Lester's Gym wants to expand its facilities by obtaining $62,000 of new exercise equipment. The equipment will have a 3-year life and will be worthless after that time. The cost of borrowed funds is
9)5 percent and the tax rate is 35 percent. The equipment can be leased for $22,500 a year. What
Is the amount of the depreciation tax shield in the second year if the equipment belongs in a 40
Percent CCA class?

Question

Quizplus · Accepted Answer

First, we need to calculate the After-Tax Cost of Debt (ATCD):
ATCD = Cost of Debt x (1 - Tax Rate)
ATCD = 0.095 x (1 - 0.35)
ATCD = 0.06175 or 6.175%

Next, we can calculate the Present Value (PV) of the lease payments:
PV = Lease Payment x (1 - Tax Rate) x (1 - (1 + Cost of Capital) ^ -Number of Years) / Cost of Capital
PV = $22,500 x (1 - 0.35) x (1 - (1 + 0.06175) ^ -3) / 0.06175
PV = $57,305.29

We also need to calculate the Capital Cost Allowance (CCA) for the equipment, which is 40%:
CCA = Cost of Equipment x CCA Rate
CCA = $62,000 x 0.4
CCA = $24,800

Now we can calculate the Depreciation Tax Shield (DTS) for the second year using the declining balance method:
DTS = (Cost of Equipment - Accumulated Depreciation) x CCA Rate x Tax Rate
Accumulated Depreciation in Year 1 = $62,000 x 0.4 = $24,800
Depreciation in Year 2 = ($62,000 - $24,800) x 0.4 = $14,880
Accumulated Depreciation in Year 2 = $24,800 + $14,880 = $39,680
DTS = ($62,000 - $39,680) x 0.4 x 0.35
DTS = $6,944

Therefore, the amount of the Depreciation Tax Shield in the second year is $6,944, which is option D.

Since the PV of the lease payments is less than the cost of buying the equipment and the DTS provides tax savings, it would be best for Lester's Gym to buy the equipment instead of leasing it.

Lester's Gym Wants to Expand Its Facilities by Obtaining $62,000