Suppose Netflix Canada is considering the purchase of special software to facilitate its enhancement of video-on-demand services. In total, the firm will purchase $48 million in new software. This software will qualify for CCA deductions at a rate of 100%. However, because of the firm’s substantial loss carry forwards, Netflix estimates its marginal tax rate to be 10% over the next five years, so it will get very little tax benefit from the CCA deductions. Thus Netflix considers leasing the software instead. Suppose Netflix and the lessor face the same 8% borrowing rate, but the lessor has a 40% tax rate. For the purpose of this question, assume the software is worthless after five years, the lease term is five years, and the lease qualifies as a true tax lease.
a. What is the lease rate for which the lessor will break even?
b. What is the gain to Netflix with this lease rate?
c. What is the source of the gain in this transaction?
