Mercy Me, Inc. is trying to decide whether to lease or buy some new equipment. The equipment costs $82,000, has a 5-year life, and belongs in a 20 percent CCA class. The equipment will be
Worthless after the 5 years and will have to be replaced. The company has a tax rate of 35 percent,
A cost of borrowed funds of 11 percent. The equipment can be leased for $17,500 a year. What is the
Amount of the after-tax lease payment?

Question

Quizplus · Accepted Answer

First, we need to calculate the CCA (Capital Cost Allowance) rate for the equipment.

CCA rate = 20% x (1 - 35% tax rate) = 13%

To calculate the after-tax lease payment, we need to find the amount of the lease payment that is tax-deductible.

Tax-deductible lease payment = lease payment / (1 - tax rate) = $17,500 / (1 - 0.35) = $26,923.08

After-tax lease payment = tax-deductible lease payment - tax savings on lease payment

Tax savings on lease payment = tax rate x tax-deductible lease payment = 0.35 x $26,923.08 = $9,423.08

After-tax lease payment = $26,923.08 - $9,423.08 = $17,500

Now, we need to calculate the PV (present value) of buying and leasing options to compare them.

PV of buying = -$82,000 (because it's a cash outflow) + PV of tax savings on CCA

PV of tax savings on CCA = (CCA rate x equipment cost) x tax rate x PV factor for 5 years

PV factor for 5 years at 11% discount rate = 3.696

PV of tax savings on CCA = (0.13 x $82,000) x 0.35 x 3.696 = $8,390.70

PV of buying = -$82,000 + $8,390.70 = -$73,609.30

PV of leasing = PV of lease payments - PV of tax savings on lease payments

PV of lease payments = annuity due factor for 5 years at 11% x after-tax lease payment

Annuity due factor for 5 years at 11% = 4.779

PV of lease payments = 4.779 x $17,500 = $83,552.25

PV of tax savings on lease payments = tax savings on lease payments x PV factor for 5 years

PV of tax savings on lease payments = $9,423.08 x 3.696 = $34,690.18

PV of leasing = $83,552.25 - $34,690.18 = $48,862.07

Since the PV of leasing is lower than the PV of buying, leasing is the better option. Therefore, the best choice is:

Answer: C (Lease the equipment)