# Rate of return

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. The 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.

(a) 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?

Please show the work preferably as an excel file.

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#### Solution Summary

The solution explains how to calculate the rate of return on a lease based on straight line depreciation and MACRS depreciation

Bond Returns, Rate of Return, Constant-Growth Model, Dividends and Taxes, Dividends and Repurchases, Sustainable Growth, Percentage of Sales

Question One: Bond Returns. You buy an 8 percent coupon, 20-year maturity bond when its yield to maturity is 9 percent. A year later, the yield to maturity is 10 percent. What is your rate of return over the year?

Question Two: Rate of Return. A bond that pays coupons annually is issued with a coupon rate of 4 percent, maturity of 30 years, and a yield to maturity of 7 percent. What rate of return will be earned by an investor who purchases the bond and holds it for 1 year if the bond's yield to maturity at the end of the year is 8 percent?

Question Three: Constant-Growth Model. Eastern Electric currently pays a dividend of about $1.64 per share and sells for $27 a share.

a. If investors believe the growth rate of dividends is 3 percent per year, what rate of return do they expect to earn on the stock?

b. If investors' required rate of return is 10 percent, what must be the growth rate they expect of the firm?

c. If the sustainable growth rate is 5 percent, and the plowback ratio is .4, what must be the rate of return earned by the firm on its new investments?

Question Four: Dividends and Taxes. Investors require an after-tax rate of return of 10 percent on their stock investments. Assume that the tax rate on dividends is 30 percent while capital gains escape taxation.

A firm will pay a $2 per share dividend 1 year from now, after which it is expected to sell at a price of $20.

a. Find the current price of the stock.

b. Find the expected before-tax rate of return for a 1-year holding period.

c. Now suppose that the dividend will be $3 per share. If the expected after-tax rate of return

is still 10 percent, and investors still expect the stock to sell at $20 in 1 year, at what price

must the stock now sell?

d. What is the before-tax rate of return? Why is it now higher than in part (b)?

Question Five: Dividends and Repurchases. While dividend yields in the United States in the late 1990s were at historically low levels, share repurchases were at historical highs. Was this a coincidence?

Question Six: Sustainable Growth. Plank's Plants had net income of $2,000 on sales of $50,000 last year. The firm paid a dividend of $500. Total assets were $100,000, of which $40,000 was financed by debt.

a. What is the firm's sustainable growth rate?

b. If the firm grows at its sustainable growth rate, how much debt will be issued next year?

c. What would be the maximum possible growth rate if the firm did not issue any debt next year?

Question Seven: Using Percentage of Sales. The 2003 financial statements for Growth Industries are presented below. Sales and costs in 2004 are projected to be 20 percent higher than in 2003. Both current assets and accounts payable are projected to rise in proportion to sales. The firm is currently operating at full capacity, so it plans to increase fixed assets in proportion to sales. What external financing will be required by the firm? Interest expense in 2004 will equal 10 percent of long-term debt outstanding at the start of the year. The firm will maintain a dividend payout ratio of .40. - see attached.

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