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?
(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.)
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.
Therefore, the Dole Company will have to make an annual lease payment of $27,168 to Deere & Company at the beginning of each year.
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Financial Management Tutorial
The Role And Objective Of Financial Management
The Domestic And International Financial Marketplace
Evaluation Of Financial Performance
Financial Planning And Forecasting
The Time Value Of Money
Risk And Return On At&t Common Stock
Fixed-income Securities: Characteristics And Valuation
Common Stock: Characteristics,valuation, And Issuance
Capital Budgeting And Cash Flow Analysis
Capital Budgeting: Decision Criteria And Real Option Considerations
Capital Budgeting And Risk
The Cost Of Capital
Capital Structure Concepts
Capital Structure Management In Practice
Working Capital Management
The Management Of Cash And Marketable Securities
Management Of Accounts Receivable And Inventories
Lease And Intermediate-term Financing
Financing With Derivatives
Internationan Financial Management
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