Question

Magna Charter has been asked to operate a Beaver bush plane for a mining company exploring north and west of Fort Liard. Magna will have a firm 1-year contract with the mining company and expects that the contract will be renewed for the 7-year duration of the exploration program. Magna has the following choices:

A. Purchase a plane for $1,000,000

B. Arrange for a 7-year operating lease from Stellar Leasing Company. Maintenance and insurance will be borne by Magna.

Lease payments will be of equal amounts each year, and due in advance at the beginning of each year. The plane falls in the 5-year class with respect to depreciation under the MACRS. Accordingly, the depreciation percentages are 20%, 32%, 19%, 12%, 11% and 6% respectively. The salvage value at the end of 7 years is estimated at $50,000. Magna’s pre-tax cost of debt is 10%. Magna has large tax-loss carry forwards; however, owing to AMT (Alternative Minimum Tax) provisions, its expected marginal tax rate is 20%. Stellar Leasing Co., on the other hand , is a highly profitable company and faces a marginal tax rate of 40%. Stellar can earn a pre-tax rate of return of 10% on investments of similar risk.

a. Evaluate the lease from the point of view of both Magna and Stellar assuming that the lease payment is $180,500. What is the range of lease payment that would acceptable from the Lessee and the Lessor’s view point.

Answer 1

Answer:

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Explanation:

Given details

1. Magna charter needs a plane for a time duration of 7 years, which can be taken on lease or bought from stellar leasing company

2. In the event that Magna charter has purchase the plane, it is qualified for depreciation, depreciation being the expense; it decreases the profit, then by profit amount.

3. Therefore tax savings on depreciation is the amount of cash inflow

4. correspondingly the lease rentals is expensive, consequently reducing the profit, thereby tax amount also.

5. Magna Charter will have to select the option that gives minimal cash out flows.

6. since the cash flows are in separate periods, & they cannot be compared, thus the cashflows are discounting to today's current value.

7. Discounting of Cash flows shall be done at post tax cost of debt, thus discount rate is 8% (10% * (1- 20%)) for Magna & 6% (10% * (1- 40%) ) for Stellar leasing company.

The diagrams in the attached images below explains Magna View point