DUKE UNIVERSITY Fuqua School of Business FINANCE 351 - CORPORATE FINANCE Problem Set #6 Prof.

Simon Gervais Questions 1. Nodhead College needs a new computer. It can either buy it for $250,000 or lease it from Compulease. The lease requires Nodhead to make six annual payments of $62,000 (starting now). Nodhead pays no tax. Compulease pays tax at 34%. Compulease can depreciate the computer for tax purposes over the next ve years. The computer will have no residual value at the end of year 5. The interest rate is 8%, and both Nodhead and Compulease borrow at that rate. Assume that you can nance with 100% debt and that the rst lease payment occurs today (i.e., at time 0). (a) What is the NPV of the lease (relative to the buy option) for Nodhead College? (b) What is the NPV of the lease to Compulease? (c) Are there gains to leasing in this problem? Explain. 2. Tomkat Corporation (the lessee) is considering the lease of a drilling machine from Korajczyk Corporation (the lessor). If Tomkat were to buy the machine the price would be $100,000. Tomkat would obtain straight-line depreciation over ve years of $20,000 a year. Currently Tomkat has a tax rate of 15% and a cost of debt of 10%. Tomkat believes that, if it leased the asset, leasing would displace debt on a one-for-one basis. (a) What is the maximum lease payment (which is equal over each of the next ve years) that Tomkat would be willing to pay? (b) The Korajczyk Corporations tax rate of 35% and its appropriate discount rate is 6% (i.e., the 6% already reects any adjustment for capital structure and tax eects). Assume that Korajczyk can either sell the equipment for $100,000 (assume that its current book value is also $100,000) or lease it out (and obtain depreciation benet). What is the minimum lease payment that Korajczyk must charge? (c) Do you think Tomkat and Korajczyk will nd it advantageous to sign a lease contract? Why? 3. Rewope, Inc., is considering whether it should lease or purchase a machine. The machine costs $300,000. If Rewope buys the machine, it will be depreciated straight-line to zero in years 1, 2 and 3. Rewope can then sell the machine for $50,000 in year 3. In order to use the machine, Rewope has to bear a maintenance cost of $10,000 in years 1, 2 and 3. The tax rate for Rewope is 30%. The (pre-tax) cost of debt for Rewope is 10%. Alternatively, Rewope can lease the machine for the three years (with payments in years 1, 2 and 3). In this case, the lessor will bear the maintenance costs. Rewope believes that, if it leases the machine, leasing will displace debt on a one-for-one basis. For simplicity, assume throughout this problem that 1 Fall 2011 Term 2

all cash ows (including maintenance costs and resale values) can be discounted at the same rate as the lease-vs-buy cash ows.1 (a) What is the maximum lease payment that Rewope is willing to pay? Rewope has identied two potential lessors. Lessor A will have to spend $12,000 every year on maintenance costs. The (pre-tax) cost of debt for lessor A is 5%. Lessor B will have to spend only $3,000 every year on maintenance costs. The (pre-tax) cost of debt for lessor B is 15%. Assume that both lessor A and lessor B have the same tax rate as Rewope, and that both of them use the same depreciation method as Rewope. (b) What is the minimum leasing payment that lessor A is willing to charge? What is the minimum leasing payment that lessor B is willing to charge? (c) Can you explain the dierences? Do you think your company will be willing to sign a lease contract with one of these potential lessors?

In theory, they should be discounted at a dierent rate as they have a dierent risk.

Solutions 1. (a) The incremental cash ows for Nodheads lease versus buy decision are as follows. 0 Purchase savings Lease payments Net cash ows 250,000 -62,000 188,000 1 -62,000 -62,000 2 -62,000 -62,000 3 -62,000 -62,000 4 -62,000 -62,000 5 -62,000 -62,000

The above cash ows are discounted at a discount rate of 8% (this is the after-tax discount rate since Nodheads tax rate is 0%), which yields a net present value of $59,548.
,000 = 17,000, (b) Notice that the cash ow benet of the depreciation tax shield is 34% 2505 and the after-tax lease income is 62,000(1 0.34) = 40,920. Thus the cash ows for Compulease are as follows.

0 Purchase price Depr. tax shield A-T lease income Net cash ows -250,000 40,920 -209,080

1 17,000 40,920 57,920

2 17,000 40,920 57,920

3 17,000 40,920 57,920

4 17,000 40,920 57,920

5 17,000 40,920 57,920

Discounting these cash ows at the after-tax rate of 8% (1 0.34) = 5.28% yields a net present value of $39,754. (c) The overall gain to leasing is negative: 39,754 59,548 = 19,794. That is, the leasing arrangement would lead to the government getting an extra $19,794 in taxes. In this problem, the lessors tax benet from depreciation is outweighed by its tax liability on the lease payment it receives. A better way to see this is by calculating the maximum lease payment (Lmax ) that the lessee would agree to (i.e., the lease payment that will make Nodheads NPV equal to zero), and showing that this number is smaller than the minimum lease payment (Lmin ) that the lessor would be willing to charge (i.e., the lease payment that would make Compuleases NPV equal to zero). These two numbers are calculated as follows: Lmax (1.08) 1 = 0 Lmax = 50,073; 1 0.08 (1.08)6 (1 0.34)Lmin (1.0528) 1 1 17,000 + =0 1 1 250,000 + 5 0.0528 (1.0528) 0.0528 (1.0528)6 Lmin = 50,627. 250,000 Clearly, Nodhead and Compulease cant agree on a lease payment that will them both realize positive net present values. 2. (a) The annual tax shield from depreciation is 20,000 15% = 3,000 for Tomkat. The lease versus buy decision leads to the following incremental cash ows for Tomkat (where L

is the actual lease payment and 0.85L is the lease payment on an after-tax basis): 0 Purchase savings Depr. tax shield lost A-T lease payments Net cash ows 100,000 3, 000 0.85L 100,000 3,000 0.85L 3, 000 0.85L 3,000 0.85L 1 5

