Question

Icehouse Inc. is considering leasing a freezer to another firm. The freezer costs $85,000. The 5 year lease requires 5 beginning of the year payments. The leasing company is depreciating the freezer on a straight-line basis over the five years. The after-tax salvage value is $35,000. Icehouse's required rate of return is 18% Assume a marginal tax rate of 40%. 

Round to the nearest $ 

What is the present value of the after-tax salvage value? 

What is the present value of the depreciation tax shield? 

What is the amount to be amortized? This is the answer to step one when working the problem. 

What is the lease payment that icehouse should charge the other party?

Answer 1

1. Calculation of present value of the after-tax salvage value:

Given that

After-tax salvage value of the freezer at the end of year 5 is $35,000

Useful life of the asset (Freezer) is 5 years

Icehouse required rate of return = 18%

Present value factor (PVAF) for 18%, 5 years is 0.44

Present value of after-tax salvage value will be = After-tax salvage value at the end of year 5 x PVAF for (18%,5years)

= $35,000 x 0.44 = $15,400

2. Calculation of present value of the depreciation tax shield:

Salvage value of the Freezer = After-tax salvage value / (1 - tax rate)

After-tax salvage value = $35,000

Tax rate = 40%

Salvage value of the Freezer at the end of year 5 = $35,000 / (1 - 0.40) = $58,333

Cost of the Freezer = $85,000

Useful life of the Freezer = 5 years

Method of depreciation is = Straight-line method (i.e. depreciated over the useful life of freezer)

Depreciable amount = Cost of the Freezer - Salvage value = $85,000 - $58,333 = $26,667

Depreciation under straight-line method = Depreciable amount / useful life of Freezer = $26,667 / 5 = $5,333

Depreciation tax shield = Depreciation x (1 - tax rate) = $5,333 x (1 - 0.40) = $2,133

Statement showing the present value of depreciation tax shield:

Year	Particulars	Amount ($)	Present Value Factor @ 18%	Present Value ($)
(A)	(B)	(C )	(D)	(E = C * D)
1	Depreciation tax shield	$2,133	0.85	$1,813.05
2	Depreciation tax shield	2,133	0.72	1,535.76
3	Depreciation tax shield	2,133	0.61	1,301.13
4	Depreciation tax shield	2,133	0.52	1,109.16
5	Depreciation tax shield	2,133	0.44	938.52
	Total			$6,697.62

Therefore the present value of depreciation tax shield for year 1 to year 5 is $6,698.

3. Calculation of amount to be amortized over the period of 5 years:

Cost of the Freezer = $85,000

Useful life of the Freezer = 5 years

Salvage value before tax (as per Note 2 above) = $58,333

Amount to be amortized over a period of 5 years = $85,000 - $58,333 = $26,667

4. Lease payment that the Icehouse should charge the other party for each year will be:

Cost of the Freezer = $85,000

Useful life of the Freezer = 5 years

Lease period = 5 years

Therefore, the yearly lease rental to be paid at the beginning of the year = Cost of the Freezer / Lease period

= $85,000 / 5 years = $17,000

Lease amount to be charged every year will be $17,000.