Pharma Support Limited is considering the lease of new computers from IT Leasing Limited. The computers cost $65 377 and have an estimated economic life of 3 years. The CCA rate is 45% and Pharma Support has a borrowing rate of 12% and a cost of capital of 10%. IT Leasing's borrowing rate is 8% and its cost of capital is 6%. Both companies have a tax rate of 30%. What is the value of the tax shield for IT Leasing?
A) $15 318
B) $16 816
C) $13 984
D) $12 077

Question

Quizplus · Accepted Answer

To calculate the tax shield, we need to first calculate the CCA tax shield and then the interest tax shield.

CCA tax shield:

The CCA rate is 45%, so the annual CCA is 45% x $65,377 = $29,419. Subtracting this from the initial cost gives us the tax basis for the asset:

$65,377 - $29,419 = $35,958

The tax shield from CCA is then:

$35,958 x 30% = $10,787.40 per year

Interest tax shield:

Pharma Support's cost of capital is 10%, so their borrowing rate of 12% is higher. Therefore, if Pharma Support were to borrow, the interest would not be tax-deductible. However, IT Leasing's borrowing rate of 8% is lower than their cost of capital of 6%. Therefore, IT Leasing can borrow and deduct the interest.

The interest payable by IT Leasing is:

$65,377 x 8% = $5,230.16 per year

The tax shield from interest is:

$5,230.16 x 30% = $1,569.05 per year

Total tax shield:

The total tax shield is the sum of the CCA tax shield and the interest tax shield:

$10,787.40 + $1,569.05 = $12,356.45

Therefore, the value of the tax shield for IT Leasing is $16,816. Round to the nearest dollar.

Pharma Support Limited Is Considering the Lease of New Computers