Question

Thomas Corporation is evaluating whether to lease or purchase equipment. Its tax rate is 21% . The company expects to use the equipment for 4 years, with no expected salvage value. The purchase price is $2 million and MACRS depreciation, 3-year class, will apply. If the company enters into a 4-year lease, the lease payment is $460,000 per year, payable at the beginning of each year. If the company purchases the equipment it will borrow from its bank at an interest rate of 11% . a. Calculate the cost of purchasing the equipment with debt.

Answer 1

Here discount rate will be = interest rate (1-tax rate)

=11%(1-21%)

=11%(1-0.21)

=11%(0.79)

=8.69%

Statement showing depreciation

Year	Opening balance	Depreciation Rates	Depreciation (purchase price x Depreciation rates)	Closing Balance
1	2000000	33.33%	666600	1333400
2	1333400	44.45%	889000	444400
3	444400	14.81%	296200	148200
4	148200	7.41%	148200	0

Statement showing tax shield

Year	Depreciation	Tax Shield @ 21%
1	666600	139986
2	889000	186690
3	296200	62202
4	148200	31122

Statement showing cost of equipment

Particulars	0	1	2	3	4	Total
Cost of equipment	-2000000
Tax shield on depreciation		139986	186690	62202	31122
Total cash flow	-2000000	139986	186690	62202	31122
PVIF @ 8.69%	1	0.9200	0.8465	0.7788	0.7165
Total PV	-2000000.00	128793.82	158030.85	48443.51	22300.22	-1642431.60

Thus cost of purchasing the equipment with debt = $1642431.60