A firm can either lease or buy some equipment costing $72,900. The lease payments would be $18,500 a year for four years. The equipment has a 4-year life after which it is expected to have a resale value of $3,600. The firm uses straight-line depreciation over the life of the asset, borrows money at 11 percent, and has a tax rate of 21 percent. The company does not expect to owe any taxes for at least four years because of its operating losses. What is the incremental cash flow for Year 3 if the company decides to lease rather than purchase the equipment?

Question

Quizplus · Accepted Answer

To calculate the incremental cash flow for Year 3, we need to compare the cash flows of leasing versus buying the equipment.

First, let's calculate the cash flows for leasing the equipment:

Lease payment per year = $18,500
Tax shield = $18,500 * 21% = $3,885

Net lease payment = $18,500 - $3,885 = $14,615

Now, let's calculate the cash flows for buying the equipment:

Depreciation per year = ($72,900 - $3,600) / 4 = $17,325
Tax shield = $17,325 * 21% = $3,648.75
Interest expense = $72,900 * 11% = $8,019
Tax shield on interest = $8,019 * 21% = $1,684.99

Net purchase cost = $72,900 - $3,648.75 - $1,684.99 = $67,566.26

Incremental cash flow for Year 3 = Net lease payment - Net purchase cost + Tax shield on interest
= $14,615 - $67,566.26 + $1,684.99
= -$51,266.27

Since the incremental cash flow for leasing is positive, we can conclude that leasing is the best choice in this scenario.

A Firm Can Either Lease or Buy Some Equipment Costing