The net present value of these cash ows, discounted at the after-tax rate of 10%(1 0.15) = 8.5%, is given by NP V = 100,000 (3,000 + 0.85L)a 5 = 88,178 3.3495L. To nd the maximum lease payment that Tomkat would be willing to pay, we need to set this quantity equal to zero, and solve for L. We nd L = 26,325. (b) The annual tax shield from depreciation is 20,000 35% = 7,000. The lease versus sell decision leads to the following incremental cash ows for Korajczyk (where L is the actual lease payment and 0.65L is the lease income on an after-tax basis): 0 Sales price lost Depr. tax shield A-T lease income Net cash ows -100,000 7,000 0.65L -100,000 7,000 + 0.65L 1 5 7,000 0.65L 7,000 + 0.65L
8.5%

= 100,000 (3,000 + 0.85L)(3.94)

The net present value of these cash ows is given by (we are told to use 6% as the discount rate) NP V = 100,000 + (7,000 + 0.65L)a 5 = 70,513 + 2.7380L. To nd the minimum lease payment that Korajczyk must charge, we need to set this quantity equal to zero, and solve for L. We nd L = 25,753. (c) Since Korajczyks break-even lease rate is lower than the maximum that Tomkat is willing to pay, a lease deal will probably be struck. The gains to leasing in this problem derive from the lessors lower cost of capital and higher depreciation tax shield (together they outweigh the higher tax the lessor has to pay on its lease income).
,000 3. (a) The yearly depreciation tax shield lost by Rewope is 3003 30% = 30,000. By leasing, Rewope will save 10,000(1 0.30) = 7,000 in (after-tax) maintenance costs. Also, by leasing, Rewope forgoes the after-tax cash ow of 50,000(1 0.30) = 35,000 resulting
6%

= 100,000 + (7,000 + 0.65L)(4.2124)

from the sale of the machine at the end of the third year. If we denote Rewopes annual lease payment by L, its lease vs. buy cash ows are as follows.
0 Purchase savings Depr. tax shield lost Maintenance costs avoided A-T lease payment Machine resale Net cash ows 300,000 23,000 0.7L 23,000 0.7L 300,000 -30,000 7,000 -0.7L -30,000 7,000 -0.7L -30,000 7,000 -0.7L -35,000 58,000 0.7L 1 2 3

The net present value of leasing as opposed to buying is then given by (we discount at the after-tax rate of 10%(1 0.30) = 7%) NP V = 300,000 (23,000 + 0.7L)a 3 7% 35,000 (1.07)3 35,000 = 300,000 (23,000 + 0.7L)(2.6243) (1.07)3 = 211,070 1.8370L.

The maximum lease payment is found by setting this last expression equal to zero. We nd L = 114,898. (b) The cash ows for Lessor A are exactly the mirror image of Rewopes cash ows, except that the after-tax maintenance costs are 12,000(1 0.30) = 8,400.
0 Purchase cost Depr. tax shield Maintenance costs A-T lease income Machine resale Net cash ows -300,000 21,600 + 0.7L 21,600 + 0.7L -300,000 30,000 -8,400 0.7L 30,000 -8,400 0.7L 30,000 -8,400 0.7L 35,000 56,600 + 0.7L 1 2 3

The net present value for Lessor A is therefore (the discount rate is 0.05(1 0.30) = 3.5%) NP VA = 300,000 + (21,600 + 0.7L)a 3 3.5% + 35,000 (1.035)3 35,000 = 300,000 + (21,600 + 0.7L)(2.8016) + (1.035)3 = 207,917 + 1.9611L.

We can set this last quantity equal to zero to nd the minimum leasing payment that Lessor A is willing to charge. We nd L = 106,018. We can perform similar calculations for Lessor B. The only dierence is that the after-tax maintenance costs for Lessor B are 3,000(1 0.30) = 2,100. 5

0 Purchase cost Depr. tax shield Maintenance costs A-T lease income Machine resale Net cash ows -300,000 -300,000

1 30,000 -2,100 0.7L 27,900 + 0.7L

2 30,000 -2,100 0.7L 27,900 + 0.7L

3 30,000 -2,100 0.7L 35,000 62,900 + 0.7L

The net present value for Lessor B is therefore (the discount rate is 0.15(1 0.30) = 10.5%) NP VB = 300,000 + (27,900 + 0.7L)a 3 10.5% + 35,000 (1.105)3 35,000 = 300,000 + (27,900 + 0.7L)(2.4651) + (1.105)3 = 205,282 + 1.7256L.

We can set this last quantity equal to zero to nd the minimum leasing payment that Lessor B is willing to charge. We nd L = 118,964. (c) Because 114,898 > 106,018 but 114,898 < 118,964, Rewope will sign a lease contract with lessor A but not with lessor B. This is because, even though Lessor B can maintain the machine for less than Lessor A, the lower cost of capital (for nancing the project) that Lessor A faces more than compensates. Thus Lessor A can charge a lower annual lease payment to Rewope.