Info

Total cash flow

+$10,000

-$2,330

-$2,330

-$2,330

-$2,330

-$2,330

Tasha has a corporate tax rate of 34 percent. For simplicity, we assume that five-year straight-line depreciation will be used for the pipe-boring machine, and, after five years, the machine will be worthless. Johnson Leasing Corporation has offered to lease the same pipe-boring machine to Tasha for lease payments of $2,500 paid at the end of each of the next five years. With the lease, Tasha would remain responsible for maintenance, insurance, and operating expenses.5

Susan Smart has been asked to compare the direct incremental cash flows from leasing the IBMC machine to the cash flows associated with buying it. The first thing she realizes is that, because Tasha will get the machine either way, the $6,000 savings will be realized whether the machine is leased or purchased. Thus, this cost savings, and any other operating costs or revenues, can be ignored in the analysis.

Upon reflection, Ms. Smart concludes that there are only three important cash flow differences between leasing and buying:6

1. If the machine is leased, Tasha must make a lease payment of $2,500 each year. However, lease payments are fully tax deductible, so the aftertax lease payment would be $2,500 X (1 - .34) = $1,650. This is a cost of leasing instead of buying.

2. If the machine is leased, Tasha does not own it and cannot depreciate it for tax purposes. The depreciation would be $10,000/5 = $2,000 per year. A $2,000 depreciation deduction generates a tax shield of $2,000 X .34 = $680 per year. Tasha loses this valuable tax shield if it leases, so this is a cost of leasing.

3. If the machine is leased, Tasha does not have to spend $10,000 today to buy it. This is a benefit from leasing.

The cash flows from leasing instead of buying are summarized in Table 26.2. Notice that the cost of the machine shows up with a positive sign in Year 0. This is a reflection of the fact that Tasha saves the initial $10,000 equipment cost by leasing instead of buying.

5We have assumed that all lease payments are made in arrears, that is, at the end of the year. Actually, many leases require payments to be made at the beginning of the year.

6There is a fourth consequence of leasing that we do not discuss here. If the machine has a nontrivial residual value, then, if we lease, we give up that residual value. This is another cost of leasing instead of buying.

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