Setting the Lease Payment Quartz Corporation is a relatively new firm Quartz has
experienced enough losses during its early years to provide it with at least eight years of tax loss
carryforwards. Thus, Quartz's effective tax rate is zero. Quartz plans to lease equipment from New
Leasing Company. The term of the lease is five years. The purchase cost of the equipment is
$780,000. New Leasing Company is in the 35 porcont tax bracket. There are no transaction costs to
the lease. Each firm can borrow at 7 percent.
1. What is Quartz's reservation price?
2. What is New Leasing Company's reservation price?
3. Explain why these reservation prices determine the negotiating range of the lease
Answers
Answer:
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Quartz's reservation price
Explanation:
1. Since the lessee has an effective tax rate of zero, there is no depreciation tax shield left. In addition, the after-tax lease payment is the same as the pre-tax payment, and the after-tax cost of the loan is the same as the pre-tax cost. To find the maximum to be paid by the lessee, we set NAL equal to zero and solve for payment, doing so, we find that the maximum amount to be paid by the lessee is:
• NAL = 0 = $840,000 – PMT (PVIFA10%,5) • PMT = 221,589.88
2. We'll first calculate the cash flow from the depreciation tax shield. The depreciation tax gradient is: • Depreciation tax gradient = ($840,000/5)(.35) = $58,800 The after-tax cost of the loan is: • After-tax credit cost = 0.10(1 - 0.35) = 0.065 Using all of this information, we can calculate the minimum lease payment for the lessee
• NPV = 0 = - $840,000 + PMT(1 - .35)(PVIFA6.50%,5) + $58,800(PVIFA6.50%,5) • PMT = $220,512.33
3. A lease payment of less than $220,512.33 would give the lessee a negative
NPV. Payment over $221,589.88 would give the lessee a negative NAL. In any case, no deal will be done. Therefore, they represent the lower and upper, and possible lease prices when negotiated.