A company needs a ₦2m machine. It can borrow and buy, or it can lease. The salesperson says leasing keeps cash free. The finance director asks a better question: which route costs less once tax is counted? Before that, there is an earlier question that people often skip: should the machine be acquired at all? Mixing the two questions is a classic exam mistake.
This topic covers the two stages of a lease or buy decision (the acquisition decision and the financing decision), finance and operating leases and IFRS 16, the relevant cash flows for each route, the post-tax cost of borrowing as the discount rate, and how to compare the present value of the costs. The previous topic covered decision trees and risk-adjusted rates.
The next covers asset replacement. Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on this topic.
In 30 seconds
Decide in two stages. Stage 1, acquisition: is the asset worth having? Use NPV at the normal post-tax cost of capital. Stage 2, financing: if yes, which method costs less? Compare the PV of the costs and pick the lower, discounting at the post-tax cost of borrowing (pre-tax rate × (1 − tax rate)).
The PV of loan interest and its tax relief at that rate equals the amount borrowed, so for borrow and buy the cost is the loan minus the PV of the tax saved on capital allowances. For an operating lease the lessee claims no allowances and gets tax relief on the full rentals.
For a finance lease the lessee can claim the allowances, so they cancel out, and only the tax relief on the interest part of the rentals differs. Under IFRS 16 a lessee shows all leases on the statement of financial position, but tax still uses the operating and finance distinction.
Key terms in plain English
| Term | What it means |
|---|---|
| Acquisition decision | Whether to get the asset at all |
| Financing decision | How to pay for the asset once it is wanted |
| Finance lease | A lease that passes substantially all risks and rewards of ownership to the lessee |
| Operating lease | A lease that does not pass them |
| Lessor | The owner who leases the asset out |
| Lessee | The user who leases the asset in |
| Rental | The regular payment under a lease |
| Post-tax cost of borrowing | The loan interest rate after tax relief |
Syllabus check
This topic is in syllabus area B (advanced investment appraisal, 30% of the marks). It covers:
- the lease or buy decision and its relevant cash flows;
- the distinction between finance and operating leases for tax;
- the choice between borrowing to buy and leasing.
CAMA 2020 and leasing
The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.
| Section | What it says | Link to this topic |
|---|---|---|
| s. 305 | A director must act in good faith in the best interests of the company | Financing should be chosen to minimise cost to the company |
| s. 308 | A director must use the care, diligence and skill of a reasonably prudent director | Directors should test the assumptions behind a financing choice |
| s. 377(1) and s. 378 | Directors prepare statements that follow IFRS and give a true and fair view | Decisions later affect reported assets, profit and cash |
| s. 385 | The directors’ report covers performance and risk | Major plans and risks are reported to shareholders |
A company that buys an asset, or leases it under a finance lease, claims the capital allowances; under an operating lease the lessor claims them. From 1 January 2026 company tax is governed by the Nigeria Tax Act 2025, which taxes companies at 30% and exempts small companies. In examination questions, use the rates and allowances given in the question.
The two stages
Stage 1, the acquisition decision. Assume the asset is bought. Use normal NPV: the purchase cost, extra revenues and costs, working capital, the residual value, and the tax on profits and the tax saved by capital allowances, discounted at the company’s normal post-tax cost of capital.
Stage 2, the financing decision. Only if the NPV is positive. The asset will be acquired whichever way it is financed, so any cash flow that is the same under both methods is not relevant. Choose the method with the lower PV of cost.
Types of lease
A finance lease transfers substantially all the risks and rewards of ownership. Signs: an option to buy at a price well below the expected fair value; a term covering most of the asset’s economic life; PV of the payments substantially equal to or above the fair value; or an asset so specialised that only the lessee can use it. An operating lease does not. Substance, not legal form, decides.
IFRS 16 has replaced IAS 17. A lessee now shows all leases on its statement of financial position, so for the lessee the accounting split has gone. The lessor still classifies leases, and tax law still refers to operating and finance leases when deciding what rentals are deductible, so the distinction still matters for this decision.
Relevant cash flows
| Cash flow | Borrow and buy | Finance lease | Operating lease |
|---|---|---|---|
| Purchase price (the amount borrowed) | Yes | No | No |
| Disposal proceeds of the asset | Yes | No | No |
| Tax saved on capital allowances | Yes | Same under both, so ignore | Yes (lessee gets none) |
| Lease rentals | No | Yes | Yes |
| Tax relief on rentals | No | Interest part only | Full rental |
The discount rate is the post-tax cost of borrowing. Borrowing at 14% with tax at 30% gives 14% × 0.7 = 9.8%. The tax relief on interest is already in that rate, and the PV of the loan’s interest and relief at 9.8% equals the sum borrowed, so the loan cash flows can be replaced by the amount borrowed.
For borrow and buy, PV of cost = loan amount − PV of the tax saved by capital allowances (and − PV of the disposal proceeds, if any). For a finance lease, the allowances are claimed either way, so compare the loan with the PV of the rentals less the tax relief on the interest part.
