Question

(Negotiating a lease rate) Amalgamated Leasing Corp. would like to submit a leasing pro- posal to the Sandoval Hardware Manufacturing Company. Sandoval has asked to lease $5 million worth of equipment under a six-year lease. Amalgamated can depreciate the equipment for tax purposes on a straight-line basis over the six-year term to an estimated residual value of $250,000. The leasing firm’s income tax rate is 40%. Amalgamated has estimated Sandoval’s six-year cost of funds to be 10% for secured debt (83.33% financing) and 12% for unsecured debt. It has also estimated the required after-tax return for an investment in the assets to be 15%.

a. At what lease rate would Amalgamated be indifferent to making the lease?

b. Assume Sandoval pays income taxes at a 30% rate. Calculate Sandoval’s net advantage to leasing at Amalgamated’s indifference lease rate.

c. At what lease rate would Sandoval be indifferent?

d. Is it possible for Amalgamated and Sandoval to find a mutually beneficial lease rate?

Answer 1

a. Cost of capital= 15%

Let lease rent=x

Tax= 40%

Dep per annum=( 5,000,000-250,000)/6=$791,666.7

Tax savings on depreciation per annum= 791,666.7*.4=$316,666.7

PVAF of 15% for 6 Years= 3.784

Cash inflow=Cash outflow

Lease rent net of tax+Tax saving on dep+ salvage value= Cost of equipment

(x-.4)*3.784 + 316,666.7*3.784+ 250,000*.432= 5,000,000

2.27x + 1,198,267+108,000 =3,693,733

x= $16,27,195

b. Net advantage of Leasing(NAL) method= Benefits of Leasing- Costs of leasing

Benefits

Purchase cost of Asset will be saved+ Tax savings on Lease rent will be there

Costs

Payment of lease rent +Loss of tax savings on depreciation +Loss of terminal value(net of tax)

Cost of Capital=12%

Benefits

Purchase cost of Asset= $5,000,000

Tax Savings on Lease Rent= 1,627,195*.3*3.784=1,847,192

Benefits= 6,847,192

Costs

Payment of Lease Rent= 1,627,195*3.784=$6,157,306

Loss on Tax savings on Dep= 898,700

Loss of Terminal Value= 108,000

Total= $7,164,006

Net advantage= $6,847,192-7,164,006= $(316,814)

c. Let rent =x

5,000,000+1.136x= 3.784x+1,006,000

3,994,000=2.648x

X= 1,508,308

d. No, because anything below $1,627,195 would not be accepted by Malagamated co. and anything above $1,508,308 would not be beneficial for Sandoval Co.