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.

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

Great response and explanation, thanks!