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. 27,176

c. 26,668

d. 28,152

Answer 1

1. For lessee

Benefit from lease = 115,000 (no need to buy)

Let the annual lease payment be 'Y'

Outflow from lease = Y x (present value annuity factor for 4 years @8% + 1)

= Y x (3.31213 + 1)

(Since the lease payments are made at the start of the periods, we have taken 1 + 4 years annuity)

Matching both outflow and benefit

115,000 = Y x 4.31213

Y = 26,668 (maximum amount acceptable to Lessee)

Note : Depreciation savings is not considered, because tax rate is nil and even if buy or lease (finance lease) the depreciation will be same)

2. For Lessor

Benefit foregone (opportunity cost) = 115,000 (which it can receive, if it sells to any other party)

Let Y be the annual lease payments received

Post tax borrowing rate = 8 x (1-0.3) = 5.6%

Benefit = Y x (1 - tax rate) x (1 + present value annuity factor for 4 years at 5.6%)

= Y x (1-0.3) x (1 + 3.49708)

= 0.7Y x (4.49708)

Matching both of these

115,000 = 0.7Y x (4.49708)

0.7Y = 25,572

Y = 36,531

This is minimum acceptable payment for Lessor

So, there can be no agreement between them because the minimum payment required for Lessor is higher than maximum lease payment acceptable for lessee.

Option a - The lessee and lessor cannot agree on the price

Note : The Tax on such sales by lessor ignored, if it is also considered

115,000 (1 - 0.3) = Y x (0.7) x (Present value annuity factor for 4 years at 8% + 1)

80,500 = 0.7Y x (1 + 3.31213)

0.7Y = 18,668.268

Y = 18,668.268/0.7

Y = 26,668.95

The minimum acceptable payment will be 26,668.95