Question

Your firm is considering leasing a new robotic milling control system. The lease lasts for 5 years. The lease calls for 5 payments of $300,000 per year. The system would cost $1,050,000 to buy and would be straight-line depreciated to a zero salvage value. The actual salvage value is zero. The firm can borrow at 8%, and the corporate tax rate is 34%.

a. What is the after-tax cash flow from leasing (relative to purchasing) in year 0?

$300,000

$495,000

$852,000

1,050,000

b.What is the after-tax cash flow from leasing (relative to purchasing) in years 1 through 5?

$-287,250

$-269,400

$-126,600

$-198,000

What is the appropriate discount rate for valuing the lease?

2.72%

5.28%

12.12%

8.00%

Answer 1

a. What is the after-tax cash flow from leasing (relative to purchasing) in year 0?

$1,050,000

There is no impact of tax on initial capital investment. Therefore after-tax cash flow from leasing (relative to purchasing) in year 0 is $1,050,000

(b) What is the after-tax cash flow from leasing (relative to purchasing) in years 1 through 5?

After-tax cashflow from leasing = Lease payment after tax + Tax saving on Depreciation

Annual Depreciation = Cost of system / Useful life of system

Annual Depreciation = 1,050,000 / 5 years = $210,000

Tax savings on Depreciation = Annual Depreciation x tax rate = $210,000 x 34%

Tax savings on Depreciation = $71,400

After-tax cashflow from leasing = -300,000 x (1-34%) + 71400

After-tax cashflow from leasing = -198000+ 71400

After-tax cashflow from leasing = -$126,600

Therefore 3rd option is correct.

(c) What is the appropriate discount rate for valuing the lease?

Appropriate discount rate for valuing the lease = Cost of borrowing x (1-Tax)

Appropriate discount rate for valuing the lease = 8% x (1-34%)

Appropriate discount rate for valuing the lease = 5,28%

Therefore 2nd option is correct.

{Discount rate should be considered after tax since interest expenses will be eligible for tax deduction}

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