Question

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?

Answer 1

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.

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