This question involves a more realistic set of facts and therefore requires a more detailed analysis of cash flows than contained in the chapter. Your company is going to negotiate a lease contract for manufacturing equipment. You have the following facts:
• The equipment costs $ 100,000 and is expected to have a five-year life with an expected salvage value of $10,000; however, it can be fully depreciated in four years using the sum-of-the-years digits method of accelerated depreciation.
• Whether leased or owned, the equipment will be sold for $1 at the end of the fifth year, and the owner will pay a capital gains tax equal to one half of the ordinary income tax rate on the difference between $1 and the book value.
• Your firm will pay no taxes for the next two years and then will return to its normal 48% tax rate.
• The leasing firm will require equal annual lease payments paid at the beginning of each year. The leasing firm's tax rate is 48%.
• Your firm can borrow at the prime rate plus 1 %, that is, at 17%.
(a) What is the maximum lease payment that your firm can afford to offer in the negotiations?
(b) What is the minimum lease payment that you think the leasing company can accept in the negotiations?