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.
Question:
What are the annual cash flows if the truck is purchased with debt financing?
Expert Answer
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: | |||
Year | Depreciation
(Rate*Purchase cost) |
Depreciation Shield (Depreciation * Tax rate) |
|
1 | 18000 | 7200 | |
2 | 27000 | 10800 | |
3 | 12000 | 4800 | |
4 | 3000 | 1200 | |
Calculation of Annual cash flows: | |||
Year | Net cash flows | ||
0 | -60000 | ||
1 | 7200 | ||
2 | 10800 | ||
3 | 4800 | ||
4 | 1200 |