A company decides that it needs a new machine, a fleet of vehicles or a computer system. It then faces a second question that is not about the machine at all: how to pay for it. It can borrow the money and buy the asset, or it can have a lessor buy it and rent it to the company. The two decisions should be kept apart.
First, is the asset worth having? That is an ordinary net present value question. Second, if it is, which way of financing is cheaper? That is a comparison of the present value of the costs of each method, using only the cash flows that differ.
This topic explains the two-stage approach, the types of lease and the effect of the lease accounting standard on the lessee, which cash flows are relevant to the financing decision, the discount rate to use, and a worked example comparing a loan with an operating lease. The next topic covers asset replacement decisions.
The syllabus requires the evaluation of leasing and borrowing to buy using Nigerian tax rules. Read simulation, risk-adjusted discount rates and discounted payback first.
In 30 seconds
A lease or buy decision has two stages: the acquisition (investment) decision, by normal net present value (NPV) at the company’s cost of capital, and then, if the asset should be acquired, the financing decision: borrow and buy, or lease. Compare the present value of cost of each financing method using only the relevant (incremental) cash flows, discounted at the after-tax cost of borrowing; choose the lower.
Borrow and buy: cost = amount borrowed − present value (PV) of tax savings on capital allowances − PV of disposal proceeds (after tax). Lease: cost = PV of rentals after tax relief. An operating lessee cannot claim capital allowances, while a buyer (and, under the rules in this course, a finance lessee) can. Operating rentals are fully tax-deductible, finance lease rentals only as to the interest element.
Under International Financial Reporting Standard (IFRS) 16 a lessee records all leases on the statement of financial position, but the tax distinction between operating and finance leases still matters.
Two decisions
A lease or buy decision is considered in two stages.
- The acquisition (investment) decision: should the asset be acquired at all? This assumes it is bought, and uses the ordinary NPV method: the purchase cost at time 0, the benefits and costs each year, working capital, the residual value, and the tax on cash profits and the tax effect of capital allowances, discounted at the company’s normal after-tax cost of capital.
- The financing decision: only if the NPV is positive, choose how to finance the acquisition: borrow and buy, or lease. The asset will be acquired whichever method is chosen, so every cash flow that is the same under both methods (revenues, operating costs) is ignored; only cash flows that change with the financing method are relevant. The better method is the one with the lower present value of cost.
Types of lease
A lease is a finance lease if it transfers substantially all the risks and rewards of ownership. An operating lease if it does not; the substance of the transaction decides, not the form.
Features of a finance lease are an option to buy at a price substantially below the expected fair value, a term covering a major part of the asset’s economic life, lease payments whose present value is substantially all of the asset’s fair value, and an asset so specialised that only the lessee can use it.
The lessor is the legal owner, but the lessee has the benefits and costs of ownership, in the same position as if it had borrowed to buy.
Under IFRS 16 a lessee records almost all leases as an asset and a liability and the accounting distinction between operating and finance leases has gone for the lessee; it remains for the lessor. But lease or buy decisions rest on cash flows, and tax law continues to distinguish the two for the deductibility of payments, so the distinction still matters here.
Relevant cash flows for the financing decision
| Cash flow | Borrow and buy | Finance lease | Operating lease |
|---|---|---|---|
| Purchase price (the amount borrowed) | Yes | ||
| Tax saving on capital allowances | Yes | Yes (the lessee cannot claim them) | |
| Disposal proceeds | Yes | Yes (the lessee gets none) | |
| Lease rentals | Yes | Yes | |
| Tax relief on rentals | Interest element only | Full rentals |
Reading the table: against a finance lease, the buyer’s capital allowances are not incremental because a finance lessee can claim them too; against an operating lease they are incremental, because only the owner claims them. Rentals are always incremental. The loan is included at the amount borrowed: the present value of the interest and its tax relief, discounted at the after-tax cost of the loan, equals the amount borrowed.
Cash flows are discounted at the after-tax cost of borrowing, because the financing decision compares two ways of borrowing.
A worked example: Zenith
Zenith needs a machine costing ₦6.0m with a four-year life and no residual value. Its operating cash flow is ₦2.4m a year before tax; tax is 30%, paid in the same year; the capital allowance is assumed to write the cost off evenly over the four years (₦1.5m a year); the normal cost of capital is 14%. The bank would lend at 15% before tax.
An operating lease would cost ₦1.9m a year, payable at the end of each year.
Stage 1: should Zenith acquire the machine?
Annual after-tax cash flow = 2.4 × 0.70 + 1.5 × 0.30 (tax saved by the allowance) = 1.68 + 0.45 = ₦2.13m. At 14% the four-year annuity factor is 2.914, so the present value is 2.13 × 2.914 = ₦6.21m, and the NPV is 6.21 − 6.0 = +₦0.21m. The machine is worth acquiring.
