Daily Enterprises is contemplating the acquisition of some new equipment. The purchase price is $47,000. The company expects to sell the equipment at the end of year 4 for $5,000. The ﬁrm uses
MACRS depreciation which allows for 33.33 percent, 44.44 percent, 14.82 percent, and 7.41 percent
Depreciation over years 1 to 4, respectively. The equipment can be leased for $12,500 a year for 4
Years. The ﬁrm can borrow money at 7.5 percent and has a 34 percent tax rate. What is the
Incremental annual cash ﬂow for year 4 if the company decides to lease the equipment rather than
Purchase it?

Question

Quizplus · Accepted Answer

To calculate the incremental annual cash flow for year 4, we need to compare two scenarios: leasing vs buying.

If the company leases the equipment, the incremental cash flow for year 4 will be:

Lease payment = -$12,500
Tax savings from lease payment = $12,500 x 0.34 = $4,250
Net lease payment = -$12,500 + $4,250 = -$8,250
Sale of equipment = $5,000

Incremental cash flow from leasing = -$8,250 + $5,000 = -$3,250

If the company buys the equipment, the incremental cash flow for year 4 will be:

Book value of equipment at year 4:
Year 1 depreciation = $47,000 x 0.3333 = $15,665.10
Year 2 depreciation = ($47,000 - $15,665.10) x 0.4444 = $14,473.93
Year 3 depreciation = ($47,000 - $15,665.10 - $14,473.93) x 0.1482 = $5,117.14
Year 4 depreciation = ($47,000 - $15,665.10 - $14,473.93 - $5,117.14) x 0.0741 = $1,384.30
Book value at year 4 = $47,000 - $15,665.10 - $14,473.93 - $5,117.14 - $1,384.30 = $10,359.53
Tax savings from depreciation = $1,384.30 x 0.34 = $470.24
Proceeds from sale of equipment = $5,000
Tax on gain/loss from sale = ($5,000 - $10,359.53) x 0.34 = -$1,855.87 (negative because it's a tax payment)

Incremental cash flow from buying = -$47,000 + $470.24 - $1,855.87 + $5,000 + $10,359.53 = -$33,026.10

Comparing the two scenarios, the incremental cash flow in year 4 is higher if the company leases the equipment ($-3,250 vs -$33,026.10). Therefore, the best choice is to lease the equipment.

Daily Enterprises Is Contemplating the Acquisition of Some New Equipment