A1:
Since the present value of the cash outflows from owning exceed the present value of the cash outflows from leasing, leasing is preferred.
|
Cash Outflows/Inflows Associated with Leasing |
|||
|
Year |
1 |
2 |
3 |
|
Lease payments |
$55,000 |
55,000 |
55,000 |
|
Maintenance |
5,000 |
6,000 |
7,000 |
|
Total tax-deductible expenses |
60,000 |
61,000 |
62,000 |
|
Tax savings |
24,000 |
24,400 |
24,800 |
|
After-tax net cash outflow from leasing |
36,000 |
36,600 |
37,200 |
Present value of the cost of leasing (using the 10 percent interest rate):
$36,000(0.909) + $36,600(0.826) + $37,200(0.751) = $90,892
|
Cash Outflows/Inflows Associated with Owning |
|||||
|
Year |
1 |
2 |
3 |
4 |
5 |
|
Maintenance |
$ 5,000 |
5,000 |
5,000 |
||
|
Depreciation |
40,000 |
60,000 |
40,000 |
Not applicable |
|
|
Interest |
20,000 |
16,000 |
12,000 |
Not applicable |
|
|
Principal Repayment |
40,000 |
40,000 |
40,000 + 80,000 balance repaid = 120,000 |
||
|
Total tax-deductible expenses |
65,000 |
81,000 |
67,000 |
||
|
Tax savings |
26,000 |
32,400 |
26,800 |
||
|
Sale of equipment |
50,000 |
||||
|
After-tax inflow from sale of equipment |
54,000 |
||||
|
After-tax net cash outflow from owning |
39,000 |
28,600 |
56,200 |
Present value of the cost of leasing (using the 10 percent interest rate):
$39,000(0.909) + 28,600(0.826) + 56,200(0.751) = $101,281
Since the asset is sold at the end of the third year, there are no entries for years 4 and 5 even though the expected life of the asset is five years.
The $80,000 balance of the loan must be repaid when the asset is sold.
The asset is sold for $50,000 but its book value is $60,000. The book value is the $200,000 cost minus the sum of the amount of depreciation during the first three years ($40,000 + $60,000 + $40,000). Since the asset is sold for $50,000, the firm has a $10,000 loss ($50,000 – $60,000). The $10,000 loss produces a $4,000 tax savings ($10,000 × 0.4). The net cash inflow from the sale is $50,000 + $4,000 = $54,000.
The cash outflow at the end of the third year is maintenance ($5,000) plus interest ($12,000) plus principal repayment ($120,000) minus the tax savings ($26,800) plus the after-tax proceeds from the sale ($54,000). That is $5,000 + $12,000 + $120,000 – $26,800 – $54,000 = $56,200.
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