Question

Suppse Netflix is considering the purchase of a computer servers and network infrastructure to facilitate its move into video on demand services. In total, it will purchase $48.1 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 5 years. However, because of the firms substantial loss carryforwards, Netflix estimates ita marginal tax rate to be 10% over the next 5 years, so it will get very little tac benefit from the depreciation expenses. Thus, Netflix considers leasing the equipment instead. Suppose Netflix and the lessor face the same 7.8% borrowing rate, but the lessor has a 35% tax rate. For tye purpose of this question, assume the equipment is worthless after 5 years, 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 Netflix with the lease rate?

c. What is the source of the gain in the transaction?

Answer 1

a.	The break-even lease rate for the lessor is 11,066,000 as shown below							(in 000's)
	LESSOR	tax rate	35%		Borrowing cost after tax			5.07%	[(1-0.35)0.078]
		Year	0	1	2	3	4	5
	Buy
	Capital Expenditures		(48,100)	—	—	—	—	—
	Depreciation tax shield at 35%		3,367	5,387	3,232	1,939	1,939	970
	Free Cash Flow (Buy)		(44,733)	5,387	3,232	1,939	1,939	970
	Lease
	Lease Payments		11,066	11,066	11,066	11,066	11,066	—
	Income tax at 35%		(3,873)	(3,873)	(3,873)	(3,873)	(3,873)	—
	Free Cash Flow (Lease)		7,193	7,193	7,193	7,193	7,193	—
	Lessor Free Cash Flow
	Buy & Lease		(37,540)	12,580	10,425	9,132	9,132	970
	NPV(Buy & Lease)		(0)
	To compute this amount, first we compute the FCF from buying the machine. The depreciation tax shield is 0.35 × ($48.1m × 0.20) = $3.367 million in year 0, 0.35 × ($48.1m × 0.32) = $5.387 million in year 1, etc, as shown in line 2. The NPV of the FCF from buying the machine (line 3) is:
	NPV(Buy) =	(-)44.733+ 5.387/1.0507+ 3.232/1.05072+ 1.939/1.05073+ 1.939/1.05074+ 0.970/1.05075
		-32.6582
	Therefore, to break-even, the PV of the after-tax lease payments must equal $32.6582 million:
	32.6582 = L x (1-0.35) x (1 + 1/.0507 * (1- 1/1.05074 ))
	and so L = 11.066 million.
b.	At a lease rate of $11.066 and a tax rate of 10%, Netflix has a gain of $0.14283 million.
	LESSEE	tax rate	10%		Borrowing cost after tax			7.02%	[(1-0.10)0.078]
		Year	0	1	2	3	4	5
	Buy
	Capital Expenditures		(48,100)	—	—	—	—	—
	Depreciation tax shield at 10%		962	1,539	924	554	554	277
	Free Cash Flow (Buy)		(47,138)	1,539	924	554	554	277
	Lease
	Lease Payments		(11,066)	(11,066)	(11,066)	(11,066)	(11,066)	—
	Income tax at 10%		1,107	1,107	1,107	1,107	1,107	—
	Free Cash Flow (Lease)		(9,959)	(9,959)	(9,959)	(9,959)	(9,959)	—
	Lessor Free Cash Flow
	Buy & Lease		37,179	(11,499)	(10,883)	(10,514)	(10,514)	(277)
	NPV(Buy & Lease)		142.83
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.