f.         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.

Sting44 ?

Following the method outlined in this question, you can calculate the
lease payments.

In Step A it?s very important to note that the salvage value of the
machine ($35,000) will get discounted for net present value (NPV) ?
but not for tax effects.

Why no taxes?  Because the leasing company is already showing a
-$40,000 income ? and the salvage simply reduces the loss.  In other
words, a company that?s losing money doesn?t have to worry about
paying taxes on any gains that are less than its losses.

The calculations in the three steps are all in this Excel spreadsheet,
which your browser should be able to read, even if you don?t have
Excel itself.  By netting up the year 5 salvage and depreciation, we
avoid the potential error mentioned in the previous paragraph.  If you
do have Excel, you can download and change the spreadsheet:

NPV Cash Flow
http://www.mooneyevents.xls/npvlease1.xls

If you have any questions about these calculations, please let us know
via a Clarification Request.

Best regards,

Omnivorous-GA

---

Clarification of Answer by omnivorous-ga on 09 Aug 2005 08:21 PDT

Sting44 --

That correct URL should be:
http://www.mooneyevents.com/npvlease1.xls

Best regards,

Omnivorous-GA