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Leasing and Inventories: ROR, after tax, MACRS depreciation, ROI

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1. Ajax Leasing Services has been approached by Gamma Tools to provide lease financing
for a new automated screw machine. The machine will cost $220,000 and will be leased
by Gamma for five years. Lease payments will be made at the beginning of each year.
Ajax will depreciate the machine on a straight-line basis of $44,000 per year down to a
book salvage value of $0. Actual salvage value is estimated to be $30,000 at the end of five
years. Ajax's marginal tax rate is 40 percent. Ajax desires to earn a 12 percent after-tax
rate of return on this lease. What are the required annual beginning-of-year lease

2. The First National Bank of Springer has established a leasing subsidiary. A local firm,
Allied Business Machines, has approached the bank to arrange lease financing for
$10 million in new machinery. Th e economic life of the machinery is estimated to be
20 years. The estimated salvage value at the end of the 20-year period is $0. Allied Business
Machines has indicated a willingness to pay the bank $1 million per year at the end
of each year for 20 years under the terms of a financial lease.

If the bank depreciates the machinery on a straight-line basis over 20 years to a $0
estimated salvage value and has a 40 percent marginal tax rate, what after-tax rate of
return will the bank earn on the lease?

b. In general, what effect would the use of MACRS depreciation by the bank have on the
rate of return it earns from the lease?

3. The following stream of after-tax cash flows are available to you as a potential equity investor
in a leveraged lease:

End of Year Cash Flow (After-Tax) End of Year Cash Flow (After-Tax)
0 $ -50 6 $ 0
1 +30 7 -5
2 +20 8 -10
3 +15 9 -15
4 +10 10 +10
5 +5

The cash flow in year 0 represents the initial equity investment. The positive cash flows
in years 1 to 5 result from the tax shield benefits from accelerated depreciation and
interest deductibility on the nonrecourse debt. The negative cash flows in years 7 to 9 are
indicative of the cash flows generated in a leveraged lease after the earlier-period tax
shields have been used. The positive cash flow occurring in year 10 is the result of the
asset's salvage value.

a. What problems would you encounter in computing the equity investor's rate of return
on this investment?

b. If, as a potential equity investor, you require an 8 percent after-tax rate of return on
investments of this type, should you make this investment?

4. The First National Bank of Great Falls is considering a leveraged lease agreement involving
some mining equipment with the Big Sky Mining Corporation. The 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. The bank has agreed
to repay the pension fund $4 million of principal each year plus interest. (The remaining
balance will be repaid in a balloon payment at the end of the fifth year.) The 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 bank's initial cash outflow and its first two years of cash

5. Drake Paper Company sells on terms of "net 30." The firm's variable cost ratio is 0.80.

a. If annual credit sales are $20 million and its accounts receivable average 15 days overdue,
what is Drake's investment in receivables?

b. Suppose that, as the result of a recession, annual credit sales decline by 10 percent to
$18 million, and customers delay their payments to an average of 25 days past the due
date. What will be Drake's new level of receivables investment?

6. Epstein Company, a wholesale distributor of jewelry, sells to retail jewelry stores on
terms of "net 120." Its average collection period is 150 days. The company is considering
the introduction of a 4 percent cash discount if customers pay within 30 days. Such a
change in credit terms is expected to reduce the average collection period to 108 days.
Epstein expects 30 percent of its customers to take the cash discount. Annual credit sales
are $6 million. Epstein's variable cost ratio is 0.667, and its required pretax return on
receivables investment is 15 percent. The company does not expect its inventory level to
change as a result of the change in credit terms. Determine the following:

a. The funds released by the change in credit terms

b. The net effect on Epstein's pretax profits

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Solution Summary

This solution assists with the necessary calculations and provides answers for each question.