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.