ADMS 3530 Lecture : Dealing with Salvage value.doc

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plumshark304

22 Mar 2013

School

York University

Department

Administrative Studies

Course

ADMS 3530

Professor

Hernan Humana

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Document Summary

Incorporating salvage into the nal formula is fairly straightforward. If the asset will have salvage value at the end of the lease, the lessee will obviously not get the salvage value (the lessor will). So we need to subtract the (appropriately discounted) foregone salvage value. We also need to remember that salvage changes the pvccats calculation. The differences between an nal problem with no salvage and a problem with salvage are shown in red. The wildcat oil company needs to decide whether to buy or lease an asset. The asset costs million and has a 25% cca rate. The equipment will have a ,000 salvage value at the end of its 5 year life. Wildcat"s tax rate is 36% and the pre-tax cost of debt is. The lease payments are at the beginning of each period, and the cca pool remains open after the lease is completed. Since the pool remains open, we can use the following formula:

Related Questions

Lease analysis As part of its overall plant modernization and cost reduction program, the management of Tanner-Woods Textile Mills has decided to install a new automated weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project was 25% versus a project required return of 12%. The loom has an invoice price of $270,000, including delivery and installation charges. The funds needed could be borrowed from the bank through a 4-year amortized loan at a 9% interest rate, with payments to be made at year-end. In the event the loom is purchased, the manufacturer will contract to maintain and service it for a fee of $18,000 per year paid at year-end. The loom falls in the MACRS 5-year class, and Tanner-Woods's marginal federal-plus-state tax rate is 40%. The applicable MACRS rates are 20%, 35%, 18%, 14%, 12%, and 5%. United Automation Inc., maker of the loom, has offered to lease the loom to Tanner-Woods for $70,000 upon delivery and installation (at t = 0) plus 4 additional annual lease payments of $70,000 to be made at the end of Years 1 through 4. (Note that there are 5 lease payments in total.) The lease agreement includes maintenance servicing. Actually, the loom has an expected life of 10 years, at which time its expected salvage value is zero; however, after 4 years, its market value is expected to equal its book value of $43,500. Tanner-Woods plans to build an entirely new plant in 4 years, so it has no interest in leasing or owning the proposed loom for more than that period. Round your answers to the nearest dollar. a.Should the loom be leased or purchased? PV cost of owning at 5.4% is $ . PV cost of leasing at 5.4% is $ . Tanner-Woods Textile should -Select-purchaselease the loom. b.The salvage value is clearly the most uncertain cash flow in the analysis. Assume that the appropriate salvage value pretax discount rate is 16%. What would be the effect of a salvage value risk adjustment on the decision? Round your answer to the nearest dollar. NPV is $ . The firm should -Select-purchaselease the loom. c.The original analysis assumed that Tanner-Woods would not need the loom after 4 years. Now assume that the firm will continue to use the loom after the lease expires. Thus, if it leased, Tanner-Woods would have to buy the asset after 4 years at the then existing market value, which is assumed to equal the book value. What effect would this requirement have on the basic analysis? (No numerical analysis is required; just verbalize.) The firm would choose to -Select-ownlease as the net advantage.

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3. (TCO D) Absolute Leasing, Inc. agrees tolease equipment to Allen, Inc. on January 1, 2012. They agree onthe followingterms:
1) The normal selling price of the equipment is $1,500,000 and thecost of the asset to Absolute Leasing, Inc. was$1,350,000.
2) At the end of the lease, the equipment will revert to AbsoluteLeasing, Inc. and have an unguaranteed residual value of $100,000.Their implicit interest rate is10%.
3) The lease is noncancelable with no renewal option. The leaseterm is 10 years (the same as the estimated economiclife).
4) Absolute Leasing, Inc. incurred costs of $9,000 in negotiatingand closing the lease. There are no uncertainties regardingadditional costs yet to be incurred and the collectability of thelease payments is reasonablypredictable.
5) The lease begins on January 1, 2012 and payments will be inequal annualinstallments.
6) Allen will pay all maintenance, insurance, and tax costsdirectly and annual payments of $140,000 on January 1 of eachyear.

Required:
a) Determine what type of lease this would be for the lessee andcalculate the initial obligation.
b) Prepare Allen, Inc.'s amortization schedule for the leaseterms.
c) Prepare all the journal entries for Allen, Inc. for 2012. Assumea calendar year fiscal year.

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Problem 1:

On January 1, 2016, Carmona Company enters into a noncancelablelease, with no renewal option, to lease a new piece of equipmentfrom Jackson Leasing Company. The lease term is for three years andthe lease payments are made on December 31 of each year.

The equipment cost Jackson $250,000, it has a fair value of$300,000 and a useful life of four years with no residual value.The equipment reverts to Jackson upon termination of the lease.Carmona guarantees a $100,000 residual value at the end of thelease term.

Both Carmona Company and Jackson Company depreciate allmachinery that they own on a straight-line basis. Carmonaâsincremental borrowing rate is 8 percent per year and CarmonaCompany does not have knowledge of the 5 percent implicit rate usedby Jackson.

Collectability of the future lease payments is reasonablypredictable, and no additional costs related to the lease areexpected.

Required:

Determine the annual lease payments, as set by the lessor.

2.Determine the amount of the minimum lease paymentsthat will be capitalized by the lessee.

What type of lease is this to Carmona Company? Be specific injustifying your answer.

What type of lease is this to Jackson Company? Be specific injustifying your answer.

Prepare any necessary journal entries on January 1, 2016, forboth parties.

Prepare any necessary journal entries on December 31, 2106 forboth parties.

Which party will depreciate the asset? What is the amount ofdepreciation expense that will be recognized by that party? Be sureto show all calculations.

How would your answer change if the residual value wereunguaranteed? (You just need to provide a narrative explanation ofits impact on both parties. I am not looking forcalculations with the new assumptions).

Problem 2

On January 1, 2016, Gowdy Company entered into an agreement tolease a piece of machinery from Reyes Corporation for four years.The machinery had a cost and fair value of $800,000 and a usefullife of seven years. The lease called for annual rental payments onDecember 31 of each year, starting on December 31, 2016. At the endof the lease term, Gowdy has the option to purchase the equipmentfor $30,000, which is significantly less than what the fair marketvalue of the equipment will be at that time.

Gowdyâs incremental borrowing rate is 10% and Reyesâs implicitborrowing rate is 8%. Gowdy is unaware of Reyesâs implicitrate.

Collectability of the future lease payments is reasonablypredictable, and no additional costs related to the lease areexpected.

Required:

What type of lease is this for Reyes? (Be specific and providejustification)

What type of lease is this for Gowdy?

Determine the annual lease payments, as set by ReyesCorporation.

Determine the minimum lease payments, as calculated byGowdy.

Prepare the entry on the date of the lease inception for boththe lessee and lessor.

Prepare the lesseeâs amortization schedule for the term of thelease.

Prepare the entry for the first interest payment for both thelessee and lessor.

Prepare the entry to record depreciation expense for the assetfor the year 2017, assuming that Gowdy uses the straight-linemethod.

Complete parts 3-6, assuming that the lease payments are madeeach January 1, starting on January 1, 2016 instead of on December31^st of each year.

ADMS 3530 Lecture : Dealing with Salvage value.doc

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