Suppose Netflix is considering the purchase of computer servers and network infr

Question

Suppose Netflix is considering the purchase of computer servers and network infra- structure to facilitate its move into video-on-demand services. In total, it will pur- chase $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?

Explanation / Answer

a. The breakeven lease rental is the minimum payment which lessor can accept in lieu of leasing the equipment.

At this level of lease rental the NAL/NPV to the lessor is zero.

Let lease rental is x

Assuming the lease rental will be recovered in the beginning of the year.

NAL = Initital Investment - Present Value of Lease rental [net of tax] - Present Value of Tax saving on depreciation

0 = 48000000 - x[1-0.35][4.312] - 14720671

2.8028 x = 33279329

x = $11873600

Break even lease rental is $11873600

Tax Saving on depreciation

b.

Present Value of tax saving on depreciation = $4205906

Assuming the loan installment is to be paid in the beginning of the year

Cumulative PVF for 5 years = 4.312

Borrowing Installment = 48000000/4.312 = $11131725

Repayment Schedule:

Cost under borrowing option = Investment + Present Value of Interest net of tax - Tax Saving on depreciation

                                              = 48000000 + 8840055 - 4205906 = $52634149

Cost under lease option =Present Value of Lease Rental net of tax

                                       = $33279326

Present Value of Lease Rental net of tax

Gain to Netflix with this lease rate = 52634149 - 33279326 = $19354823

Year Opening WDV Depreciation Closing WDV Tax Saving PVF @ 8% Present Value 0 48000000 9600000 38400000 3360000 1 3360000 1 38400000 15360000 23040000 5376000 0.926 4978176 2 23040000 9216000 13824000 3225600 0.857 2764339 3 13824000 5529600 8294400 1935360 0.794 1536676 4 8294400 5529600 2764800 1935360 0.735 1422490 5 2764800 2764800 0 967680 0.681 658990 14720671

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