Question

Greencore Corporation is considering leasing a new equipment. The lease lasts for 8 years. The lease calls for 8 payments of $225,000 per year with the first payment occurring immediately. The equipment would cost $1,480,000 to buy and would be straight-line depreciated to a zero salvage value over 8 years. The actual salvage value is negligible because of technological obsolescence. The firm can borrow at a rate of 6%. The corporate tax rate is 25%. What is the after-tax cash flow from leasing relative to the after-tax cash flow from purchasing in year 6?

Answer 1

The lease lasts for 8 years

The lease calls for 8 payments of $225,000 per year with the first payment occurring immediately

The equipment would cost $1,480,000 to buy and would be straight-line depreciated to a zero salvage value over 8 years

The firm can borrow at a rate of 6%.

The corporate tax rate is 25%.

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What is the after-tax cash flow from leasing relative to the after-tax cash flow from purchasing in year 6?

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It is operating leas, so the leas payment is not capitalize, write as expenses in the period.

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Following will be the Cash Flow from leasing

Year 0-7

Leas Rent payments = $225000

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After tax CF From leasing = Leas Rent payments - Tax rate

Tax rate = 25%

.

After tax CF From leasing = ($225000 - 25% tax) = $ -168750

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Following will be the Cash Flow from Purchasing option:

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Depreciation Exp. = $1480000 / 8 (as zero salvage value) = $185000

after tax depreciation = Depreciation Exp - tax rate

after tax depreciation = 185000 - 25% = $138750

.

We assume that for purchasing the equipment, we need to take a loan with 8 year term. With equal yearly installment payment.

Fund needed = 1480000 to purchase equipment

.

CF from loan financing

(Assuming loan to be paid in 8 years installment starting from year 1)

.

year	Principal(a)	interest @6%	outstanding	interest after tax(b)	Dep after tax(c)	CF after tax(c-a-b)
1	185000	88,800	1295000	66600	138750	-1,12,850
2	185000	77700	1110000	58275	138750	-1,04,525
3	185000	66600	925000	49950	138750	-96,200
4	185000	55500	740000	41625	138750	-87,875
5	185000	44400	555000	33300	138750	-79,550
6	185000	33300	370000	24975	138750	-71,225
7	185000	22200	185000	16650	138750	-62,900
8	185000	11100	0	8325	138750	-54,575

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After tax cash flow in year 6 for purchsing option = -$71,225