ABC LeasingABC Leasing has an after-tax cost of borrowing of 10%. The company is in a 35% tax bracket. A new machine will be purchased for $100,000. The straight-line method is used to calculate depreciation. With heavy use, the salvage value is zero. The firm now wants to rent out this machine for 5 years at a required return of 15%. The first lease payment starts once the contract has been signed. Furthermore, lease payments received by the lessor are fully taxable.
-Refer to Scenario: ABC Leasing.What is the net cost of this machine for the lessor as a legal owner receiving all tax benefits?

Question

Quizplus · Accepted Answer

The net cost of the machine for the lessor, considering tax benefits from depreciation and the after-tax cost of borrowing, is calculated by considering the initial cost, depreciation tax shields, and the cost of capital. Since the machine has a zero salvage value and is depreciated using the straight-line method over 5 years, the annual depreciation expense is $20,000 ($100,000 / 5 years). The tax shield from depreciation is $7,000 per year ($20,000 * 35%), totaling $35,000 over 5 years. The after-tax cost of the machine is the initial cost minus the total tax shield, which is $65,000 ($100,000 - $35,000). However, considering the after-tax cost of borrowing (10%), the present value of these tax shields would be less, leading to a net cost closer to option C, $73,465, when accounting for the time value of money and the cost of capital.

ABC LeasingABC Leasing Has an After-Tax Cost of Borrowing of 10