Concept explainers
- (1) Assume that the lease payments were actually $280,000 per year, that Consolidated Leasing is also in the 25% tax bracket, and that it also
forecasts a $200,000 residual value. Also, to furnish the maintenance support, it would have to purchase a maintenance contract from the manufacturer at the same $20,000 annual cost, again paid in advance. Consolidated Leasing can obtain an expected 10% pre-tax return on investments of similar risk. What are itsNPV andIRR of leasing under these conditions? - (2) What do you think the lessor’s NPV would be if the lease payment were set at $260,000 per year? (Hint: The lessor’s cash flows would be a “mirror image” of the lessee’s cash flows.)
(1)
Case Study:
LS Inc has to acquire new market data and quotation system for its new home office. The system may display the data onscreen or may save it for later retrieval and system also allow customers to make call and can convey current quotes. Cost of the equipment is $ 1,000,000 and if the company wants to purchase the equipment they can borrow a loan at a interest rate of 10%. Useful life of equipment is 6 years and it comes under 3 years MARCS class or it can purchase a contract of 4 years where $20,000 have to be paid at the beginning of each year and it will be sold after 4 years and for consolidated ;leasing it will cost for $260,000 which include maintenance cost. Federal plus state tax is 25%.
To determine:
The value of NPV and IRR of leasing
Explanation of Solution
The Lessor invests $1, 000, 0000 to buy the equipment
Particulars | Year 0 | Year 1 | Year 2 | Year 3 | Year 4 |
Equipment Cost | ($1,000,000) | $0 | $0 | $0 | $0 |
Depreciation expense | $0 | $83,325 | $111,125 | $37,025 | $18,525 |
Maintenance | ($20,000) | ($20,000) | ($20,000) | ($20,000) | $0 |
Tax saving on maintenance | $5,000 | $5,000 | $5,000 | $5,000 | $0 |
Lease payment | $280,000 | $280,000 | $280,000 | $280,000 | $0 |
Tax on lease payment | ($70,000) | ($70,000) | ($70,000) | ($70,000) | $0 |
Residual Value | $0 | $0 | $0 | $0 | $200,000 |
Tax on residual value | $0 | $0 | $0 | $0 | ($50,000) |
Net cash flow | ($805,000) | $278,325 | $306,125 | $232,025 | $168,525 |
Present value factor1 | 1 | 0.930232 | 0.865332 | 0.804961 | 0.748801 |
Present Values | ($805,000) | $258906.82 | $264899.75 | 186771.07 | $126191.68 |
Net Present Value at after tax cost of debt. | $31769.32 |
Therefore the NPV @7.5% is $31,770.
Working Note:
Calculation of After Tax Return:
2. Calculation of Present Value Factor
Calculation of Total Present Values:
Calculation of Net Present Value:
(2)
To determine:
Lessor’s NPV if lease payment is $260,000 per year.
Explanation of Solution
Formula to calculate net present value:
Substitute the value of present value of cash inflows: $568,758.82 and total present value of cash outflow: $825,000.
Calculation of net present value:
Therefore, the net present value if lease payment of $260,000 is made will be $(256,241.18)
Working Notes:
Particulars | Year 0 | Year 1 | Year 2 | Year 3 | Year 4 |
Equipment Cost | ($1,000,000) | $0 | $0 | $0 | $0 |
Depreciation expense | $0 | $83,325 | $111,125 | $37,025 | $18,525 |
Maintenance | ($20,000) | ($20,000) | ($20,000) | ($20,000) | $0 |
Tax saving on maintenance | $5,000 | $5,000 | $5,000 | $5,000 | $0 |
Lease payment | $260,000 | $260,000 | $260,000 | $260,000 | $0 |
Tax on lease payment | ($70,000) | ($70,000) | ($70,000) | ($70,000) | $0 |
Residual Value | $0 | $0 | $0 | $0 | $200,000 |
Tax on residual value | $0 | $0 | $0 | $0 | ($50,000) |
Net cash flow | ($825,000) | $258,325 | $286,125 | $212,025 | $168,525 |
Present value factor1 | 1 | 0.930232 | 0.865332 | 0.804961 | 0.748801 |
Present Values | ($825,000) | $240,302.18 | $247,593.11 | $170,671.85 | $126,191.68 |
Net Present Value at after tax cost of debt. | $(256,241.18) |
Calculation of Total Present Values:
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Chapter 19 Solutions
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