Question

On December 31, 2016, IU Corporation signed a 6-year, non-cancelable lease for a machine. The terms of the lease called for IU Corporation to make payments of $12,108 at the beginning of each year, starting December 31, 2016. The machine has an estimated useful life of 8 years and a $6000 unguaranteed residual value. The machine reverts to the lessor at the end of the lease term. IU Corporation uses the straight-line method of depreciation for all of its plant assets. IU’s incremental borrowing rate is 8 percent, and the lessor’s implicit rate is unknown.

Compute the present value of IU’s lease payments (rounded to the nearest dollar)

Answer 1

Answer) The unguaranteed residual value is not considered as an outflow for the lessee. Only if he guarantees any residual value he should ensure that value is returned back to the lessor. Hence the amount of $6000 will not be forming part of our calculation.

Note: The present value of tax benefits arising from the depreciation charged is not considered as a reduction in cash flow since tax rate is not available in the question.

Present value of IUs payment is

	1 year	2 year	3 rd year	4 th year	5 th Year
Pv factor	0.925926	0.857339	0.793832	0.73503	0.680583
Amount	12108	12108	12108	12108	12108
Present value (Amount * Pv factor	11211.11	10380.66	9611.721	8899.741	8240.501
Total					48343.73
Add: The first payment made in the beginning of lease					12108
Total Present value of cash outflows					60451.73