Question

Daily Enterprises is contemplating the acquisition of some new equipment. The purchase price is $35,000. The equipment has a 4-year life. The company expects to sell the equipment at the end of year 4 for $7,000. The firm uses MACRS depreciation which allows for 33.33 percent, 44.44 percent, 14.82 percent, and 7.41 percent depreciation over years 1 to 4, respectively. The equipment can be leased for $9,000 a year. The firm can borrow money at 9 percent and has a 33 percent tax rate. What is the incremental annual cash flow for year 4 if the company decides to lease the equipment rather than purchase it?

A. $-14,452

B. $-6,100

C. $-6,894

D. $-11,120

E. $-11,576

Answer 1

Solution:
	Answer is E. $-11,576
Working Notes:
	As life of the machine and lease period same means it will a Finance lease
Hence
	Incremental Cash flow for 4th year for finance lease will be
	= Lease cost net of tax + Depreciation cost saving tax + Salvage value net of tax
1st	Lease cost net of tax
	= Annual lease cost x (1- Tax rate )
	=$9,000 x ( 1- 0.33)
	=$9,000 x 0.67
	=$6,030
2nd
	Depreciation cost saving tax
	= Cost of machine x depreciation rate for 4th year x tax rate
	= 35,000 x 7.41% x 33%
	=855.855
3rd	Salvage value net of tax
	= Salvage value x (1- tax rate)
	= 7000 x (1 - 0.33)
	= 7000 x 0.67
	=4690
	Incremental Cash flow for 4th year for finance lease will be
	= Lease cost net of tax + Depreciation cost saving tax + Salvage value net of tax
	=6030 + 855.855 + 4690
	=11,575.8555
	=11,576
Since	Daily enterprises is Lessee it will be negative
	-11576
Please feel free to ask if anything about above solution in comment section of the question.