Question & Answer: 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 h…..

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
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