Homework SourseSuppose Amazon is considering the purchase of computer serve
Suppose Amazon is considering the purchase of computer servers and network infrastructure to expand its very successful business offering cloud-based computing. In total, it will purchase $47.2 million in new equipment. This equipment will qualify for accelerated depreciation: 20% can be expensed immediately, followed by 32%, 19.2%, 11.52%, 11.52%, and 5.76% over the next five years. However, because of the firm\'s substantial loss carryforwards and other credits, Amazon estimates its marginal tax rate to be 10% over the next five years, so it will get very little tax benefit from the depreciation expenses. Thus, Amazon considers leasing the equipment instead. Suppose Amazon and the lessor face the same 7.6% borrowing rate, but the lessor has a 35% tax rate. For the purpose of this question, assume the equipment is worthless after five years, the lease term is five years, and the lease qualifies as a true tax lease. a. What is the lease rate for which the lessor will break even? b. What is the gain to Amazon with this lease rate? c. What is the source of the gain in this transaction?
Solution
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| a. | The break-even lease rate for the lessor is 10,823,000 as shown below | (in 000\'s) | |||||||
| LESSOR | tax rate | 35% | Borrowing cost after tax | 4.94% | [(1-0.35)0.076] | ||||
| Year | 0 | 1 | 2 | 3 | 4 | 5 | |||
| Buy | |||||||||
| Capital Expenditures | (47,200) | — | — | — | — | — | |||
| Depreciation tax shield at 35% | 3,304 | 5,286 | 3,172 | 1,903 | 1,903 | 952 | |||
| Free Cash Flow (Buy) | (43,896) | 5,286 | 3,172 | 1,903 | 1,903 | 952 | |||
| Lease | |||||||||
| Lease Payments | 10,823 | 10,823 | 10,823 | 10,823 | 10,823 | — | |||
| Income tax at 35% | (3,788) | (3,788) | (3,788) | (3,788) | (3,788) | — | |||
| Free Cash Flow (Lease) | 7,035 | 7,035 | 7,035 | 7,035 | 7,035 | — | |||
| Lessor Free Cash Flow | |||||||||
| Buy & Lease | (36,861) | 12,321 | 10,207 | 8,938 | 8,938 | 952 | |||
| NPV(Buy & Lease) | |||||||||
| To compute this amount, first we compute the FCF from buying the machine. The depreciation tax shield is 0.35 × ($47.2m × 0.20) = $3.304 million in year 0, 0.35 × ($47.2m × 0.32) = $5.286 million in year 1, etc, as shown in line 2. The NPV of the FCF from buying the machine (line 3) is: | |||||||||
| NPV(Buy) = | (-)43.896+ 5.286/1.0494+ 3.172/1.04942+ 1.903/1.04943+ 1.903/1.04944+ 0.952/1.04945 | ||||||||
| -32.0145 | |||||||||
| Therefore, to break-even, the PV of the after-tax lease payments must equal $32.0145 million: | |||||||||
| 32.0145 = L x (1-0.35) x (1 + 1/.0494 * (1- 1/1.04944 )) | |||||||||
| and so L = 10.823 million. | |||||||||
| b. | At a lease rate of $10.823 and a tax rate of 10%, Netflix has a gain of $0.13588 million. | ||||||||
| LESSEE | tax rate | 10% | Borrowing cost after tax | 6.84% | [(1-0.10)0.076] | ||||
| Year | 0 | 1 | 2 | 3 | 4 | 5 | |||
| Buy | |||||||||
| Capital Expenditures | (47,200) | — | — | — | — | — | |||
| Depreciation tax shield at 10% | 944 | 1,510 | 906 | 544 | 544 | 272 | |||
| Free Cash Flow (Buy) | (46,256) | 1,510 | 906 | 544 | 544 | 272 | |||
| Lease | |||||||||
| Lease Payments | (10,823) | (10,823) | (10,823) | (10,823) | (10,823) | — | |||
| Income tax at 10% | 1,082 | 1,082 | 1,082 | 1,082 | 1,082 | — | |||
| Free Cash Flow (Lease) | (9,741) | (9,741) | (9,741) | (9,741) | (9,741) | — | |||
| Lessor Free Cash Flow | |||||||||
| Buy & Lease | 36,515 | (11,251) | (10,647) | (10,284) | (10,284) | (272) | |||
| NPV(Buy & Lease) | 135.88 | ||||||||
| c. | The source of the gain is the difference in tax rates between the two parties. Because the depreciation tax shield is more accelerated than the lease payments, there is a gain from shifting the depreciation tax shields to the party with the higher tax rate. | ||||||||
