Question

Spectrum Corporation is considering leasing a new equipment. The lease lasts for 8 years. The lease calls for 8 payments of $142,000 per year with the first payment occurring immediately. The equipment would cost $1,020,000 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?

		-$127,425
		-$138,375
		-$112,500
		-$94,725
		None of the above

Answer 1

Advantage each year = Cash flow with leasing - cash flow with buying.

Buying :

Cash outflow in year 0 = cost of equipment.

Cash inflow in each year = annual depreciation * tax rate (The depreciation is a tax-deductible expense, and hence provides a depreciation tax shield. This is treated as a cash inflow).

Annual depreciation tax shield = (cost of equipment / depreciable life) * tax rate = ($1,020,000 / 8) * 25% = $31,875

Leasing :

Net cash outflow with leasing = lease payment * (1 - tax rate) = $142,000 * (1 - 25%) = $106,500.

Advantage in year 6 = -$106,500 - $31,875

Advantage in year 6 = -$138,375

after-tax cash flow from leasing relative to the after-tax cash flow from purchasing in year 6 = -$138,375