Turner's has decided to modernize its production facility by acquiring $2.4 million in new fixed assets that will be depreciated straight-line to zero over five years. This equipment will have no salvage value but will provide $1,880,000 in annual pretax cost savings. Turner's tax rate is 21 percent and its pretax cost of debt is 8.6 percent. Thrifty Leasing has offered a 5-year lease on this equipment with annual payments due at the beginning of each year. What is the maximum lease payment that would be acceptable to Turner's?

Question

Quizplus · Accepted Answer

First, we calculate the annual depreciation expense:

Annual Depreciation Expense = $2.4 million / 5 = $480,000

Next, we calculate the after-tax cost savings:

After-Tax Cost Savings = $1,880,000 x (1 - 0.21) = $1,487,200

To determine the maximum lease payment that would be acceptable to Turner's, we need to calculate the present value of the after-tax cost savings and subtract the cost of the lease payments. We'll use the after-tax cost of debt as the discount rate:

Present Value of After-Tax Cost Savings = $1,487,200 / (1 + 0.086 x (1 - 0.21)) + $480,000 x 5 x 0.21 / (1 + 0.086 x (1 - 0.21))^5 = $5,341,067

Now we can solve for the maximum lease payment:

$5,341,067 = PMT x (1 - 1 / (1 + 0.086 x (1 - 0.21))^5) / (0.086 x (1 - 0.21))
PMT = $570,497

Therefore, the maximum lease payment that would be acceptable to Turner's is $570,497, which is option B.

Turner's Has Decided to Modernize Its Production Facility by Acquiring