Your employer, Barnaby Well Company, is considering the acquisition of a new drill truck and your boss has asked you to evaluate the decision that she has made to buy the truck. The truck has a purchase price of $60,000 and a useful life of 4 years and a zero salvage value. Barnaby can borrow to buy the truck for $60,000 or lease the truck for $15,000 for 4 years, paid at the beginning of each year.
If debt is used to buy the truck, Barnaby can borrow at 8% annual interest, with payments at the end of each year. The marginal tax rate for the firm is 40%. The asset is classified as a 3-year cost recovery asset for depreciation purposes. According to the current tax laws, Barnaby is allowed to use MACRS depreciation with 30% rate for year one, 45% for year two, 20% for year three and 5% for year four. There will be no salvage value at the end of the fourth year.
What are the annual cash flows if the truck is purchased with debt financing?
|Purchase price of truck =||60000|
|Useful life of truck =||4|
|Salvage value =||0|
|Borrowing rate =||8%|
|Tax rate =||40%|
|After tax debt = 8%*(1-0.40) = 8%*0.60 = 4.8%|
|Calculation of depreciation tax shield:|
Shield (Depreciation * Tax rate)
|Calculation of Annual cash flows:|
|Year||Net cash flows|