The First National Bank of Great Falls is considering a leveraged lease agreemen
ID: 2654064 • Letter: T
Question
The First National Bank of Great Falls is considering a leveraged lease agreement involving some mining equipment with the Big Sky Mining Corporation. Th e bank (40 percent tax bracket) will be the lessor; the mining company, the lessee (0 percent tax bracket); and a large California pension fund, the lender. Big Sky is seeking $50 million, and the pension fund has agreed to lend the bank $40 million at 10 percent. Th e bank has agreed to repay the pension fund $4 million of principal each year plus interest. (Th e remaining balance will be repaid in a balloon payment at the end of the fi ft h year.) Th e equipment will be depreciated on a straight-line basis over a 5-year estimated useful life with no expected salvage value. Assuming that Big Sky has agreed to annual lease payments of $10 million, calculate the banks initial cash outfl ow and its fi rst two years of cash infl ows.
Explanation / Answer
California Pension Fund has agreed to lend the Bank, $40 Million at 10%. Thus, Banks Initial Cash Outflows will be
= $50 Million - $40 Million
= $10 Million
Bank will receive Annual Lease payment of $10 Million from the mining Company. The Bank will than repay $4 Million to the pension fund with interest each year. (The remaining balance will be repaid in a balloon payment at the end of the fi ft h year.)
Interest to pension fund in the first year = $40 Million * 0.10 = $4 Million
Interest (Net of Tax) = 4 (1-0.40) = $2.4 Million
Principal Repayment in the first year = $4 Million
Total Repayment in the first year = $6.4 Million
Annual Lease Payment Receivable each year (net of tax) = $10 Million (1-0.40) = $6 Million
Net Cash Inflow in the first year = 6-6.4 = -$0.4 Million
Similarly,
Interest to pension fund in the second year = (40-4)*0.10 = $3.6 Million
Interest (Net of Tax) = 3.6(1-0.40) = $2.16 Million
Repayment of principal in the second year = $4 Million
Total Repayment to the pension fund in the second year = $6.16 Million
Annual Lease Payment Receivable each year (net of tax) = $10 Million (1-0.40) = $6 Million
Net Cash Inflow in the second year = -$0.16 Million
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