Contech (lessee) wishes to lease a printing press valued at $60,000 from Wrenn Capital (lessor) for a period of 4 years. Wrenn expects to depreciate the asset on a straight-line basis to a salvage value of $0. Actual salvage value is expected to be $8,000 at the end of 4 years. If Wrenn requires a 12% after-tax rate of return on the lease, what is the lessor's amount to be amortized? Assume Wrenn's marginal tax rate is 40%.

Question

Quizplus · Accepted Answer

First, we need to calculate the depreciation expense per year:
($60,000 - $0) / 4 years = $15,000 per year

Then, we need to calculate the after-tax cash flows per year for Wrenn:
Before-tax lease payment = depreciation expense + desired rate of return = $15,000 + ($60,000 x 12%) = $22,200
Lessor's tax savings = depreciation expense x lessor's marginal tax rate = $15,000 x 40% = $6,000
After-tax lease payment = before-tax lease payment - lessor's tax savings = $22,200 - $6,000 = $16,200 per year

To calculate the lessor's amount to be amortized, we can use the annuity formula:
PMT = A / ((1 - (1 / (1 + r)^n)) / r)
where PMT = after-tax lease payment, A = present value or amount to be amortized, r = after-tax discount rate, and n = number of periods (years)

Plugging in the numbers, we have:
$16,200 = A / ((1 - (1 / (1 + 0.12)^4)) / 0.12)
Solving for A, we get:
A = $38,725

Therefore, the lessor's amount to be amortized is $38,725 (choice B).

Contech (Lessee) Wishes to Lease a Printing Press Valued at $60,000