To find the interest part, estimate the lease’s implicit rate (the IRR of the rentals against the asset price) and build an amortisation table.
ICAN’s example (Crimson). A machine costs ₦3m, lasts three years with no residual value and gives operating cash surpluses of ₦1.6m a year. Allowances are 15% straight-line. Tax is 30%, paid one year in arrears. The after-tax cost of capital is 20%. Borrowing costs 14% before tax. Leasing costs ₦1.3m a year in arrears (a finance lease).
- Acquisition: NPV at 20% is about +₦50,000 (₦50k), so acquire the machine.
- Financing:
post-tax borrowing cost = 14% × 0.7 = 9.8%.
The lease’s implicit rate is about 14.4%, so the interest in the rentals is ₦431k, ₦306k and ₦163k, giving tax relief of ₦130k, ₦92k and ₦49k one year in arrears. - PV of leasing = about ₦3.03m against ₦3.0m for buying with the loan. Borrow and buy.
The rules in more depth
Why the two stages are separate
A poor project does not become good because it is leased. If the NPV in Stage 1 is negative, the asset should not be acquired at all.
Why the discount rate is the post-tax cost of borrowing
Leasing is a substitute for borrowing, so its cash flows are compared with the cost of the loan it replaces, after tax.
Why allowances drop out for a finance lease
The lessee claims them whether it buys or leases, so they do not differ between the options.
Why only the interest in a finance lease gets tax relief
The capital part of the rental repays the cost of the asset, which is dealt with through allowances. Only the finance charge is a deductible expense.
Effect on analysis
Build two columns of costs, discount both at the post-tax borrowing rate, compare the PVs and recommend the cheaper, adding any non-financial factors such as flexibility and obsolescence risk.
Worked examples
Example 1: borrow and buy against an operating lease. A machine costs ₦2,000k. Allowances are straight-line over four years (₦500k a year). Tax is 30%, paid in the same year. The loan costs 12% before tax. An operating lease costs ₦550k a year for four years in arrears. The annuity factor for 4 years at 8.4% is 3.283.
- Post-tax cost of borrowing.
12% × 0.7 = 8.4%. - Buying.
tax saved = 500 × 30% = 150 a year.
PV = 150 × 3.283 = 492.
Cost = 2,000 − 492 = ₦1,508k. - Leasing.
relief = 550 × 30% = 165, so net rental = 385.
PV = 385 × 3.283 = ₦1,264k.
Lease: it is about ₦244k cheaper.
Example 2: classifying a lease. The lease runs for 9 of the asset’s 10 years, the PV of the payments is 97% of the fair value and the lessee may buy at the end for a nominal sum.
- The term covers most of the economic life.
- The PV of payments is substantially the whole fair value.
- There is a bargain purchase option, so it is a finance lease.
Example 3: relevant flows. A company will lease a truck under an operating lease. Which flows differ between buying with a loan and leasing?
- Relevant: the loan amount, the rentals, the tax relief on the full rentals, the tax saved on allowances and any disposal proceeds.
- Not relevant: running costs and revenues from using the truck, because they are the same either way.
- Discount at the post-tax cost of borrowing.
Example 4: the first stage fails. A project NPV at the normal post-tax cost of capital is −₦300k.
- The asset should not be acquired.
- Leasing would not change the underlying NPV, which is a measure of the project.
- No financing comparison is needed.
How to score full marks
- Split the answer into the acquisition and financing decisions.
- State the type of lease and who claims the allowances.
- Discount financing flows at the post-tax cost of borrowing.
- Include only the flows that differ.
- Compare the PVs of cost and recommend the lower.
- Add non-financial points such as flexibility and obsolescence.
Common mistakes in the exam
- Using the project discount rate for the financing comparison.
- Including running costs that are the same under both options.
- Giving the operating lessee capital allowances.
- Giving tax relief on the full rentals of a finance lease.
- Skipping the acquisition decision.
- Choosing the highest PV of cost.
Quick revision
- Stage 1: NPV of the project. Stage 2: lowest PV of financing cost.
- Discount at the post-tax cost of borrowing.
- Borrow and buy: loan minus PV of allowance savings.
- Operating lease: relief on full rentals, no allowances for the lessee.
- Finance lease: allowances equal under both; relief on the interest part.
- IFRS 16: lessee capitalises all leases; tax still uses the old split.
- CAMA 2020: ss. 305, 308, 377(1), 378, 385.
Practice questions
These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.
Recall check: multiple choice
Recent ICAN papers are written, although older papers such as May 2014 included multiple-choice questions. These questions are for quick recall. The written questions that follow are closer to the exam.
