You own a high-tech manufacturing entity. You would like to expand your operations but to do so you need to either lease or buy a $1.2 million piece of equipment for the next three years. The lease payments would be $475,000 a year for the three years. If the equipment is purchased, it will be depreciated straight-line to zero over the three-year period. The equipment will have no residual value at the end of the three years. Should the equipment be leased, the lessor and the lessee will both have marginal tax rates of 34%. The loan rate for your firm for this purpose is 8% pre-tax.

What is the after-tax cost of debt for the lessee?
A) 4.67%
B) 5.28%
C) 7.33%
D) 8.00%
E) 10.72%

Question

You own a high-tech manufacturing entity. You would like to expand your operations but to do so you need to either lease or buy a $1.2 million piece of equipment for the next three years. The lease payments would be $475,000 a year for the three years. If the equipment is purchased, it will be depreciated straight-line to zero over the three-year period. The equipment will have no residual value at the end of the three years. Should the equipment be leased, the lessor and the lessee will both have marginal tax rates of 34%. The loan rate for your firm for this purpose is 8% pre-tax.

What is the after-tax cost of debt for the lessee?

What is the after-tax cost of debt for the lessee?
A) 4.67%
B) 5.28%
C) 7.33%
D) 8.00%
E) 10.72%

Quizplus · Accepted Answer

The after-tax cost of debt for the lessee is calculated by taking the pre-tax cost of debt and adjusting it for the tax shield. The formula is: After-tax cost of debt = Pre-tax cost of debt * (1 - Tax rate). Here, the pre-tax cost of debt is 8%, and the tax rate is 34%. So, the after-tax cost of debt = 8% * (1 - 0.34) = 8% * 0.66 = 5.28%.

You Own a High-Tech Manufacturing Entity