Quartz Corporation is a relatively new firm. Quartz has experienced enough losses during its early years...

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.

Solutions

Expert Solution

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.

jeff jeffy answered 1 year ago

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