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Q: Financing ( Answered,   0 Comments )
Subject: Financing
Category: Business and Money > Finance
Asked by: bladehulk-ga
List Price: $13.50
Posted: 28 Nov 2006 09:34 PST
Expires: 28 Dec 2006 09:34 PST
Question ID: 786225
An assest costs $86.87.  Only straight-line depreciation is allowed
for this asset.  The asset's useful life is two years.  It will have
no salvage value.  The corporate tax rate on ordinary income is 34%. 
The interst rate on risk-free cash flows is 10%.

a. What set of lease payments will make the lessee and the lessor equally well off?

b. Show the general condition that will make the value of a lease to
the lessor the negative of the value to the lessee.

c. Assume that the lessee pays no taxes and the lessor is in the 34%
tax bracket.  For what range of lease payments does the lease have a
positive NPV for both parties?
Subject: Re: Financing
Answered By: omnivorous-ga on 28 Nov 2006 12:00 PST
Bladehulk ?

In setting up this problem, it is important to note that lease
payments are made in advance at the beginning of each year.

Thus the timing of the two lease payments will be year 0 (today!) and
year 1.  The lessor?s cash outflow for the asset is in year 0 too.

By contrast, taxes are paid at the end of the year.  Depreciation will
reduce income to the lessor by $43.435 per year ? which rounds to
$43.44 in the spreadsheet below.  That?s not the positive cash flow ?
but the tax ?credit? which I?ve marked ?tax rebate? is $43.44 * tax
rate = $14.77 each year.

Lease Cost

The NPV of the cash flows to the lessor is ($61.24).  

So, the answer to (a) is: two equal payments in year 0 and year 1 that
match $61.24 in NPV.  The number turns out to be $32.08, as indicated
on line 14.

b. For the lease to be negative to the lessor, there has to be a
reduction in the ?discounted cash? flow equal to the increase in the
discounted cash flow to the lessee.

This is NOT the same as a $1 reduction in the lease payment, due to
timing.  You can prove this by reducing the line 14 amount by $1 and
see what happens to the total PV of cash flows.

c.	This example uses lessor in 34% range and lessee with no taxes
because we have no idea what the cash flows for the lessee are.

Any lease payment above $32.08 is positive for the lessor.
Any cash flow for the lessee that produces a POSITIVE NPV, taking into
account the lease payment has a positive NPV for the lessee.  This
could be $35 or $40 --- we don't know anything about the lessee's cash
flow here.

Best regards,

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