A company is deciding whether to lease or buy a piece of equipment. Purchase: Cost $500,000. Useful life 5 years. Residual value $0. Tax rate 30%. Lease: Annual payment $110,000 for 5 years. Tax rate 30%. Which of the following factors is MOST relevant to the financial analysis of this decision?

Answer options:

The book depreciation method used for financial reporting.

The interest rate on the company's existing line of credit.

The tax shield from depreciation (if buying) versus the tax deduction of lease payments (if leasing).

The impact on EBITDA.

How to approach this question

Focus on Cash Flows. Depreciation is a non-cash expense but reduces taxes (cash outflow). Lease payments are cash outflows but tax deductible.

Full Answer

C.The tax shield from depreciation (if buying) versus the tax deduction of lease payments (if leasing).✓ Correct

The decision hinges on the timing and amount of cash flows. Buying involves an upfront outflow and subsequent tax savings from depreciation. Leasing involves periodic outflows which are tax deductible. The tax treatment is the primary differentiator in the cash flow model.

Common mistakes

Focusing on accounting income (EBITDA/Net Income) instead of cash flows.

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