A firm could lease the equipment in the previous questionfor $3,700 a year. If the firm purchased the equipment for $10,000, the maintenance expense will be $350 a year; depreciation is $2,500 annually, and the firm pays $250 to have the equipment removed. Construct projected annual cash outflows for each alternative. Assume a 25% income tax rate. Is leasing the better alternative if the firm uses 10 percent cost of funds?

Question

What will be an ideal response?

Answer 1

Determination of cash flows under purchasing:Year                     0              1               2             3             4Purchase          $10,000Maintenance                     $350.00    350.00      350.00     350.00Depreciation                     2,500.00   2,500.00   2,500.00   2,500.00Tax deductible                  2,850.00   2,850.00   2,850.00   2,850.00expensesTax savings                      (712.50)   (712.50)    (712.50)   (712.50)Removal of asset (after tax savings)                                 187.50?Cash outflows                               $10,000    (362.50)   (365.50)    (362.50)  (175.00)Interest factor 1.0             .909         .826           .751       .683?Present value of cash outflows under owning:                         $10,000    (329.51)   (299.43)    (272.24)  (119.25)Summation:       $8,979.57??Cash outflows under leasing:Year                     1 - 4Lease payment      $3,700  Tax savings           925      Cash outflows       2,775?Present value of cash outflows under leasing:$2,775(PVAIF 10I, 4N) = $2,775(3.170) = $8,796.75?The present value of the cash outflows from leasing is smaller, so that alternative is preferred. Point out the cash outflow required to remove the asset instead of a cash inflow from the sale of any residual value. If the asset could be sold instead of having to pay for its removal, this may alter the analysis in favor of owning.?