Jamestown Industries is contemplating the acquisition of some new equipment. The purchase price is $40,000. The equipment has a 4-year life after which time it will be worthless. The equipment belongs in a 35 percent CCA class. The equipment can be leased for $11,000 a year. The firm can borrow money at 7 percent and has a 35 percent tax rate. What is the incremental annual cash flow for year 2 if the company decides to lease the equipment rather than purchase it?

A) -$11,193
B) -$7,904
C) -$4,778
D) -$2,916
E) -$928

Question

Jackson Wilkes · Accepted Answer

Final Answer : A, Explanation :  The incremental annual cash flow for year 2 if the company decides to lease the equipment rather than purchase it is -$11,193. This is because the company would save $11,000 in lease payments, but would have to pay $7,904 in additional taxes on the depreciation deduction. The net savings would be $11,000 - $7,904 = $3,096. However, the company would also have to pay $4,000 in interest on the loan used to purchase the equipment. This would result in a net incremental cash flow of $3,096 - $4,000 = -$11,193.

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