In: Finance
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 carry-forwards. 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 $650,000. Assume straight line depreciation. New Leasing Company is in the 35 percent tax bracket. There are no transaction costs to the lease. Each firm can borrow at 7 percent.
What is Quartz’s maximum lease price?
What is New Leasing Company’s minimum lease price?
Explain why these reservation prices determine the negotiation range of the lease.
Quartz Corporation | |||||||
What is Quartz’s maximum lease price? | |||||||
The reservation payment is found by setting the NPV of the lease to $0, and then | |||||||
solving for the lease payment. | |||||||
For Quartz Corp, the lessee: | |||||||
Since Quartz's effective tax rate is 0, the after tax discount rate is 7%. | |||||||
Set the NPV = 0, and solve for L: | |||||||
NPV (lease) = Cost - after tax PV(lease payments) | |||||||
0 = $650,000 - L ( PVIFA 5,7% ) | |||||||
0 = $650,000 - L (4.1002) | |||||||
L = $158,528.9 | |||||||
The lease payment is Quartz’s reservation price. | |||||||
i.e. for L > $158,528.9, Quartz will have NPV<0. | |||||||
What is New Leasing Company’s minimum lease price? | |||||||
For New Leasing, the lessor: | |||||||
NPV = Cost + after tax PV(Lease payments) + PV(Depr tax shield) | |||||||
Depreciation = $650,000 / 5 = $ 130000 per annum | |||||||
Depreciation tax shield = $130,000 × 0.35 = $ 45500 | |||||||
After-tax discount rate = 0.07 (1 - 0.35) = 0.0455 = 4.55% | |||||||
As in part a., set NPV = 0, and solve for L: | |||||||
NPV (lease) = 0 = -$650,000 + L (1 - 0.35) (PVIFA 5,4.55% ) + $ 45500 ( PVIFA 5 ,4.55%) | |||||||
L = $ 158107.40 | |||||||
This lease payment is New Leasing Co’s reservation price. | |||||||
i.e. for L < 158,107.40, New Leasing will have NPV<0. | |||||||
Explain why these reservation prices determine the negotiation range of the lease. | |||||||
A lease payment less than $158,107.40 will give New Leasing a negative NPV. | |||||||
A payment higher than $158,528.9 will give Quartz a negative NPV. | |||||||
In either case, no deal will be struck. Therefore, these represent the lower and | |||||||
upper bounds of possible lease prices during negotiations. |