Question

A computer costs $500,000 and is depreciated for tax purposes straight-line over years 1 through 5. Assume that it has zero salvage value at the end of five years. The user wishes to lease the computer by making six annual lease payments, the first of which is due immediately. If taxes are paid without delay and the rate of interest is 10%, what is the minimum acceptable lease payment for a lessor who pays tax at 21%?

Answer 1

Depreciation expense p.a = (500000÷5) = $ 100,000

Tax savings on depreciation p.a = 100000×21% = $ 21,000

PV of ordinary annuity (10%, 5 years) = 3.79079

PV of tax saving = 21000×3.79079 = $ 79,607

Cost of computer = $ 500,000

Total PV of cash ouflow = 500000-79607 = $ 420,393

PV of annuity due (10%, 6 years) = 4.79079

After tax annual rentals = 420393÷4.79079 = $ 87,750

Before tax rentals = 87750÷79% = $ 111,076

Hence, the minimum acceptable lease payment is $ 111,076.