Question

A firm wants the use of a machine that costs $100,000. If the firm purchases the equipment, it will depreciate the equipment at the rate of $20,000 a year for four years, at which time the equipment will have a residual value of $20,000. Maintenance will be $2,500 a year. The firm could lease the equipment for four years for an annual lease payment of $26,342. Currently, the firm is in the 40 percent income tax bracket.

a. Determine the firm’s cash inflows and outflows from purchasing the equipment and from leasing.

Answer 1

If the firm purchases the equipment, the total cash outflow will be $190,000. If the firm leases the equipment, the total cash outflow will be $105,368. Purchasing the equipment does not result in immediate cash inflows, but ownership may provide long-term benefits. Leasing allows the firm to use the equipment without a large upfront cost and can result in potential tax savings.

Step-by-step explanation:

When purchasing the equipment, the firm will have a cash outflow of $100,000 initially. The equipment will then depreciate at a rate of $20,000 per year for four years, resulting in a total cash outflow of $80,000 ($20,000 x 4). Additionally, there will be maintenance costs of $2,500 per year, totaling $10,000 ($2,500 x 4). Therefore, the total cash outflow from purchasing the equipment will be $190,000 ($100,000 + $80,000 + $10,000).

Alternatively, if the firm chooses to lease the equipment, the annual lease payment is $26,342 for four years. Hence, the total cash outflow from leasing will be $105,368 ($26,342 x 4).

In terms of cash inflows, purchasing the equipment does not result in any immediate cash inflows. However, ownership of the equipment may provide future benefits such as increased production capacity or savings on leasing costs in the long run. On the other hand, leasing the equipment allows the firm to use the equipment without a large upfront cost, and the lease payment is a tax-deductible expense. This can result in potential tax savings for the firm.