Question

Juno Amination Inc. wants to lease some new equipment for 5 years. The lease contract requires five annual lease payments that begin at the inception of the lease. The equipment would cost $115,000 to buy and would be depreciated straightline to a zero salvage value. The actual salvage value is zero. The applicable pretax borrowing rate is 8 percent. The lessee’s tax rate is 0. The lessor's tax rate is 30 percent. What is the minimum price that will be acceptable to both parties?

a. The lessee and the lessor cannot agree on the price

       
b. $28,152

       
c. $26,668

       
d. $27,176

Answer 1

Cost of equipment = $115000

Straight line depreciation each year = $115000/5 = $23000

Tax rate = 30%

Depreciation tax shield = Straight line depreciation each year x Tax rate

= $23000 x 30% = $6900

After tax borrowing rate for lessor = 8% x (1 - 0.30)

= 8% x 0.70 = 5.6%

Present value of depreciation tax shield = $6900 x Present value annuity factor(5.6%,5)

= $6900 x 4.2586 = $29384.34

Let lease rent be A.

Present value of lease rent = A + A x Present value annuity factor(5.6%,4)

= A + A x 3.49 = A + 3.49A = 4.49A

Tax on lease rent = A x 0.3 = 0.3A

Present value of tax on lease rent = 0.3A x Present value annuity factor(5.6%,5)

= 0.3A x 4.2586 = 1.28A

As per equation,

Present value of lease rent - Present value of tax on lease rent = Cost of equipment - Present value of depreciation tax shield

4.49A - 1.28A = $115000 - $29384.34

3.21A = $85615.66

3.21A = $85615.66

A = $85615.66/3.21

A = $26671.55 which is approximately $26668

Correct answer is c. $26,668

Note : Answer is slightly different due to rounding off error.