You are considering purchasing industrial equipment to expand one of your production lines. The equipment
costs $100,000 and has an estimated service life of 6 years. Assuming that the equipment will be financed
entirely from your business-retained earnings (equity funds), a fellow engineer has calculated the expected
after tax cash flows, including the salvage value, at the end of its project life are as follows: Now you are pondering the possibility of financing the entire amount by borrowing from a local bank at 12%
interest. You can make an arrangement to pay only the interest each year over the project period by deferring
the principal payment until the end of 6 years. Your firm's interest rate is also 12%. The expected marginal
income tax rate over the project period is known to be 40%. What is the amount of economic gain (or loss) in
present worth by using debt financing over equity financing?

Question

You are considering purchasing industrial equipment to expand one of your production lines. The equipment
costs $100,000 and has an estimated service life of 6 years. Assuming that the equipment will be financed
entirely from your business-retained earnings (equity funds), a fellow engineer has calculated the expected
after tax cash flows, including the salvage value, at the end of its project life are as follows:  Now you are pondering the possibility of financing the entire amount by borrowing from a local bank at 12%
interest. You can make an arrangement to pay only the interest each year over the project period by deferring
the principal payment until the end of 6 years. Your firm's interest rate is also 12%. The expected marginal
income tax rate over the project period is known to be 40%. What is the amount of economic gain (or loss) in
present worth by using debt financing over equity financing?

Quizplus · Accepted Answer

The Answer is Note that the borrowing rate is the same as the MARR. Since there will be tax savings from equity
financing (retained earnings), the economic gains ($29,519) from using debt financing represents entirely
savings from interest deduction.

Note that the borrowing rate is the same as the MARR. Since there will be tax savings from equity financing (retained earnings), the economic gains ($29,519) from using debt financing represents entirely savings from interest deduction.

You Are Considering Purchasing Industrial Equipment to Expand One of Your