David, the sole proprietor of a small machine shop, is evaluating the investment of a piece of equipment that can either be purchased or leased. The expected annual net cash flow before tax from the equipment is $40,000. The equipment would be used for four years at which time it is estimated that the salvage value would be $25,000.

Details of the two options are :

Buy: The equipment can be bought for $100,000 and depreciated straight line to zero over four years.

Lease: Annual lease payments of $27,000 are payable in advance, whilst the tax benefit from the lease payments is claimed at the end of the year. The residual value is $30,000.

David has a personal tax rate of40% and requires a return on his investment of 15% pa. His before-tax cost of a loan is 12% pa.

a. Should David invest in the equipment?

b. Should David lease or buy the equipment?

please provide detailed explaination