FIN534 - Finance Tutorial - 46916

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1. Suppose an H1200 supercomputer has a cost of $200,000 and will have a residual market value
of $60,000 in five years. The risk-free interest rate is 5% APR with monthly compounding.
a. What is the risk-free monthly lease rate for a five-year lease in a perfect market?
b. What would be the monthly payment for a five-year $200,000 risk-free loan to purchase the
H1200?

 

2. Suppose the risk-free interest rate is 5% APR with monthly compounding. If a $2 million MRI
machine can be leased for seven years for $22,000 per month, what residual value must the lessor
recover to break even in a perfect market with no risk?

 

3. Consider a five-year lease for a $400,000 bottling machine, with a residual market value of
$150,000 at the end of the five years. If the risk-free interest rate is 6% APR with monthly
compounding, compute the monthly lease payment in a perfect market for the following leases:
a. A fair market value lease
b. A $1.00 out lease
c. A fixed price lease with an $80,000 final price

 

4. Acme Distribution currently has the following items on its balance sheet:
How will Acme’s balance sheet change if it enters into an $80 million capital lease for new
warehouses? What will its book debt-equity ratio be? How will Acme’s balance sheet and debtequity
ratio change if the lease is an operating lease?

 

5. Your firm is considering leasing a $50,000 copier. The copier has an estimated economic life of
eight years. Suppose the appropriate discount rate is 9% APR with monthly compounding.
Classify each lease below as a capital lease or operating lease, and explain why:
a. A four-year fair market value lease with payments of $1150 per month
b. A six-year fair market value lease with payments of $790 per month
c. A five-year fair market value lease with payments of $925 per month
d. A five-year fair market value lease with payments of $1000 per month and an option to
cancel after three years with a $9000 cancellation penalty

 

6. Craxton Engineering will either purchase or lease a new $756,000 fabricator. If purchased, the
fabricator will be depreciated on a straight-line basis over seven years. Craxton can lease the
fabricator for $130,000 per year for seven years. Craxton’s tax rate is 35%. (Assume the
fabricator has no residual value at the end of the seven years.)
a. What are the free cash flow consequences of buying the fabricator if the lease is a true tax
lease?
b. What are the free cash flow consequences of leasing the fabricator if the lease is a true tax
lease?
c. What are the incremental free cash flows of leasing versus buying?

 

7. Riverton Mining plans to purchase or lease $220,000 worth of excavation equipment. If
purchased, the equipment will be depreciated on a straight-line basis over five years, after which
it will be worthless. If leased, the annual lease payments will be $55,000 per year for five years.
Assume Riverton’s borrowing cost is 8%, its tax rate is 35%, and the lease qualifies as a true tax
lease.
a. If Riverton purchases the equipment, what is the amount of the lease-equivalent loan?
b. Is Riverton better off leasing the equipment or financing the purchase using the lease
equivalent loan?
c. What is the effective after-tax lease borrowing rate? How does this compare to Riverton’s
actual after-tax borrowing rate?

 

8. Suppose Clorox can lease a new computer data processing system for $975,000 per year for five
years. Alternatively, it can purchase the system for $4.25 million. Assume Clorox has a
borrowing cost of 7% and a tax rate of 35%, and the system will be obsolete at the end of five
years.
a. If Clorox will depreciate the computer equipment on a straight-line basis over the next five
years, and if the lease qualifies as a true tax lease, is it better to lease or finance the purchase
of the equipment?
b. Suppose that if Clorox buys the equipment, it will use accelerated depreciation for tax
purposes. Specifically, suppose it can expense 20% of the purchase price immediately and
can take depreciation deductions equal to 32%, 19.2%, 11.52%, 11.52%, and 5.76% of the
purchase price over the next five years. Compare leasing with purchase in this case.

 

9. Suppose Procter and Gamble (P&G) is considering purchasing $15 million in new
manufacturing equipment. If it purchases the equipment, it will depreciate it on a straight-line
basis over the five years, after which the equipment will be worthless. It will also be responsible
for maintenance expenses of $1 million per year. Alternatively, it can lease the equipment for
$4.2 million per year for the five years, in which case the lessor will provide necessary
maintenance. Assume P&G’s tax rate is 35% and its borrowing cost is 7%.
a. What is the NPV associated with leasing the equipment versus financing it with the lease
equivalent loan?
b. What is the break-even lease rate—that is, what lease amount could P&G pay each year and
be indifferent between leasing and financing a purchase?

 

10. Suppose Netflix is considering the purchase of computer servers and network infrastructure to
facilitate its move into video-on-demand services. In total, it will purchase $48 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, Netflix 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, Netflix considers leasing the equipment instead. Suppose Netflix and the lessor
face the same 8% 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 Netflix with this lease rate?
c. What is the source of the gain in this transaction?

 

 

Solution Description

1. Suppose an H1200 supercomputer has a cost of $200,000 and will have a residual market value
of $60,000 in five years. The risk-free interest rate is 5% APR with monthly compounding.
a. What is the risk-free monthly lease rate for a five-year lease in a perfect market?
b. What would be the monthly payment for a five-year $200,000 risk-free loan to purchase the
H1200?

 

2. Suppose the risk-free interest rate is 5% APR with monthly compounding. If a $2 million MRI
machine can be leased for seven years for $22,000 per month, what residual value must the lessor
recover to break even in a perfect market with no risk?

 

3. Consider a five-year lease for a $400,000 bottling machine, with a residual market value of
$150,000 at the end of the five years. If the risk-free interest rate is 6% APR with monthly
compounding, compute the monthly lease payment in a perfect market for the following leases:
a. A fair market value lease
b. A $1.00 out lease
c. A fixed price lease with an $80,000 final price

 

4. Acme Distribution currently has the following items on its balance sheet:
How will Acme’s balance sheet change if it enters into an $80 million capital lease for new
warehouses? What will its

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