Burton Enterprises is trying to determine if leasing would be a better alternative than purchasing $61,000 of new equipment. The equipment has a 4-year life after which time it will be worthless. The equipment belongs in a 20 percent CCA class and can be leased for $16,000 a year. The firm can borrow money at 7.25 percent and has a 35 percent tax rate. What is the incremental annual cash flow for year 2 if the company decides to lease the equipment rather than purchase it?
A) -$28,020
B) -$20,868
C) -$14,243
D) -$11,667
E) -$9,564

Question

Quizplus · Accepted Answer

The incremental cash flow is calculated by considering the tax shield from CCA, the interest on borrowing, and the lease payments. The CCA tax shield for year 2 is $61,000 * 0.20 * 0.35 = $4,270. The interest expense is $61,000 * 0.0725 = $4,422.5, and the tax shield on interest is $4,422.5 * 0.35 = $1,548.875. The lease payment is $16,000, and the tax shield on the lease is $16,000 * 0.35 = $5,600. The net cash flow is: Lease payment - CCA tax shield - Interest tax shield + Lease tax shield = $16,000 - $4,270 - $1,548.875 + $5,600 = -$14,243.125, rounded to -$14,243.

Burton Enterprises Is Trying to Determine If Leasing Would Be