You are considering purchasing industrial equipment to meet the peak demand which will last only two years. The equipment costs $I00,000 and has an estimated market value of $40,000 at the end of two years. The expected marginal income tax rate during the project period is known to be 40%. Your firm’s interest rate (discount rate) is also 12%. Two types of financing are considered. where revenues and O&M expenses are not affected by the type of financing.

• Option I (Debt financing): Assuming that the equipment will be financed entirely from a bank loan at 10% over 2 years. You can make an arrangement to pay only the interest each year over the project period by deferring the principal payment until the end of 2 years. For tax purpose, the machine will be depreciated by a straight-line method with zero salvage value over 5 years (no half-year convention).
• Option 2 (Lease financing): Now you are considering the possibility of leasing the equipment under a two-year contract for a lease payment of $42,000 per year. payable at the beginning of each year. Determine the net incremental after-tax cash flows under Option 1. Determine the net incremental after-tax cash flows under Option 2. What annual lease payment (before tax) would make the two options economically indifferent?