A lessor can borrow at a rate of 7 percent and has a tax rate of 21 percent.The lessee can borrow at a rate of 8 percent and has a tax rate of 21 percent.Assume an asset costs $138,000 and can be leased in exchange for two annual payments of $70,000 with the first payment due at the time of signing.What is the incremental cash flow at Time 0 for the lessee for a purchase instead of a lease?

Question

Quizplus · Accepted Answer

For the lessee, the incremental cash flow at Time 0 for purchasing the asset instead of leasing it would be:

Initial investment = cost of the asset = $138,000

PV of tax shield from depreciation = Depreciation x Tax rate x PVIFA(8%, 2) 
= (138,000/2) x 21% x 1.7833 
= $48,881.74

PV of interest tax shield from borrowing = Interest expense x Tax rate x PVIFA(7%, 2) 
= (138,000 x 7%) x 21% x 1.7833 
= $17,668.00

The incremental cash flow at Time 0 for purchasing instead of leasing = 
Initial investment - PV of tax shield from depreciation - PV of interest tax shield from borrowing 
= 138,000 - 48,881.74 - 17,668.00 
= -$82,549.26 ≈ -$82,700

Therefore, the best choice is (D) -$82,700.

A Lessor Can Borrow at a Rate of 7 Percent