A lease calls for payments of $1 million at the end of each of the next five years and payments of $2 million at the end of each of the following five years. The asset to be leased costs $10 million. The 10-year depreciation schedule to a residual value of $500,000 at the end of the lease term is given here. The lessee's marginal income tax rate is currently 40%. Its cost of 10-year secured debt is 12.5%. Its required return for the project is 15% after tax and 17.5% pretax.
a. Calculate the net advantage to leasing.
b. How would your answer to part a change if the lessee did not expect to pay any income taxes for the next three years but to pay income taxes each year thereafter at a 40% rate?
(Hint: Any tax losses in years 1 to 3 can be carried forward and realized in year 4.)
Year 1 2 3 4 5 6 7 8 9 10
Depreciation ($000) 2,000 1,750 1,500 1,250 1,000 400 400 400 400 400