Suppose Netflix is considering to purchase $5 million of equipment. This equipme

Question

Suppose Netflix is considering to purchase $5 million of equipment. This equipment will qualify for five years accelerated depreciation beginning in the same year as the capital expenditure. Netflix estimates its marginal federal and state tax rate to be 40% Suppose Netflix has a 5% borrowing rate and the lease payments beginning of each year are $0.9 million for a lease term of 5 years. The equipment can be disposed for 20% of its original value at the end of the five years.

a.     For purchase, what are the depreciation, tax shield and free cash flows?

c.      Compute the NAL. Should Netflix buy or lease this equipment?

d.     What is the breakeven residual value?

using excel sheet to answer the question

Explanation / Answer

Cost of equipment 5000000 Method of Depreciation Accelerated starting from year of expenditure Marginal Federal tax rate 40% Borrowing rate 5% Annual Lease Payments 0.9 Million or 900000 Lease Term 5 years Disposal value 20% or original value or 1000000 (a) Year 0 1 2 3 4 Initial Investment 5000000 Depreciation at 20% 1000000 1000000 1000000 1000000 1000000 Depreciation Tax Shield 400000 400000 400000 400000 400000 (Depn * Tax rate) Balance amount 600000 600000 600000 600000 600000 Tax payable 240000 240000 240000 240000 240000 Net cash flow 360000 360000 360000 360000 360000 Free cash flow 760000 760000 760000 760000 760000 (Depn tax shiled + net flow) Discount rate 5% Discount factor (=1/(1+disc rate)^year 1 0.952381 0.907029 0.863838 0.822702 Discount flows = Disc factor * free cash flow 760000 723809.5 689342.4 656516.6 625253.9 Discounted value of disposal value = discounted factor * disposal value = 0.822702 * 1000000 822702.5 Net Present Value =-Purchase cost + annual discounted flow+duscounted value of residual value =-5000000+760000+723809.50+689342.40+656516.60+625253.90+822702.50 -722375 Present value of lease payments 0 1 2 3 4 Lease amount 900000 900000 900000 900000 900000 Discount factor 1 0.952381 0.907029 0.863838 0.822702 Present value of lease payments 900000 857142.9 816326.5 777453.8 740432.2 Net lease value =900000+857142.90+816326.50+777453.80+740432.20 4091355 Net Advantage of Lease Net present value of Lease - Net Present value of purchase =4091355-(-722375) 4813731 Since NAL is positive it is better to take the equipment on lease Break-even residual value is the amount where the NPV is zero Let X be the breakeven residual value That is -5000000+760000+723809.50+689342.40+656516.60+625253.90+x*0.822702 = 0 -2145077.60 + x * 0.822702 = 0 x*0.822702 = 2145077.50 x = 2145077.50/0.822702 = 2607356.73 The Break even residual value is $2607356.73

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