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Carolina Inc. is deciding whether to buy or lease a piece of equipment. Analyst estimated the...

Carolina Inc. is deciding whether to buy or lease a piece of equipment. Analyst estimated the CFs associated with both options. Equipment can be purchased for $100,000, it will last for 10 years and will be depreciated straight line to zero (no residual value). Alternatively, Carolina can lease this equipment at $14,000 per year. Since this is true tax lease, Carolina can deduct lease payments as an operating expense when they are paid.

If Carolina’s borrowing rate is 7% and tax rate is 40%, should Carolina lease or purchase equipment? Why?

(Hint: depreciation creates tax shield, lease payments also create tax shield).

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Answer #1

Carolina should lease the equipment, because the present value of Cashflows is high in buy option.

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