Question

Craxton Engineering will either purchase or lease a new $751,000 fabricator. If​ purchased, the fabricator will be depreciated on a​ straight-line basis over seven years. Craxton can lease the fabricator for $129, 000 per year for seven years.​ Craxton's tax rate is 35%.

​(Assume the fabricator has no residual value at the end of the seven​years.)

a. What are the free cash flow consequences of buying the fabricator if the lease is a true tax​ lease?

b. What are the free cash flow consequences of leasing the fabricator if the lease is a true tax​ lease?

c. What are the incremental free cash flows of leasing versus​ buying?

Answer 1

	a	ALTERNATIVE 1-PURCHASE
		Free Cash Flow:
		Cost of Fabricator in year 0	($751,000)
		Depreciation Tax shield:
		Annual Depreciation=751000/7=	$107,286
		Annual Depreciation Tax Shield	$37,550	(107286*Tax Rate(35%))
		Year	0	1	2	3	4	5	6	7
		Free Cash Flow	($751,000)	$37,550	$37,550	$37,550	$37,550	$37,550	$37,550	$37,550
	b	ALTERNATIVE 2-LEASE
		Before tax annual cash flow	($129,000)
		After Tax Annual Cash Flow=129000*(1-Tax Rate)	($83,850)
		Year	0	1	2	3	4	5	6	7
		Free Cash Flow	$0	-$83,850	-$83,850	-$83,850	-$83,850	-$83,850	-$83,850	-$83,850
	c	Incremental Free Cash Flow	0	1	2	3	4	5	6	7
			($751,000)	$121,400	$121,400	$121,400	$121,400	$121,400	$121,400	$121,400