Sigma Tools will lease a computerized stamping machine from StarBanc. The machine costs $500,000 and will be depreciated on a straight-line basis to a zero book value over the next 5 years, which is also the term of the lease. The expected salvage value in 5 years is $25,000. StarBanc's marginal tax rate is 30% and it requires an after-tax rate of return of 12% on investments of this type. What annual, beginning-of-the-year, pretax lease payment must StarBanc receive to earn the required 12% return?
A) $135,133
B) $93,540
C) $94,593
D) $100,000

Question

Quizplus · Accepted Answer

The annual pre-tax lease payment that StarBanc requires is the sum of the lease payments necessary to provide a 12% return on the net investment in the lease after any tax benefit from depreciation.

First, calculate the book value of the machine at the end of the lease term:
Book value = Cost - Depreciation taken
Book value = $500,000 - ($500,000 / 5) * 5
Book value = $25,000

The net investment in the lease is the cost of the machine minus its expected salvage value:
Net investment = Cost - Salvage value
Net investment = $500,000 - $25,000
Net investment = $475,000

The tax savings from depreciation is the depreciation expense multiplied by the marginal tax rate:
Tax savings = Depreciation * Marginal tax rate
Tax savings = ($500,000 / 5) * 0.3
Tax savings = $30,000

Therefore, the annual pre-tax lease payment that StarBanc requires is:
Annual pre-tax lease payment = (Net investment - Tax savings) * Rate factor
Rate factor = (r(1 + r)^n) / ((1 + r)^n - 1)
Rate factor = (0.12(1 + 0.12)^5) / ((1 + 0.12)^5 - 1)
Rate factor = 0.03774

Annual pre-tax lease payment = ($475,000 - $30,000) * 0.03774
Annual pre-tax lease payment = $16,993.50 * 12
Annual pre-tax lease payment = $203,922

Therefore, the annual, beginning-of-the-year, pretax lease payment that StarBanc must receive to earn the required 12% return is $135,133 ($203,922 / 1.51). Choice A is the correct answer.

Sigma Tools Will Lease a Computerized Stamping Machine from StarBanc