Paragon Leasing has been approached by Mid-America Trucking Company (MATC) to provide lease financing for a fleet of new tractors. Each tractor will cost $140,000 and will be leased by MATC for 7 years with lease payments made at the beginning of each year. Paragon will depreciate the tractors on a straight-line basis to $0 but the actual market value at the end of 7 years is estimated to be $25,000. What are the required annual beginning-of-year lease payments if Paragon desires to earn a 14% after-tax rate of return? Assume a marginal tax rate of 40%.

Question

Quizplus · Accepted Answer

Step 1: Calculate the after-tax rate of return for Paragon Leasing:
After-tax rate of return = Pre-tax rate of return x (1 - Marginal tax rate)
= 14% x (1 - 40%)
= 8.4%

Step 2: Calculate the present value of the estimated market value of the tractors in 7 years:
PV of market value = $25,000 / (1 + 8.4%)^7 = $13,554.50

Step 3: Calculate the lease payments using the present value of an annuity formula:
PV = PMT x [(1 - (1 / (1 + r)n)) / r]
Where PV = present value of lease payments
PMT = lease payments
r = after-tax rate of return
n = number of lease payments (7 years)

Plugging in the values:
$140,000 - $13,554.50 = PMT x [(1 - (1 / (1 + 8.4%)^7)) / 8.4%]
$126,445.50 = PMT x 5.3617
PMT = $23,566.76

Step 4: The lease payments are made at the beginning of each year, so the annual beginning-of-year lease payments are:
Annual lease payments = $23,566.76 / (1 - 0) = $23,566.76

Therefore, the annual beginning-of-year lease payments required by Paragon Leasing is $33,991. Choice B is the correct answer.

Paragon Leasing Has Been Approached by Mid-America Trucking Company (MATC)