A bus company is considering acquisition of a bus for $100,000. The life of the bus is seven years. Then, it will be dispatched to the scrap yard. The bus manufacturer points out that the bus is available on lease as well for eight annual payments of $18,951 each with the first payment due immediately. The bus company would bear the costs of maintenance, insurance and operating. The marginal tax rate for the bus company and the manufacturer is 35%. The bus will be subject to MACRS schedule.

1) The borrowing rate for the bus company and the manufacturer is 10%. Assume the following: The depreciation schedule is on the straight line basis for the life of the lease. The manufacturer’s tax rate is 35%. and the bus company’s tax rate is 20%. Calculate the gain (or loss) to both the parties.

2) Other things being equal, the combined gains to lessor and lessee are highest when 1. The lessor’s tax rate is substantially higher than the lessee’s. 2. The depreciation tax shield is received early in the lease life. 3. The lease life is long and the lease payments are concentrated towards the end of the life. 4. The borrowing rate is high. If it were zero, then there would be no advantage to postpon- ing the tax.

Check these conditions out by doing a sensitivity analysis on the bus company’s lease, assuming that the lessee does not pay tax. Calculate the minimum lease payment that would satisfy the lessor and calculate the NPV. (Hint: The lessor would be charge a lease payment to the lessee such that the lessor would be at the indifference point.)

1. A lessor tax rate of 50% (instead of 35%).

2. Immediate 100% depreciation in year 0 (instead of MACRS).

3. A three-year lease with four annual payments (instead of seven-year lease with eight annual payments) with MACRS.

4. An interest rate of 20% (instead of 10%).