A company can buy a machine for $100,000 at the start of year 1 (time 0) (4-year life, no residual value) or lease it for $28,000 a year payable at the end of each of years 1 to 4. Tax is 25%, with tax effects arising in the same year as the related cash flow. If bought, tax-allowable depreciation of 25% reducing balance is available from year 1, with a balancing allowance in year 4. The company can borrow at 8% before tax. Using exact (unrounded) discount factors, which option has the lower present value of cost, and by how much (to the nearest $)?

Correct answer: A) Lease, by $5,859

Explanation

Discount at the after-tax cost of borrowing: 8% x (1 - 0.25) = 6%. Buy: 100,000 less PV of tax savings on TAD (25,000, 18,750, 14,062.5 and balancing allowance 42,187.5, each x 25%) = $78,626. Lease: 28,000 x 0.75 = 21,000 a year x 4-year annuity factor at 6% (3.4651) = $72,767. Leasing is cheaper by $5,859 (exact discount factors, rounded to the nearest $). Tax relief on the lease payments and the TAD tax savings both arise in years 1 to 4, as tax is stated to be paid in the same year. Discounting both options at the pre-tax rate of 8% gives a difference of $10,096.