Shine Ltd is considering purchasing or leasing new equipment.If it purchases the equipment it will cost $500 000 and if it leases the equipment it will be required to pay six rentals of $115 000 each.The equipment can be depreciated over three years on a straight-line basis for tax purposes.The residual value is expected to be zero and the tax rate is 30 per cent.What is the incremental cash flow in Year 3 for leasing the equipment rather than buying it for Year 3? Assume that rental payments are paid at the beginning of each period.

Question

Quizplus · Accepted Answer

To calculate the incremental cash flow in Year 3 for leasing the equipment rather than buying, we need to compare the cash flows of leasing and buying options in Year 3 only.

For leasing:
Cash outflow = $115,000 (rental payment)
Tax shield = $34,500 (30% tax rate * $115,000 rental payment)
Net cash outflow = $80,500 ($115,000 - $34,500)

For buying:
Depreciation expense = ($500,000 / 3) = $166,667
Tax shield = $50,000 (30% tax rate * $166,667 depreciation expense)
Net cash outflow = $116,667 ($166,667 - $50,000)

Therefore, the incremental cash flow in Year 3 for leasing instead of buying is:
Incremental cash flow = Net cash outflow from buying - Net cash outflow from leasing
= $116,667 - $80,500
= $36,167 (positive)

This means that buying will result in a net cash outflow of $36,167 more than leasing in Year 3. Therefore, the best choice is to lease the equipment rather than buying.

Shine Ltd Is Considering Purchasing or Leasing New Equipment