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Q: Present Value Lease Problem ( Answered 3 out of 5 stars,   0 Comments )
Subject: Present Value Lease Problem
Category: Business and Money > Finance
Asked by: mrynot-ga
List Price: $5.00
Posted: 07 Feb 2005 06:58 PST
Expires: 09 Mar 2005 06:58 PST
Question ID: 470314
I need some tutoring in this finance course I am taking, in
preparation for an up coming examination. The following question
contains information of a ficticous company.

Present Value Lease Problem?Calculating Annual Payments

Leases R Us, Inc. (LRU) has been contracted by Robotics of Beverly Hills (RBH) to
provide lease financing for a machine that would assist in automating
a large part of their
current assembly line. Annual lease payments will start at the
beginning of each year.
The purchase price of this machine is $200,000, and it will be leased
by RBH for a period
of 5 years. LRU will utilize straight line depreciation of $40,000 per
year with a zero book
salvage value. However, salvage value is estimated to actually be
$35,000 at the end of
5 years. LRU is required to earn a 14%, after-tax rate of return on
the lease. LRU uses a
marginal tax rate of 40%. Calculate the annual lease payments. (Remember, these
payments are to be considered at the beginning of each year?annuity due.)
Hints for students:

There are 3 major steps that need to be accomplished in order to
calculate the annual
lease payment.

Step A: You need to calculate the amount to be amortized. This would
be the cost of the
machine less the PV of the after tax salvage value of the machine and
less the PV of the
depreciation tax shield

Step B: You need to calculate the annual after-tax required lease
income. (Remember, in
this step, you need to calculate it as an annuity due?a beginning of
the year payment.)
Take your answer from Step A as a present value, and using the number of years and
the required rate of return, calculate the payment.

Step C: Calculate the lease payment. You need to adjust for the
appropriate tax rate.
Therefore, take your answer in Step B and divide it by (1 - the tax
rate). This will give you
the required lease payment.

Help please?
Subject: Re: Present Value Lease Problem
Answered By: omnivorous-ga on 07 Feb 2005 10:32 PST
Rated:3 out of 5 stars
Mrynot ?

The explanation of how to handle a leasing problem in the hints is excellent.  
I?ve set up a spreadsheet to handle the calculations and done it in
the Step A/Step B/Step C manner described:

Some notes for you:

A.	In Step A it?s key to have the timing of your payments correct:
finance problems often use the ?Year 0? convention for everything
happening today.

Also, though there?s $40,000 in depreciation the final year you won?t
see all of that because of the re-capture on sale.

Next, it?s important to note that, while you?re paying taxes (and
that?s negative cash flow), the depreciation is a non-cash item and so
comes back in the form of a ?tax rebate,? which is POSITIVE cash flow.
 The leasing firm has to be profitable for that to happen.

B.	There are two ways to get your Payment amount: plug in a constant
lease payment guess in each of the 5 years.  I guessed $35,000 ? you
can change it on the spreadsheet to any amount that you want.  You?re
trying to get to an identical PV as the total in Step A ? and
obviously $35,000 is too little.

You can also use Microsoft?s PMT function, which requires:
Rate: 14%
NPER (number of periods): 5
PV: $152,342
FV (end future valuation): 0
Beginning/end of period for payment: 1 (beginning; if it were a bond
or interest payment it would be the end of the period)

You can see the PMT format in the spreadsheet, but it?s:

So the lease payments would be $64,875 -- a high amount by current
lease standards because the interest rate is higher; the tax rate is
far above the corporate rate of 33% today; and depreciation terms are
much more conservative than current allowances.

Best regards,

mrynot-ga rated this answer:3 out of 5 stars

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