A computer costs $500,000 and is depreciated for tax purposes straight-line over years 1 through 5. Assume that it has zero salvage value at the end of five years. The user wishes to lease the computer by making six annual lease payments, the first of which is due immediately. If taxes are paid without delay and the rate of interest is 10%, what is the minimum acceptable lease payment for a lessor who pays tax at 21%?

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The depreciation expense each year is $100,000 ($500,000 / 5). The total tax shield from depreciation is $21,000 per year ($100,000 × 21%). Since the lease payments are made in arrears, the present value of the six payments is found by discounting them back four years (the present value of an ordinary annuity for six years discounted at 10% for four years). This can be found using a financial calculator or by using the formula: $((1 - (1 + 0.10)^-6) / 0.10) x 3.486 = $2.188 million. At a 21% tax rate, the tax liability each year is $6,930 ($33,000 × 21%). Since the lease payments are considered ordinary income, the tax liability is $3,510 in each year of the lease term. The after-tax cash flow for the lessor each year is the lease payment minus the tax liability, which equals $23,682 ($27,192 - $3,510). The present value of the lease payments after adjusting for taxes is therefore $79,179 ($23,682 x 3.486). To make the lease viable, the cost to the lessor of the asset must be recoverable from the before-tax cash outflows in the lease term. This amount equals $508,690 ($500,000 + $33,000 x 6). Therefore, the minimum acceptable lease payment for the lessor is $104,967 ($508,690 / 4.844).

A Computer Costs $500,000 and Is Depreciated for Tax Purposes