Stage 2: how to finance it?
The after-tax cost of borrowing is 15% × (1 − 0.30) = 10.5%, and the four-year annuity factor at 10.5% is 3.136.
| Working | PV of cost ₦m | |
|---|---|---|
| Borrow and buy | ||
| Amount borrowed | 6.000 | |
| Less tax saved on allowances | 0.45 × 3.136 | (1.411) |
| Net cost | 4.589 | |
| Operating lease | ||
| Rentals after tax | 1.9 × 0.70 = 1.33; 1.33 × 3.136 | 4.171 |
The lease costs ₦4.171m in present value terms against ₦4.589m for borrowing and buying, so leasing is cheaper by ₦0.42m. The decision is to acquire the machine and finance it with the operating lease, subject to the qualitative points below.
Other considerations
- Flexibility and obsolescence: a lease may give the right to return the asset or upgrade it, which is valuable if the technology changes quickly, but may include penalties for early termination.
- Residual value risk: in a lease it passes to the lessor; a buyer bears it.
- Maintenance and other services may be included in a lease.
- Capital and borrowing capacity: a lease does not require a large cash outlay, but under IFRS 16 it appears as a liability and affects gearing ratios and loan covenants.
- Tax position: a company that cannot use capital allowances (because it has no taxable profit) gains less from owning, and may prefer a lease where the lessor passes on its tax benefit through a lower rental.
The ideas in more depth
Why the loan is valued at its face amount
A loan of ₦6m at 15% requires interest of ₦0.9m a year with tax relief of 30%, and repayment of ₦6m at the end. Discounting these at the after-tax cost, 10.5%, gives exactly ₦6m. So instead of listing interest, relief and repayment, the buy option can be shown simply as the amount borrowed. This is only true if the discount rate equals the after-tax cost of the loan.
Why the discount rate is the cost of borrowing and not the cost of capital
The financing decision compares two ways of raising debt-like finance for the same asset, so the cash flows are as safe as debt payments and are discounted at the cost of debt. The cost of capital is used in the first stage because there the cash flows carry the risk of the business.
Sources and references
- International Financial Reporting Standard (IFRS) 16 Leases for the lessee’s accounting; the Nigeria Tax Act 2025 for capital allowances and the deductibility of lease payments. Treat the rules in a question as the rules to apply.
These points are stated as at 5 November 2026.
Worked examples
Example 1: the borrowing rate. The loan costs 15% before tax and tax is 30%. Required: the after-tax rate.
- After-tax rate.
15% × 0.70 = 10.5%.
Example 2: the lease cost. Rental ₦1.9m a year for 4 years; tax 30%; factor 3.136. Required: the present value of cost.
- After tax.
1.9 × 0.70 = ₦1.33m a year. - PV.
1.33 × 3.136 = ₦4.17m.
Example 3: the buy cost. Loan ₦6.0m; allowance saving ₦0.45m a year for 4 years; factor 3.136. Required: the present value of cost.
- Tax saved.
0.45 × 3.136 = ₦1.41m. - Net cost.
6.0 − 1.41 = ₦4.59m.
How to answer in the exam
- Do the acquisition decision first and state that financing follows only if the NPV is positive.
- Name the type of lease and use the right incremental items (allowances, tax relief on rentals).
- Discount at the after-tax cost of borrowing and show the annuity factor.
- Compare present values of cost, state the decision and add the qualitative factors.
Common mistakes in the exam
- Discounting the financing flows at the cost of capital.
- Using the pre-tax interest rate as the discount rate.
- Forgetting the capital allowances in the buy option against an operating lease.
- Including the capital allowances in both options against a finance lease.
- Ignoring the tax relief on rentals.
- Choosing the financing method before establishing that the asset is worth acquiring.
Quick revision
- Two stages: acquire (NPV), then finance (lower present value of cost).
- Buy: loan − PV of allowances − PV of disposal proceeds. Lease: PV of rentals after tax.
- Discount at the after-tax cost of borrowing.
- Operating lessee gets no allowances; operating rentals fully deductible.
Practice questions
These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.
