Suppose Netflix is considering the purchase of computer servers and network infr
ID: 2774369 • Letter: S
Question
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. 8 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 5 years. However, because of the firm's substantial loss carryforwards, Netflix estimates its marginal tax rate to be 10% over the next 5 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. 2% borrowing rate, but the lessor has a 35% tax rate. For the purpose of this question, assume the equipment is worthless after 5 years, the lease term is 5 years, and the lease qualifies as a true tax lease. What is the lease rate for which the lessor will break even? What is the gain to Netflix with this lease rate? What is the source of the gain in this transaction? What is the lease rate for which the lessor will break even? The break-even lease is $ (Round to the nearest dollar.) What is the gain to Netflix with this lease rate? The gain to Netflix with this lease rate is $ (Round to the nearest dollar.) What is the source of the gain in this transaction? (Select from the drop-down menus.) The source of the gain is the difference in Llj between the two parties. Because the depreciation tax shield is $ accelerated than the lease payments, there is a from shifting the depreciation tax shields to the party with the tax rate.Explanation / Answer
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Depreciation rate
20%
32%
19.20%
11.52%
11.52%
5.76%
Depreciation amount
9,760
15,616
9,370
5,622
5,622
2,811
Buy
Capital cost
-48,800
-
-
-
-
-
Depreciation tax shield at 35%
3,416
5,466
3,279
1,968
1,968
984
Buying free cash flows
-45,384
5,466
3,279
1,968
1,968
984
Post tax interest rate = 8% * (1 - 0.35) = 5.20% = 0.052
The NPV of the FCF from buying the machine is:
NPV (buying) = -45,384 + 5466/1.052 + 3279/1.0522 + 1968/1.0523 + 1968/1.0524 + 984/1.0525
= -30,037
Therefore, to break-even, the PV of the after-tax lease payments must equal $30.037 million:
30.037 = L(1 - 0.35) {1+1/.052(1-1/1.0524)}
L = 10.202
The break-even lease rate for the lessor is $10,202,000.
c. The source of the gain is the difference in tax rates between the two parties. Because the
depreciation tax shield is more accelerated than the lease payments, there is a gain from shifting
the depreciation tax shields to the party with the higher tax rate.
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Depreciation rate
20%
32%
19.20%
11.52%
11.52%
5.76%
Depreciation amount
9,760
15,616
9,370
5,622
5,622
2,811
Buy
Capital cost
-48,800
-
-
-
-
-
Depreciation tax shield at 35%
3,416
5,466
3,279
1,968
1,968
984
Buying free cash flows
-45,384
5,466
3,279
1,968
1,968
984
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