Question

Quartz Corporation is a relatively new firm. Quartz has experienced enough losses during its early years to provide it with at least eight years of tax loss carryforwards. Thus, Quartz’s effective tax rate is zero. Quartz plans to lease equipment from New Leasing Company. The term of the lease is five years. The purchase cost of the equipment is $860,000. New Leasing Company is in the 35 percent tax bracket. There are no transaction costs to the lease. Each firm can borrow at 9 percent.

a.	What is Quartz’s reservation price? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Reservation price

$

b.	What is New Leasing Company’s reservation price? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Reservation price

$

Answer 1

(a): $221,099.51

(b): $220,197.70

Calculations and explanations:

(a):

Since the lessee has an effective tax rate of zero, there is no depreciation tax shield foregone. Also, the after-tax lease payment is the same as the pre-tax payment, and the after-tax cost of debt is the same as the pre-tax cost. To find the most the lessee would pay, we set the NAL equal to zero and solve for the payment, doing so, we find the most the lessee will pay is:

NAL = 0 = 860,000 – PMT (PVIFA 9%, 5)

Or PMT (PVIFA 9%, 5) = 860,000

Now PVIFA = [1 – (1+r)^-n]/r

So PVIFA 9%, 5 = [1-(1.09)^-5]/0.09

= 3.889651

Thus PMT*3.889651 = 860,000

Or PMT = 860,000/3.889651

= $221,099.51

(b): Depreciation tax shield = (860,000/5)*0.35 = $60,200

After tax cost of debt = 0.09*(1-35%) = 5.85%

Now, NPV = 0 = -860,000 + PMT(1-0.35)(PVIFA 5.85%, 5) + 60,200(PVIFA 5.85%, 5)

PVIFA 5.85%, 5 = [1-(1.0585)^-5]/0.0585 = 4.2296086

So, 0 = -860,000 + PMT*0.65*4.2296086 + 60,200*4.2296086

Or 0 = -860,000 + PMT*0.65*4.2296086 + 254,622.44

Or PMT*0.65*4.2296086 = 605,377.56

Or PMT = 220,197.70