Present Value Lease Problem
Category: Business and Money > Finance
Asked by: lily3_98-ga
List Price: $5.00
01 Oct 2005 09:39 PDT
Expires: 31 Oct 2005 08:39 PST
Question ID: 575017
Mr. Lease has been hired by Cameltrod 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.) A. 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 B. Calculate the annual after-tax required lease income. 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. 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.
Re: Present Value Lease Problem
Answered By: omnivorous-ga on 01 Oct 2005 10:06 PDT
Lily3_98 ? You can calculate the lease payments in 3 steps ? Step A: Calculate the Net Present Value (NPV) of the amount to be amortized. Step B: Calculate the annual after-tax required lease income. By taking your answer from Step 1 as an NPV then use the number of years and the required rate of return to get the required payment. Step C: Calculate the lease payment by taking the answer from Step B and adjusting for taxes. You?ll divide it by (1 - the tax rate). 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. Even without Excel, it's viewable in your browser: NPV Cash Flow http://www.mooneyevents.com/mrlease.xls So the lease is $64,875.32 --- You will often see this problem worked incorrectly, such as in the example below. It?s incorrect because of the tax handling of the salvage value, which it claims back twice ? both in step A and step C: http://www.justanswer.com/JA/ASP_A/T_75792/TR/finance.htm?get=last If you have any questions about these calculations, please let us know via a Clarification Request before rating this Google Answer. Best regards, Omnivorous-GA
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