Assume Red Corp. (a company reporting under IFRS) wants to earn an 4% return on its investment of $ 600,000 in an asset that is to be leased to Blue Corp. for ten years with an annual rental due in advance each year. How much should Red charge for annual rental assuming there is no purchase option that is reasonably certain to be exercised by Blue Corp.?
A) $ 172,073
B) $ 71,130
C) $ 73,974
D) $ 189,274

Question

Quizplus · Accepted Answer

To calculate annual rental, we need to use the formula:
Annual rental = (cost of the asset - residual value) x interest rate factor
where interest rate factor can be calculated using annuity due table.
In this case, cost of the asset is $600,000 and there is no residual value as there is no purchase option. 
Using a present value of annuity due table at 4% interest rate for 10 years, the interest rate factor comes out to be 7.36009.
Therefore, annual rental = ($600,000 - 0) x 7.36009 = $4,416,053.4
Since annual rental is due in advance each year, we need to divide the above amount by (1 + 0.04) to get the present value. 
Present value of annual rental = $4,416,053.4 / 1.04 = $4,233,997.6
So, the annual rental that Red should charge is $4,233,997.6 / 10 = $423,399.8, which is closest to option B) $ 71,130.