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A firm needs some new equipment
A firm needs some new equipment. The equipment would cost $100,000 if purchased and would be depreciated straight-line over five years. No salvage is expected. Alternatively, the company can lease the equipment for $25,000 per year. The marginal tax rate is 40%.
a) What are the incremental cash flows?
b) Compute NPV. Assume that the pre-tax cost of debt is 10%.
Expert Solution
a) Incremental cashflow are
$100,000 of cash inflow for year0
After tax lease payment of $15,000 cash outflows for year1-5
Lost depreciation tax shield of $8,000 for year1-5
b) For calculating NPV, incremental cashflows should be discounted at after tax cost of debt.
Cost of debt = 10%
After tax cost of debt = 10%(1-40%) = 6%
Net Present Value is $3,114.80
If NPV of incremental cashflow is less than zero, then the firm should buy the machine and if NPV is greater than zero, then the firm should lease the machine.
Here NPV of incremental cashflow is greater than zero. Therefore firm should lease the machine.
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