Nu-Tek is considering leasing some equipment for 4 years with equal annual lease payments.The equipment would cost $74,000 to buy and would be depreciated straightline over 4 years to a zero salvage value.The actual salvage value is zero.The applicable pretax borrowing rate is 7.3 percent.The lessee does not expect to owe taxes for several years while the lessor's tax rate is 21 percent.What is the minimum lease payment that will be acceptable to both parties?

Question

Quizplus · Accepted Answer

To find the minimum lease payment, we can use the present value of annuity formula:

PV = Lease Payment * (1 - (1 + r)-n) / r

Where, PV = Present value of lease payments, r = pretax borrowing rate, n = number of lease payments.

We can calculate the present value of buying the equipment:

PV of Equipment = $74,000

The depreciation expense each year would be $18,500 ($74,000 / 4). Since the actual salvage value is zero, the book value at the end of each year would be:

Year 1: $74,000 - $18,500 = $55,500
Year 2: $55,500 - $18,500 = $37,000
Year 3: $37,000 - $18,500 = $18,500
Year 4: $18,500 - $18,500 = $0

The present value of the depreciation tax shield for the lessor would be:

PV of Tax Shield = ($18,500 * 0.21) / (1 + 0.21)^3 + ($18,500 * 0.21) / (1 + 0.21)^2 + ($18,500 * 0.21) / (1 + 0.21) + ($18,500 * 0.21) = $14,604.13

The present value of the lease payments for the lessee would be equal to the present value of the equipment minus the present value of the tax shield:

PV of Lease Payments = $74,000 - $14,604.13 = $59,395.87

We can now solve for the minimum lease payment:

Lease Payment = PV of Lease Payments * r / (1 - (1 + r)-n)
Lease Payment = $59,395.87 * 0.073 / (1 - (1 + 0.073)^-4)
Lease Payment = $21,970.82

Therefore, the minimum lease payment that will be acceptable to both parties is $21,970.82 (Option B).

Nu-Tek Is Considering Leasing Some Equipment for 4 Years with Equal