Your ﬁrm is considering either leasing or buying some new equipment. The lessor will charge $17,500 a year for 3 years should you decide to lease. The purchase price is $61,000. The
Equipment has a 3-year life after which it is expected to have a resale value of $13,000. Your ﬁrm
Uses straight-line depreciation, borrows money at 9 percent, and has a 34 percent tax rate. What is
The after-tax salvage value of the equipment?
A) $8,580
B) $9,701
C) $11,407
D) $18,529
E) $19,697

Question

Quizplus · Accepted Answer

To compare the lease and buy options, we need to calculate the after-tax cash flows for each option.

For leasing: 
Annual lease payment = $17,500
After-tax lease payment = $17,500 x (1 - 0.34) = $11,550
Total after-tax lease payments over 3 years = $11,550 x 3 = $34,650

For buying: 
Depreciation expense per year = ($61,000 - $13,000) / 3 = $16,000
Tax savings per year from depreciation = $16,000 x 0.34 = $5,440
After-tax cost of borrowing = 0.09 x (1 - 0.34) = 0.0594
Annual interest expense = $61,000 x 0.0594 = $3,623.40
Total after-tax interest expenses over 3 years = $3,623.40 x 3 = $10,870.20

Year 0:
-Buying the equipment for $61,000

Year 1:
-Depreciation: $16,000
-Interest: $3,623.40
-Tax savings from depreciation: $5,440

Year 2:
-Depreciation: $16,000
-Interest: $3,623.40
-Tax savings from depreciation: $5,440

Year 3:
-Depreciation: $16,000
-Interest: $3,623.40
-Resale value: $13,000
-Tax savings from depreciation: $5,440

Total after-tax cash flows for buying = -$61,000 + $5,440 + $5,440 + $5,440 + $5,440 + $13,000 - $10,870.20 = $17,889.20

Comparing the two options, we can see that the after-tax cash flow for buying is higher than leasing. Therefore, buying is the better option.

To calculate the after-tax salvage value of the equipment, we need to subtract the tax on the gain from the resale value. The gain is the resale value ($13,000) minus the book value (which is the purchase price minus accumulated depreciation so far, which is $16,000 x 3 = $48,000). Therefore, the gain is $13,000 - $48,000 = -$35,000 (which means it is a loss).
The tax on this loss is 0 because there is no tax benefit. Therefore, the after-tax salvage value is just the resale value: $13,000.

The best choice is: 
Answer: B) Buy the equipment
 Buying the equipment has a higher after-tax cash flow compared to leasing. Therefore, buying is the better option. The after-tax salvage value of the equipment is $13,000.

Your ﬁRm Is Considering Either Leasing or Buying Some New