Question

Coffeemania is considering leasing a coffee making machine for its recently opened store. The lease agreement requires 7 lease payments in the amount of $6,300 per year paid at the beginning of each year. Each coffee making machine's purchase price is $38,000, and it depreciates straight-line to zero value over the duration of the lease. Coffeemania pays a 26% tax rate on its corporate income. The company's annual borrowing rate is 4%. Coffeemania needs to figure out whether leasing, rather than buying the coffee making machine, is the right way to go. The necessary calculations show that the incremental cash flow for "Year 0" equals negative (i.e., < $0) $38,000 . What does this cash flow include / doesn't include? It includes the after-tax lease payment (cash outflow), It doesn't include the after-tax lease payment (cash inflow), It includes the depreciation tax shield (cash outflow), It [ Select ] the depreciation tax shield (cash inflow), It [ Select ] the purchase price (cash outflow), It [ Select ] the purchase price (cash inflow).

Answer 1

The negative $38,000 incremental cash flow in 'Year 0' for Coffee mania includes the purchase price (cash outflow) and the depreciation tax shield (cash inflow), indicating the immediate expense and future tax savings from buying a coffee machine rather than leasing it.

Step-by-step explanation:

To understand whether leasing is more beneficial than buying a coffee-making machine for Coffee mania, the incremental cash flow for 'Year 0' is considered. In this scenario, the incremental cash flow is reported as negative $38,000, which represents the cash outflow for purchasing the machine outright.

This cash flow calculation includes the full purchase price of the machine as a cash outflow and does not include any lease payments, as these are not applicable in the purchase scenario.

Notably, the depreciation tax shield is also included as a cash inflow due to the tax savings from depreciation expenses. This shield reflects a reduction in tax liability as the asset depreciates over time, offering a delayed monetary benefit.

Overall, the presence of the depreciation tax shield mitigates the initial cash outflow, yet the initial purchase price remains a significant outflow that impacts Coffeemania's immediate financial position.