Craxton Engineering will either purchase or lease a new $756,000 fabricator. If purchased, the fabricator will be depreciated on a straight-line basis over 7 years. Craxton can lease the fabricator for $130,000 per year for 7 years. Craxton’s tax rate is 35%. (Assume the fabricator has no residual value at the end of the 7 years.)
a. What are the free cash flow consequences of buying the fabricator if the lease is a true tax lease?
b. What are the free cash flow consequences of leasing the fabricator if the lease is a true tax lease?
c. What are the incremental free cash flows of leasing versus buying?
Problem 25-7 on Purchase versus Lease based on Chapter 25
Riverton Mining plans to purchase or lease $220,000 worth of excavation equipment. If purchased, the equipment will be depreciated on a straight-line basis over 5 years, after which it will be worthless. If leased, the annual lease payments will be $55,000 per year for 5 years.
Assume Riverton’s borrowing cost is 8%, its tax rate is 35%, and the lease qualifies as a true tax lease.
a. If Riverton purchases the equipment, what is the amount of the lease-equivalent loan?
b. Is Riverton better off leasing the equipment or financing the purchase using the lease equivalent loan?
c. What is the effective after-tax lease borrowing rate? How does this compare to Riverton’s actual after-tax borrowing rate?