review the additional problem comparing leasing versus purchasing.

A1:

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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.