Recall check: multiple choice
Question 1. The first stage of a lease or buy decision is to decide:
- Which lessor to use
- The rental
- Whether the asset should be acquired at all
- The loan rate
Show the answer
C. By normal NPV analysis.
Question 2. The financing decision is made by comparing:
- Revenues
- The present values of cost of each method
- Accounting profits
- Payback periods
Show the answer
B. The lower present value of cost is preferred.
Question 3. The discount rate for the financing decision is:
- The after-tax cost of borrowing
- The cost of equity
- The inflation rate
- The tax rate
Show the answer
A. Both methods are forms of borrowing.
Question 4. A finance lease is one that:
- Lasts one year
- Has no rentals
- Is cancellable
- Transfers substantially all the risks and rewards of ownership
Show the answer
D. Substance over form.
Question 5. Operating lease rentals are:
- Not deductible
- Fully tax-deductible
- Deductible as to interest only
- Added to profit
Show the answer
B. So the tax relief on rentals is incremental.
Question 6. An operating lessee:
- Cannot claim capital allowances
- Claims all allowances
- Owns the asset
- Receives the disposal proceeds
Show the answer
A. They belong to the lessor.
Question 7. The loan in the buy option is shown at:
- Interest only
- Nil
- The amount borrowed
- Double the interest
Show the answer
C. Its present value at the after-tax cost equals the amount.
Question 8. Under the lease accounting standard, a lessee:
- Records no leases
- Records only finance leases
- Records only short leases
- Records almost all leases as assets and liabilities
Show the answer
D. The tax distinction still matters.
Question 9. Cash flows that are the same under both methods are:
- Added
- Doubled
- Ignored in the financing decision
- Discounted twice
Show the answer
C. Only differences are relevant.
Question 10. The after-tax cost of a 15% loan at tax of 30% is:
- 10.5%
- 4.5%
- 19.5%
- 15%
Show the answer
A. 15% × 0.70.
Section B style: written questions
Question 11 (10 marks). (a) Describe the two stages of a lease or buy decision. (4 marks) (b) State the relevant cash flows when borrowing and buying is compared with an operating lease. (4 marks) (c) State the discount rate and why. (2 marks)
Question 12 (15 marks). A machine costs ₦3.0m, lasts three years and has no residual value. Tax is 30% in the year of the cost; the allowance is ₦1.0m a year. A loan would cost 12.5% before tax. An operating lease would cost ₦1.2m a year in arrears. (a) Calculate the after-tax cost of the loan and the annuity factor for 3 years at that rate (2.543).
(3 marks) (b) Calculate the present value of cost of borrowing and buying. (6 marks) (c) Calculate the present value of cost of leasing. (4 marks) (d) State the decision. (2 marks)
A further written question
Question 13 (20 marks). A machine costs ₦10m, lasts five years and is sold at the end for ₦1.2m, on which tax is payable because its tax value is nil. The allowance writes off the cost evenly over five years; tax is 30% in the year of the cost. A loan would cost 10% before tax. An operating lease would cost ₦2.6m a year in arrears. After-tax factors at 7%: annuity for 5 years 4.100; year 5 factor 0.713.
(a) Calculate the after-tax cost of borrowing. (2 marks) (b) Calculate the tax saved by allowances each year and its present value. (5 marks) (c) Calculate the present value of the net disposal proceeds. (4 marks) (d) Calculate the present value of cost of borrowing and buying. (3 marks) (e) Calculate the present value of cost of leasing and decide. (6 marks)
Model answers
Show the model answer to Question 11
(a) Stage 1: decide whether to acquire the asset, by NPV at the cost of capital (2). Stage 2: if so, choose the financing method with the lower present value of cost (2).
(b) The amount borrowed; the tax saved on capital allowances; disposal proceeds; lease rentals; tax relief on the full rentals (1 each, any four).
(c) The after-tax cost of borrowing (1), because both are forms of borrowing and the cash flows carry the risk of debt (1).
Show the model answer to Question 12
(a) 12.5% × 0.70 = 8.75% (1.5); factor 2.543 (1.5).
(b)
- Tax saved 30% × ₦1.0m = ₦0.3m a year (2)
- present value 0.3 × 2.543 = ₦0.763m (2)
- net cost 3.000 − 0.763 = ₦2.237m (2).
(c)
- After-tax rental 1.2 × 0.70 = ₦0.84m (2)
- present value 0.84 × 2.543 = ₦2.136m (2).
(d) Leasing is cheaper by about ₦0.10m, so lease (2).
Show the model answer to Question 13
(a) 10% × 0.70 = 7% (2).
(b)
- Allowance 10 ÷ 5 = ₦2.0m
- tax saved 30% × 2.0 = ₦0.6m a year (2)
- present value 0.6 × 4.100 = ₦2.46m (3).
(c)
- Proceeds 1.2 less tax 30% = ₦0.84m
- present value 0.84 × 0.713 = ₦0.60m (4).
(d) 10.00 − 2.46 − 0.60 = ₦6.94m (3).
(e)
- After-tax rental 2.6 × 0.70 = ₦1.82m
- present value 1.82 × 4.100 = ₦7.46m (4).
- Borrowing and buying is cheaper by about ₦0.52m, so borrow and buy (2).
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