Chapter 19, Problem 7MC

1. (1) Assume that the lease payments were actually $280,000 per year, that Consolidated Leasing is also in the 25% tax bracket, and that it also forecasts a $200,000 residual value. Also, to furnish the maintenance support, it would have to purchase a maintenance contract from the manufacturer at the same $20,000 annual cost, again paid in advance. Consolidated Leasing can obtain an expected 10% pre-tax return on investments of similar risk. What are its NPV and IRR of leasing under these conditions?
2. (2) What do you think the lessor’s NPV would be if the lease payment were set at $260,000 per year? (Hint: The lessor’s cash flows would be a “mirror image” of the lessee’s cash flows.)

Summary Introduction

Case Study:

LS Inc has to acquire new market data and quotation system for its new home office. The system may display the data onscreen or may save it for later retrieval and system also allow customers to make call and can convey current quotes. Cost of the equipment is $ 1,000,000 and if the company wants to purchase the equipment they can borrow a loan at a interest rate of 10%. Useful life of equipment is 6 years and it comes under 3 years MARCS class or it can purchase a contract of 4 years where $20,000 have to be paid at the beginning of each year and it will be sold after 4 years and for consolidated ;leasing it will cost for $260,000 which include maintenance cost. Federal plus state tax is 25%.

To determine:

The value of NPV and IRR of leasing

Explanation of Solution

The Lessor invests $1, 000, 0000 to buy the equipment

Particulars	Year 0	Year 1	Year 2	Year 3	Year 4
Equipment Cost	($1,000,000)	$0	$0	$0	$0
Depreciation expense	$0	$83,325	$111,125	$37,025	$18,525
Maintenance	($20,000)	($20,000)	($20,000)	($20,000)	$0
Tax saving on maintenance	$5,000	$5,000	$5,000	$5,000	$0
Lease payment	$280,000	$280,000	$280,000	$280,000	$0
Tax on lease payment	($70,000)	($70,000)	($70,000)	($70,000)	$0
Residual Value	$0	$0	$0	$0	$200,000
Tax on residual value	$0	$0	$0	$0	($50,000)
Net cash flow	($805,000)	$278,325	$306,125	$232,025	$168,525
Present value factor1	1	0.930232	0.865332	0.804961	0.748801
Present Values $\left(\begin{array}{l}\text{After}\text{tax}\text{cash}\text{flows}\\ \times \text{Present}\text{value}\text{factor}\end{array}\right)$	($805,000)	$258906.82	$264899.75	186771.07	$126191.68
Net Present Value at after tax cost of debt.	$31769.32

Therefore the NPV @7.5% is $31,770.

Working Note:

Calculation of After Tax Return:

$\begin{array}{c}\text{After Tax Return}=\text{Return on Investment}\times \left(\text{1}-\text{Tax Rate}\right)\\ =10\%\left(1-0.25\right)\\ =7.5\%\end{array}$

2. Calculation of Present Value Factor

$\begin{array}{c}\text{Present}\text{Value}\text{Factor}={\left(\frac{1}{1+\text{r}}\right)}^{\text{n}}\\ \text{Year}1={\left(\frac{1}{1+0.075}\right)}^1\\ =0.930232\\ \text{Year}2={\left(\frac{1}{1+0.075}\right)}^2\\ =0.865332\end{array}$

$\begin{array}{c}\text{Year}3={\left(\frac{1}{1+0.075}\right)}^3\\ =0.8049606\\ \text{Year}4={\left(\frac{1}{1+0.075}\right)}^4\\ =0.7488005\end{array}$

Calculation of Total Present Values:

$\begin{array}{c}\text{Total Present Values}=\text{Year 1}+\text{Year 2}+\text{Year 3}+\text{Year }4\\ =\$258,906.82+\$264,899.75+\$186,771.07+\$126,191.68\\ =\$836,769.32\end{array}$

Calculation of Net Present Value:

$\begin{array}{c}\text{Net Present Value}=\text{Present Value of Cash Inflows}-\text{Total Present Values of Cash Outflow}\\ =\$836,769.32-\$805,000\\ =\$31,769.32\end{array}$

Summary Introduction

To determine:

Lessor’s NPV if lease payment is $260,000 per year.

Explanation of Solution

Formula to calculate net present value:

$\text{Net Present Value}=\left(\begin{array}{l}\text{Present Value of Cash Inflows}\\ -\text{Total Present Values of Cash Outflow}\end{array}\right)$

Substitute the value of present value of cash inflows: $568,758.82 and total present value of cash outflow: $825,000.

Calculation of net present value:

$\begin{array}{c}\text{Net Present Value}=\$568,758.82-\$825,000\\ =\$\left(256,241.18\right)\end{array}$

Therefore, the net present value if lease payment of $260,000 is made will be $(256,241.18)

Working Notes:

Particulars	Year 0	Year 1	Year 2	Year 3	Year 4
Equipment Cost	($1,000,000)	$0	$0	$0	$0
Depreciation expense	$0	$83,325	$111,125	$37,025	$18,525
Maintenance	($20,000)	($20,000)	($20,000)	($20,000)	$0
Tax saving on maintenance	$5,000	$5,000	$5,000	$5,000	$0
Lease payment	$260,000	$260,000	$260,000	$260,000	$0
Tax on lease payment	($70,000)	($70,000)	($70,000)	($70,000)	$0
Residual Value	$0	$0	$0	$0	$200,000
Tax on residual value	$0	$0	$0	$0	($50,000)
Net cash flow	($825,000)	$258,325	$286,125	$212,025	$168,525
Present value factor1	1	0.930232	0.865332	0.804961	0.748801
Present Values $\left(\begin{array}{l}\text{After}\text{tax}\text{cash}\text{flows}\\ \times \text{Present}\text{value}\text{factor}\end{array}\right)$	($825,000)	$240,302.18	$247,593.11	$170,671.85	$126,191.68
Net Present Value at after tax cost of debt.	$(256,241.18)

Calculation of Total Present Values:

$\begin{array}{c}\text{Total Present Values}=\text{Year 1}+\text{Year 2}+\text{Year 3}+\text{Year }4\\ =\$24,302.18+\$247,593.11+\$170,671.85+\$126,191.68\\ =\$568,758.82\end{array}$