A firm could buy an asset for $18,000 by borrowing the funds at 10 percent for three years with interest paid annually and the entire loan repaid at maturity.

The firm could lease the equipment for $7,000 a year including maintenance.

If the firm does buy, maintenance will be $1,000 a year.

The estimated after-tax salvage value is $1,250, and depreciation will be $6,000 annually.

Construct projected cash outflows for each alternative for three

years. Assume a 30 percent income tax rate.

Is leasing the better alternative if management uses a cost of funds of 10 percent?

Cash outflows under leasing:

Year 0 1 2 3 4

Lease payment

Tax savings

Cash outflows

PV cash outflows under leasing:

Cash flows under purchasing and borrowing:

Year 1 2 3

Principal

repayment

Interest

Maintenance

Depreciation

Tax deductible

expenses

Tax savings

Salvage value 1,250 (listed under year 3)

(after tax)

Cash outflows

PV of cash outflows

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Which alternative should management select? Why?