Spingboro Industries can either lease or buy some equipment. The lease payments would be $16,000 a year. The purchase price is $54,900. The equipment has a 3-year life after which it is expected to have a resale value of $9,000. The firm uses straight-line depreciation over the asset's life, borrows money at 8.75 percent, and has a 35 percent tax rate. What is the incremental cash flow for year 1 if the company decides to lease the equipment rather than purchase it?

Question

Quizplus · Accepted Answer

To calculate the incremental cash flow for year 1 if the company decides to lease rather than purchase, we need to compare the cash flows under both scenarios. 1. **Lease Scenario**: The cash outflow is straightforward - it's the lease payment, which is $16,000. However, since lease payments are tax-deductible, the after-tax cost is $16,000 * (1 - 0.35) = $10,400.2. **Buy Scenario**: The purchase involves several components:   - **Depreciation**: The equipment costs $54,900 and has a salvage value of $9,000, leading to a total depreciation of ($54,900 - $9,000) / 3 = $15,300 per year. This depreciation is tax-deductible, providing a tax shield of $15,300 * 0.35 = $5,355.   - **Interest Expense**: Assuming the entire purchase is financed, the interest expense in the first year is $54,900 * 0.0875 = $4,803.75. This is also tax-deductible, providing a tax shield of $4,803.75 * 0.35 = $1,681.31.   - **Net Cash Outflow**: The initial purchase price is $54,900, but we need to consider the tax shields: $5,355 (depreciation tax shield) + $1,681.31 (interest tax shield) = $7,036.31. So, the net cash outflow is $54,900 - $7,036.31 = $47,863.69.3. **Incremental Cash Flow (Lease vs. Buy)**: The incremental cash flow for year 1 is the lease cost (after tax) minus the net cash outflow from buying (considering tax shields), which is $10,400 - $47,863.69. However, this calculation seems to miss the correct framing for incremental cash flow, which should focus on the difference in cash flows between leasing and buying in the first year only, not including the entire purchase price for buying since it's not an annual expense.The correct approach is to compare the annual lease expense to the annual cost of owning (depreciation tax shield plus interest tax shield). The initial calculation provided doesn't align with standard incremental cash flow analysis, which compares the costs and savings within the same period.Given the options and the methodology typically used for such calculations, there seems to be a misunderstanding in the calculation process described. The correct process should focus on the annual difference:- **Annual Lease Cost (After Tax)**: $10,400- **Annual Ownership Cost Savings**: Depreciation tax shield + interest tax shield = $5,355 + $1,681.31 = $7,036.31The question seems to seek the incremental cash flow for the first year, which would typically compare the lease payments (and their tax effects) to the tax savings from depreciation and interest if the equipment were purchased. However, the detailed calculation that leads directly to one of the provided answer choices is not accurately reflected in the explanation above due to a misinterpretation of how the purchase price and its financing affect the first year's cash flow directly.Given the options and typical financial analysis, the correct answer would involve calculating the net cost of leasing (including tax savings) versus the net benefits (tax savings from depreciation and interest) of buying for the first year. The provided calculations and explanations do not directly lead to a clear answer without further clarification on the correct methodology for comparing the first year's cash flows under leasing versus buying.

Spingboro Industries Can Either Lease or Buy Some Equipment