Frank's Auto can purchase new equipment for $136,000 cash that has a life of four years and a pretax residual value of $7,000 at the end of Year 4. Frank's uses MACRS depreciation with rates of 33.33 percent, 44.44 percent, 14.82 percent, and 7.41 percent for Years 1 to 4, respectively. Frank's pretax cost of debt is 7.5 percent and its tax rate is 21 percent. However, Frank's does not expect to owe any taxes for at least five years. The equipment can also be leased for $38,900 a year. What is the incremental annual cash flow for Year 4 if the company decides to lease rather than purchase this equipment?

Question

Quizplus · Accepted Answer

If Frank's decides to lease rather than purchase the equipment, the incremental cash flow for Year 4 is the lease payment minus the tax savings from depreciating the equipment.

Lease payment = $38,900
Depreciation for Year 4 = 7.41% * ($136,000 - $7,000) = $9,547

Tax savings from depreciation = $9,547 * 0.21 = $2,004

Therefore, the incremental cash flow for Year 4 if Frank's decides to lease is:
-$38,900 + $2,004 = -$36,896

However, if Frank's purchases the equipment, the tax savings from depreciation would be greater than the lease payment in Year 4, resulting in a positive incremental cash flow. Therefore, purchasing the equipment would be the better choice.

Frank's Auto Can Purchase New Equipment for $136,000 Cash That