Question 1. The first stage of a lease or buy decision is:
- Choosing the financing
- Deciding whether to acquire the asset
- Valuing the lease
- Setting rentals
Show the answer
B. Use NPV.
Question 2. The financing cash flows are discounted at:
- The post-tax cost of borrowing
- The WACC
- Zero
- The inflation rate
Show the answer
A. Pre-tax rate × (1 − tax rate).
Question 3. Post-tax cost of 14% borrowing at 30% tax is:
- 9.8%
- 14%
- 4.2%
- 16%
Show the answer
A. 14% × 0.7.
Question 4. A lease that transfers substantially all risks and rewards of ownership is a:
- Finance lease
- Operating lease
- Short lease
- Sale only
Show the answer
A. Substance over form.
Question 5. An operating lessee, as ICAN describes the tax rules, claims:
- Capital allowances
- No capital allowances
- Double allowances
- Balancing charges
Show the answer
B. The lessor claims them.
Question 6. For a finance lease, tax relief on rentals is on:
- The full rental
- The interest part only
- Nothing
- The capital part only
Show the answer
B. The rest goes through allowances.
Question 7. The preferred financing method has:
- The higher PV of cost
- The lower PV of cost
- The longer term
- The higher tax
Show the answer
B. It is the cheaper option.
Question 8. Under IFRS 16 a lessee:
- Capitalises all leases
- Capitalises only finance leases
- Capitalises no leases
- Ignores rentals
Show the answer
A. The old split no longer applies to lessees.
Question 9. Costs that are the same under both financing options are:
- Relevant
- Not relevant to the financing choice
- Doubled
- Deducted from NPV
Show the answer
B. Ignore them.
Question 10. Which section of CAMA 2020 sets the director’s duty of care and skill?
- Section 308
- Section 400
- Section 405
- Section 409
Show the answer
A. Directors should test the assumptions behind a decision.
Written questions
Question 11 (10 marks). (a) Explain the two stages of a lease or buy decision. (4 marks) (b) State four features that indicate a finance lease. (4 marks) (c) Explain what IFRS 16 changed for lessees. (2 marks)
Question 12 (20 marks). Ife Ltd will acquire a machine costing ₦2,000k, with no residual value and straight-line allowances over four years. Tax is 30%, paid in the same year. It can borrow at 12% before tax or take an operating lease at ₦550k a year for four years in arrears. The annuity factor for 4 years at 8.4% is 3.283. (a) Calculate the post-tax cost of borrowing.
(2 marks) (b) Calculate the PV of the cost of borrowing and buying. (7 marks) (c) Calculate the PV of the cost of leasing. (6 marks) (d) Recommend and give two non-financial factors. (5 marks)
Question 13 (10 marks). (a) Explain why allowances are ignored when comparing borrowing with a finance lease. (4 marks) (b) Explain why only the interest part of a finance lease rental is tax deductible. (3 marks) (c) State why the post-tax cost of borrowing is used. (3 marks)
Model answers
Show the model answer to Question 11
(a) Stages (4 marks). The acquisition decision: should the asset be acquired? It uses NPV at the normal cost of capital. (2) The financing decision: if so, which method costs least? It compares the PV of costs. (2)
(b) Finance lease features (4 marks). An option to buy at a price well below fair value; the term covers most of the economic life; the PV of payments is substantially the whole fair value; the asset is so specialised that only the lessee can use it. (1 each)
(c) IFRS 16 (2 marks). A lessee shows all leases on the statement of financial position, so the operating and finance split no longer applies to its accounting. (2)
Show the model answer to Question 12
(a) Rate (2 marks). 12% × (1 − 0.30) = 8.4%. (2)
(b) Buying (7 marks).
- Amount borrowed = ₦2,000k. (1)
- Annual allowance.
2,000 ÷ 4 = 500, so tax saved = 500 × 30% = ₦150k a year. (2) - PV of tax saved.
150 × 3.283 = ₦492k. (2) - PV of cost.
2,000 − 492 = ₦1,508k. (2)
(c) Leasing (6 marks).
- Rental ₦550k, tax relief 30% = ₦165k, so net ₦385k a year. (3)
- PV = 385 × 3.283 = ₦1,264k. (3)
(d) Recommendation (5 marks). Lease, because its PV of cost is about ₦244k lower. (2) Non-financial: flexibility to change the machine; protection against obsolescence; the lessor’s maintenance; or the loss of ownership and control. Any two. (3)
Show the model answer to Question 13
(a) Allowances (4 marks). A finance lessee can claim allowances whether it buys or leases, so the tax saving is the same under both options. (2) Only cash flows that differ between the options are relevant. (2)
(b) Interest part (3 marks). The capital part of the rental repays the cost of the asset, which is relieved through allowances. (1.5) Only the finance charge is an expense for tax. (1.5)
(c) Post-tax cost (3 marks). Leasing is an alternative to borrowing, so its cash flows are compared with the cost of the loan it replaces. (1.5) Interest is tax deductible, so the comparison uses the rate after tax relief. (1.5)
Pathfinder on Lease or buy: acquisition and financing decisions
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on this topic. Leasing appears in financing questions. Worked examples 1 to 4 show how to apply the method.
Revise first: Worked examples
Questions ask which flows differ between the options. See the section on relevant cash flows.
Revise first: Relevant cash flows
Source: ICAN Pathfinder, Strategic Financial Management. Diets covered: No stand-alone question in the May 2014 or November 2014 Pathfinder.
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