# Determining Lease Payments:The Lessor’s Perspective - Financial Management

Suppose that the Dole Company (lessee) desires to lease a piece of farm equipment valued at $100,000 from Deere & Company (lessor) for a period of five years. Under the terms of the lease, payments are to be made at the beginning of each of the five years. Deere expects to depreciate the asset on a straight-line basis of$20,000 per year down to a book salvage value of $0. Actual salvage value is expected to be$10,000 at the end of five years.

This sal-vage value will be treated as a recapture of depreciation and taxed at Deere’s marginal tax rate of 40 percent. Thus, the after-tax salvage value will be $6,000 ($10,000 actual salvage less $4,000 tax on depreciation recapture). If Deere requires an 11 percent after-tax rate of return on the lease, what will be the annual lease payments? • Step 1: Compute the lessor’s amount to be amortized. In this case, it is the$100,000 initial outlay minus the present value of the after-tax salvage at the end of year 5 minus the present value of the after-tax depreciation tax shield for each year. (Recall that depreciation reduces taxable income by the amount of the depreciation and thus reduces a firm’s cash outflow for tax payments by an amount equal to the depreciation times the company’s marginal ordinary tax rate.)

(If an accelerated depreciation method, such as MACRS, was used by the lessor, the present value of the annual depreciation tax shield would have to be done using a series of Table PVIF factors, because the annual depreciation tax shield normally will change most years under accelerated depreciation methods.)

• Step 2: Compute the annual after-tax lease income. This is the income that the lessor must receive in order to earn the needed 11 percent return.Remember that lease payments received by a lessor are treated as taxable, ordinary income. These payments can be computed using the appropriate interest factor for the present value of an annuity (PVIFA from Table ). Because lease payments are normally made at the beginning of each year,they constitute an annuity due.

Thus, the last four payments, which occur at the ends of years 1 through 4, are discounted, whereas the present value of the first payment, made at the beginning of year 1, is not discounted. Recall from Chapter 5 that taking the PVIFA for 11 percent and five years and multiplying by (1 + 0.11) gives the required PVIFA for an annuity due. If PMT is the annual after-tax lease income to the lessor, the present value of the lease income may be set equal to the amount to be amortized to determine th required PMT, as follows:

Therefore, Deere & Company needs to receive five beginning-of-the-year, after-tax lease income amounts of $16,301 (calculator accuracy) in order to earn an 11 percent after-tax return on the lease. • Step 3:Convert the lease income requirement of the lessor to a lease payment requirement of the lessee. Recalling that lease payments received by the lessor from the lessee are taxed as ordinary income, we can convert the after-tax lease income requirement of the lessor into a lease payment requirement for the lessee as follows: Therefore, the Dole Company will have to make an annual lease payment of$27,168 to Deere & Company at the beginning of each year.