper. Check how leasing interacts with cash conversion cycle and working capital management when rentals replace loan instalments in the cash budget, and browse more coverage on the ABFM tag hub.

Run a few full numericals under timed conditions before exam day, then head to the CAIIB course page for structured practice — that is where these questions are actually won or lost.